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

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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 PLEASE DO NOT QUOTE Overview The long expansion in the UK was preceded by

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SLIDE 1

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

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SLIDE 2

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

  • n 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

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SLIDE 3

External Balance in the UK

Current Account/GDP over time

Real FX rate over time

80 90 100 110 120 130 140 150 160 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1 ‐6 ‐4 ‐2 2 4 6 1975Q1 1980Q1 1985Q1 1990Q1 1995Q1 2000Q1 2005Q1

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SLIDE 4

Index of Financial liberalisation

0.00 0.20 0.40 0.60 0.80 1.00 1.20 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

Australia Belgium Canada Finland France Italy Japan Netherlands Norway Portugal Sweden

United Kingdom

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.

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SLIDE 5

Index of Labour Market Liberalisation

1 2 3 4 5 6 7 8 9 10 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

Australia Belgium Canada Finland France Italy Japan Netherlands Norway Portugal Sweden

United Kingdom

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.

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SLIDE 6

Index of Product Market Liberalisation

1 2 3 4 5 6 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

Australia Belgium Canada Finland France Italy Japan Netherlands Norway Portugal Sweden

United Kingdom

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.

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SLIDE 7

Index of FX Regime Flexibility

We use the de‐facto fine classification from Ilzetzki, Reinhart and Rogoff (2012). Higher values indicate greater flexibility.

2 4 6 8 10 12 14 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

Australia Belgium Canada Finland France Italy Japan Netherlands Norway Portugal Sweden United Kingdom United States

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SLIDE 8

Economic Theory

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

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SLIDE 9

Economic theory (ii)

Type of Liberalisation Impact of current account reaction to monetary policy

Financial Effect via loosening liquidity constraints  greater fraction of the population responding to interest rate changes  income absorption effect becomes stronger Labour i) Removal of wage rigidity makes  makes 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 Exchange Rate Greater FX flexibility  Adjustment of Current Account should be smaller

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SLIDE 10

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

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SLIDE 11

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

  • bservables  allows for conditional impulse

responses

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SLIDE 12

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

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SLIDE 13

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

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SLIDE 14

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

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SLIDE 15

Identification scheme

Consumption Consumer prices interest rates Current Account Real exchange rate Supply Shock ? Demand Shock ? Monetary Policy Shock ?

  • 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

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SLIDE 16

How does Monetary policy affect the Current account balance?

10 20

  • 1

1 2 3 Consumption bas eline 10 20 2 4 6 8 CPI 10 20

  • 2
  • 1

1 2 Short Rate 10 20

  • 2
  • 1

1 2 CA/GDP 10 20

  • 3
  • 2
  • 1

1 Real FX Rate

Median 16th Quantile 84th Quantile

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SLIDE 17

Does the effect vary with financial liberalisation?

10 20

  • 1

1 2 Consumption Fin Repressed 10 20

  • 5

5 CPI 10 20

  • 2
  • 1

1 Short Rate 10 20

  • 2

2 CA/GDP 10 20

  • 4
  • 2

2 Real FX Rate 10 20

  • 2

2 4 Consumption Fin Liberalised 10 20 5 10 CPI 10 20

  • 2

2 4 Short Rate 10 20

  • 2

2 CA/GDP 10 20

  • 5

5 Real FX Rate 10 20

  • 1

1 2 Consumption Difference 10 20

  • 5

5 CPI 10 20

  • 1

1 2 Short Rate 10 20

  • 1

1 CA/GDP 10 20

  • 1

1 2 Real FX Rate Median 16th Quantile 84th Quantile

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SLIDE 18

Does the effect vary with labour market liberalisation?

10 20

  • 1

1 2 Consumption Rigid Labour Market 10 20 2 4 6 CPI 10 20

  • 2
  • 1

1 Short Rate 10 20

  • 1

1 2 CA/GDP 10 20

  • 4
  • 2

2 Real FX Rate 10 20

  • 2

2 4 6 Consumption Flexible Labour Market 10 20 5 10 CPI 10 20

  • 2

2 4 Short Rate 10 20

  • 4
  • 2

2 CA/GDP 10 20

  • 4
  • 2

2 4 Real FX Rate 10 20

  • 1

1 2 Consumption Difference 10 20

  • 2

2 4 CPI 10 20

  • 0.5

0.5 1 1.5 Short Rate 10 20

  • 1.5
  • 1
  • 0.5

0.5 CA/GDP 10 20

  • 1
  • 0.5

0.5 1 Real FX Rate Median 16th Quantile 84th Quantile

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SLIDE 19

Does the effect vary with product market liberalisation?

10 20

  • 2

2 4 Consumption Regulated Product Market 10 20 5 10 CPI 10 20

  • 2
  • 1

1 2 Short Rate 10 20

  • 2
  • 1

1 2 CA/GDP 10 20

  • 4
  • 2

2 Real FX Rate 10 20

  • 1

1 2 Consumption Deregulated Product Market 10 20

  • 4
  • 2

2 4 CPI 10 20

  • 4
  • 2

2 Short Rate 10 20

  • 1

1 2 CA/GDP 10 20

  • 6
  • 4
  • 2

2 Real FX Rate 10 20

  • 1

1 2 Consumption Difference 10 20

  • 6
  • 4
  • 2

2 CPI 10 20

  • 1.5
  • 1
  • 0.5

0.5 Short Rate 10 20

  • 1

1 2 CA/GDP 10 20

  • 2
  • 1

1 Real FX Rate Median 16th Quantile 84th Quantile

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SLIDE 20

Does the effect vary with FX Regime?

10 20

  • 1

1 2 Consumption Fixed FX 10 20 2 4 6 8 CPI 10 20

  • 2
  • 1

1 2 Short Rate 10 20

  • 2
  • 1

1 2 CA/GDP 10 20

  • 4
  • 2

2 Real FX Rate 10 20 1 2 3 4 Consumption Flexible FX 10 20 5 10 CPI 10 20

  • 2
  • 1

1 2 Short Rate 10 20

  • 2
  • 1

1 2 CA/GDP 10 20

  • 4
  • 2

2 Real FX Rate 10 20

  • 0.5

0.5 1 1.5 Consumption Difference 10 20

  • 1

1 2 3 CPI 10 20

  • 0.5

0.5 1 Short Rate 10 20

  • 1
  • 0.5

0.5 1 CA/GDP 10 20

  • 1

1 2 Real FX Rate Median 16th Quantile 84th Quantile

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SLIDE 21

Impulse Response Summary

  • Financial/Labour market liberalisation lead income‐absorption

to outweigh expenditure switching effect

  • Product market liberalisation leads expenditure switching to
  • utweigh income‐absorption effect (Most relevant for the UK)
  • Results are robust to identification with choleski

decomposition

Financial Labour Product FX Regime CA response when market is repressed/regulated

+ + ‐

CA response when market is liberalised/ regulated

‐ ‐ + ‐

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SLIDE 22

What explains macroeconomic

  • utcomes in the UK?

‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2 Unexplained Aggregate Supply Aggregate Demand Monetary Policy Consumption Growth

‐0.014 ‐0.012 ‐0.01 ‐0.008 ‐0.006 ‐0.004 ‐0.002 0.002

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2 Unexplained Aggregate Supply Aggregate Demand Monetary Policy CPI Inflation

Consumption Growth Baseline Inflation Baseline

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SLIDE 23

What explains macroeconomic

  • utcomes in the UK? (II)

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

‐0.2 ‐0.15 ‐0.1 ‐0.05 0.05 0.1

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Real FX Rate

Current Account Baseline Exchange Rate Baseline

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SLIDE 24

How would outcomes look like in the absence of financial liberalisation?

‐0.03 ‐0.02 ‐0.01 0.01 0.02 0.03 Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 25

How would outcomes look like in the absence of labour market liberalisation?

‐0.05 ‐0.04 ‐0.03 ‐0.02 ‐0.01 0.01 0.02 0.03 Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 26

How would outcomes look like in the absence of product market liberalisation?

‐0.02 ‐0.01 0.01 0.02 0.03 0.04 0.05

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 27

How would outcomes look like in the absence of FX regime liberalisation?

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 28

How would the shocks need to look like to reach the same outcome in absence of Financial Liberalisation ?

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Current Account Baseline

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SLIDE 29

How would the shocks need to look like to reach the same outcome in absence

  • f Labour Market Liberalisation?

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02 Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Current Account Baseline

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SLIDE 30

How would the shocks need to look like to reach the same outcome in absence

  • f Product Market Liberalisation ?

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 31

How would the shocks need to look like to reach the same outcome in absence of FX Regime Liberalisation ?

‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q4 1993 Q3 1994 Q2 1995 Q1 1995 Q4 1996 Q3 1997 Q2 1998 Q1 1998 Q4 1999 Q3 2000 Q2 2001 Q1 2001 Q4 2002 Q3 2003 Q2 2004 Q1 2004 Q4 2005 Q3 2006 Q2

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account ‐0.03 ‐0.025 ‐0.02 ‐0.015 ‐0.01 ‐0.005 0.005 0.01 0.015 0.02

1992 Q1 1992 Q3 1993 Q1 1993 Q3 1994 Q1 1994 Q3 1995 Q1 1995 Q3 1996 Q1 1996 Q3 1997 Q1 1997 Q3 1998 Q1 1998 Q3 1999 Q1 1999 Q3 2000 Q1 2000 Q3 2001 Q1 2001 Q3 2002 Q1 2002 Q3 2003 Q1 2003 Q3 2004 Q1 2004 Q3 2005 Q1 2005 Q3 2006 Q1 2006 Q3

Unexplained Aggregate Supply Aggregate Demand Monetary Policy Current Account

Current Account Baseline Current Account

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SLIDE 32

Conclusion

  • Product market liberalisation and labour

market liberalisation played major, but

  • ffsetting, roles in the evolution of the UK’s

balance of payments during the long expansion.

  • Financial market liberalisation was not an

important factor.