An Augmented Monetary An Augmented Monetary Conditions Index: A Framework Conditions Index: A Framework

and A Test with US Dataand A Test with US Data Prof Ho Lok SangProf Ho Lok Sang

DirectorDirectorCentre for Public Policy Studies Centre for Public Policy Studies Lingnan University Hong KongLingnan University Hong Kong

Objectives of this Talk:Objectives of this Talk:

To present a framework for evaluating if To present a framework for evaluating if monetary policy is consistent with “internal monetary policy is consistent with “internal balance” in the sense of full employment balance” in the sense of full employment and balanced budgetand balanced budget

To present initial results based on US dataTo present initial results based on US data

Key ResultsKey Results The proposed framework is useful and amenable The proposed framework is useful and amenable

to empirical testingto empirical testing US data suggests that the Fed has been biased US data suggests that the Fed has been biased

towards excessive conservatism and that its policy towards excessive conservatism and that its policy is an important contributing factor behind the is an important contributing factor behind the large fiscal deficits of the US governmentlarge fiscal deficits of the US government

Conversely, we could conclude that US fiscal Conversely, we could conclude that US fiscal policy was generally too expansionary and would policy was generally too expansionary and would have caused inflation if it had not been for the Fed have caused inflation if it had not been for the Fed to tighten up its monetary reins. to tighten up its monetary reins.

Mishkin(1999) discussed four monetary Mishkin(1999) discussed four monetary policy regimespolicy regimes

exchange rate targeting, e.g. HKDexchange rate targeting, e.g. HKD monetary aggregate targeting, e.g., monetary aggregate targeting, e.g.,

Germany before the European monetary Germany before the European monetary union and Switzerlandunion and Switzerland

inflation targeting, e.g. New Zealand, UK, inflation targeting, e.g. New Zealand, UK, CanadaCanada

an eclectic approach, e.g. US under an eclectic approach, e.g. US under Greenspan Greenspan

Our Innovation: How About Targeting an MCI?Our Innovation: How About Targeting an MCI?

(1) aggregate demand at the full (1) aggregate demand at the full employment output level (full employment output level (full employment without overheating) employment without overheating)

(2) fiscal budget balance at full (2) fiscal budget balance at full employment (fiscal sustainability), employment (fiscal sustainability), and and

(3) monetary conditions should be (3) monetary conditions should be compatible with full employment compatible with full employment budget balance (IB compatibility budget balance (IB compatibility condition).condition).

Three desirable conditionsThree desirable conditions

Theoretical Framework Theoretical Framework

GDP GDP Yd +T-B Yd +T-B When aggregate demand is in equilibrium, When aggregate demand is in equilibrium,

income must be equal to expenditures, so income must be equal to expenditures, so we have:we have:

Yd +T-B = C + I + G + X- MYd +T-B = C + I + G + X- M This is the Keynesian cross condition for This is the Keynesian cross condition for

aggregate demand equilibrium, which can aggregate demand equilibrium, which can be transposed to obtain:be transposed to obtain:

T-G-B = I-S-(M-X). T-G-B = I-S-(M-X). This says Government Savings (GS) = This says Government Savings (GS) =

Private Sector Savings Deficiency (PD). Private Sector Savings Deficiency (PD).

The Fiscal Conditions IndexThe Fiscal Conditions Index

T-G-B, or GS by notation, can be written as a fuT-G-B, or GS by notation, can be written as a function of effective tax rate, lumpsum tax, governction of effective tax rate, lumpsum tax, government expenditures, and the GDP Y. Setting Gnment expenditures, and the GDP Y. Setting GS = 0, we can write Y as a function g(t, t0, G), wiS = 0, we can write Y as a function g(t, t0, G), with the following properties:th the following properties:

g’1< 0 , g’2 < 0, and g’3 > 0g’1< 0 , g’2 < 0, and g’3 > 0 g is an indicator of fiscal conditionsg is an indicator of fiscal conditions Dividing g by the potential GDP yields the FiscaDividing g by the potential GDP yields the Fisca

l Conditions Index.l Conditions Index.

Figure 2: Achieving Full Employment Equilibrium and Budget BalanceInternal Balance: full employment with budget balance whereby GS is positioned at GS* and the (r*, e*) combination would position PD at PD*

Y

GS*=T-G-B

PD*=I-S-(M-X)

Full employment GDPGS,PD

The Monetary Conditions IndexThe Monetary Conditions Index

Let us express the private savings gap PD as a fLet us express the private savings gap PD as a function of r, e, Y, W:unction of r, e, Y, W:

PD = I(r,e) – [Yd(Y) – C(Yd(Y), W, r)] + X(e)– M (Yd(Y), e)PD = I(r,e) – [Yd(Y) – C(Yd(Y), W, r)] + X(e)– M (Yd(Y), e)

Setting PD = 0, we can write Y as a function m( Setting PD = 0, we can write Y as a function m( r, e, W). r, e, W).

Diagramatically, setting PD=0 focuses our atteDiagramatically, setting PD=0 focuses our attention on the horizontal axis. ntion on the horizontal axis.

MCI = Y(PD=0)/PGDPMCI = Y(PD=0)/PGDP

Three Alternative Approaches to Three Alternative Approaches to Estimating potential GDPEstimating potential GDP

Hodrick Prescott filter used at nominal GHodrick Prescott filter used at nominal GDP data(A)DP data(A)

HP filter used at real data, then reflated HP filter used at real data, then reflated to nominal values(B)to nominal values(B)

Assume natural rate of unemployment tAssume natural rate of unemployment to be at 4.5%, which historically produceo be at 4.5%, which historically produced little inflation pressures and permitted d little inflation pressures and permitted balancing of the Budget.(C)balancing of the Budget.(C)

MCI(B)MCI(B)

MCI(C)MCI(C)

US Deficits Ratio HistoricalUS Deficits Ratio Historical

(Office of Management and Budget:(Office of Management and Budget: % of GDP % of GDP at far rightat far right

Some explanations about the exchange ratSome explanations about the exchange rate index used: Based on A New Indexed Unie index used: Based on A New Indexed Unit of Account called the World Currency Unit of Account called the World Currency Uni

t(Ho, 2000):t(Ho, 2000):

Basket is a basket of “global output.” By design, the WCU Basket is a basket of “global output.” By design, the WCU basket consists of the GDPs(outputs) of the key economic zbasket consists of the GDPs(outputs) of the key economic zones in the base year 0. ones in the base year 0.

Let QLet Qi0i0 be the GDP of country/zone i in base year 0, measu be the GDP of country/zone i in base year 0, measu

red in the domestic currency. Thus red in the domestic currency. Thus

1 WCU1 WCU00 = = { Q{ Q1010 ,Q ,Q2020 ,Q ,Q3030 , Q , Q4040, Q, Q5050 } } [1][1]

This says that a WCUThis says that a WCU00 is some fraction is some fraction of the basket of base year GDPs. of the basket of base year GDPs.

Valuation of this unit in the base year, VValuation of this unit in the base year, V0US$00US$0 , is obtained by defining , is obtained by defining such that: such that:

QQi0i0 . e . e i0i0 = US$ 100 = US$ 100 [2],[2],

where:where: Q Qi0i0 . e . e i0 i0 is the nominal value of the GDPs in the base year in US dollars, and is the nominal value of the GDPs in the base year in US dollars, and

ee i0 i0 is the exchange rate converting one unit of the currency of i into US$ in year 0; is the exchange rate converting one unit of the currency of i into US$ in year 0;

is a scaling factor that defines the size of the basket and thus the real value of the is a scaling factor that defines the size of the basket and thus the real value of the unit;unit;

Valuation of the WCU:Valuation of the WCU: VV0US$t 0US$t = = Q Qi0i0 .P .Pitit/P/Pi0i0 .e .e it.it. [3] [3]

This implies the USD is overvalued by 20 to 25 per cent relative to what is necessary for balanced budget and full employment.

Table 3 Normalized Cointegrating CoefficientsTable 3 Normalized Cointegrating Coefficients Dependent Variable HK Exports IndexDependent Variable HK Exports Index

HKRE OGDP Constant

Coefficients(t-statistics)

-1.7306(11.6816)***

1.8135(9.2648)***

15.3521

*** denotes significance at 1% level

Table 4 Error Correction Estimates. Table 4 Error Correction Estimates. Dependent Variable: D(HKEXI)Dependent Variable: D(HKEXI)

ECM (-1) D(HKEXI) (-1) D(HKRE) (-1) D(OGDP) (-1) Constant

Coefficient(t-statistics)

-0.2078(-4.9984)***

0.1190(1.2399)

0.1078(0.7568)

1.3664(1.5402)

0.0157(2.2242)**

1. D denotes first differences2. ECM denotes error correction term3. ** and *** denote significance at 5% and 1% level respectively4. Adj. R2 = 0.3433

e: real effective exchange rate index

eUS$ : Price of the local currency in US dollars, or US$ exchange rate

HKEXI : Hong Kong Total Exports Volume Index 2000=100

HKRE : WCU / HKD (The price of HKD in WCU)

HKWCt : Price of WCU in Hong Kong dollars at time t.

OGDP : OECD GDP Volume Index 2000=100

P : Domestic price level, measured as consumer price index

List of Variables and their List of Variables and their DescriptionsDescriptions

R : Local nominal prime rate

r : Real interest rate defined in WCU0

REt :Real exchange rate defined relative to the WCU0, = P*eUS$/V0US$t

WCU0 : World currency unit basket of GDPs in base year 0.

V0US$t : Valuation of WCU0 in US dollars at time t.