Archive for December 12th, 2008

How Malta and Fiji got impacted?

December 12, 2008

I have been trying to post experiences of individual countries in this global crisis – Iceland, Hungary, Ukraine ,India, China, Taiwan and Korea. I came across 2 speeches which explain the situation of 2 island economies – Malta and Fiji.

Let us first see Malta’s case:

First, Malta has a small open economy, highly dependent on trade. As the recession grips our major markets, Maltese exporters will be increasingly affected. Indeed, firms in the automotive sector have already been hit, while the bleak outlook for the UK economy in particular is likely to have a negative impact on tourism. As the export sector comes under pressure, this will have an adverse effect on domestic demand. Accordingly, the Bank’s growth projections for 2009 have been revised downwards to under 2%. This, in turn, could have repercussions for the banking system as asset quality deteriorates.

Second, partly because of the small size of the economy, bank loan portfolios are highly concentrated. More specifically, domestic banks are exposed to the construction, mortgage, and property development sectors directly to the extent of over 50% of total loans, and in the  form of collateral securing other lending.

And now Fiji:

Fiji’s commodity exports will be affected insofar as external demand falls. Hence, demand-driven exports, such as tourism, water and garments are likely to slow down. Supply-driven exports, while unaffected from the global crisis, are bound by on-going structural constraints. Overall, there is likely to be a slowdown in the growth of total exports.

Personal remittances are likely to decline further.

Overall, imports are expected to rise. The weakening of the Fiji dollar, coupled with higher duty, is likely to raise the price of cement and cars out of Japan, dampening demand. On the other hand, the strengthening of the Fiji dollar against the Aussie and Kiwi dollars will lower food prices received from Australia and New Zealand. However, demand may be inelastic.

The trade balance may worsen.

Negative impact on Tourism revenues is the common problem in both.

IMF says commodity prices leads to inflation; BIS disagrees

December 12, 2008

Economists and economic research often leads to opposing ideas. This is what makes the field exciting for some and inconsistent for some. I came across 2 pieces of research which suggest opposite ideas.

BIS in its recent quarterly review has a paper by Stephen G Cecchetti and Richhild Moessner. It says:

Our evidence suggests that in recent years core inflation has not tended to revert to headline, which suggests that higher commodity prices have generally not spawned strong second-round effects on inflation.  

In another research from IMF:

 It appears inflation in the region has been driven primarily by a large increase in the relative price of commodities, in tandem with inflation elsewhere. With commodity prices falling rapidly in recent months, a key question is whether the run-up that started in 2003 was a temporary or a lasting phenomenon.

Then IMF goes onto show that rise in commodity prices  is a lasting phenomenon and monetary policy will be tested again as most of this inflation is of imported variety which cannot be managed by monetary policy.

What could lead to different findings? One,  sample size of both studies are different. BIS sample is of 19 economies of mixed variety and IMF on Asia-Pacific economies.  Two, econometric model looks to be different. But this is always the case with no two research using the same model (which makes economics exciting (or inconsistent).

Happy confusions!

What is liquidity trap?

December 12, 2008

 Gauti Eggertsson, a  NY Fed Economist has done considerable research on Great Depression, Liquidity Trap and Zero-bound interest rates. It is fascinating to see so many economists still doing so much research on great depression. With the crisis, I am sure more is to follow. No wonder, Fed Chairman Bernanke in his book on Great Depression said:

To understand the Great Depression is the Holy Grail of macroeconomics. Not only did the Depression give birth to macroeconomics as a distinct field of study, but also—to an extent that is not always fully appreciated—the experience of the 1930s continues to influence macroeconomists’ beliefs, policy recommendations, and research agendas. And, practicalities aside, finding an explanation for the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.

We do not yet have our hands on the Grail by any means, but during the past fifteen years or so substantial progress toward the goal of understanding the Depression has been made.

 I came across this superb primerfrom Eggertsson on a topic which is going to increase going ahead – liquidity trap. It is slightly technical with equations etc but one can skip it.

A liquidity trap is defined as a situation in which the short-term nominal interest rate is zero. The old Keynesian literature emphasized that increasing money supply has no effect in a liquidity trap so that monetary policy is ineffective.

The modern literature, in contrast, emphasizes that, even if increasing the current money supply has no effect, monetary policy is far from ineffective at zero interest rates. What is important, however, is not the current money supply but managing expectations about the future money supply in states of the world in which interest rates are positive.


To recall, Keynes main ideas came in force as US faced liquidity trap and Keynes said monetary policy is ineffective as interest rates had become zero. And then came the idea of using fiscal policy – govt expenditure, tax cuts etc to  pump-prime the economy. And we had a set of policies popularly called as Keynesian.

Then came the new theory post Milton Friedman, which said monetary policy is far from ineffective in liquidity trap. Even at zero interest rates monetary policy can do wonders (see this Vincent Reinhart speech for details). It is this second view which continues to be debates hugely by economists. It was debated during Japan’s deflation, US deflation scare in 2003 and is being debated now (debate is expected to grow severe going ahead).

What Eggertsson points out is the need to shape expectations in liquidity trap/zero interest rates.

The lesson of the irrelevance results is that monetary policy is ineffective if it cannot stir expectations. The previous section illustrated, however, that shaping expectations in the correct way can be very important for minimizing the output contraction and deflation associated with deflationary shocks. This, however, may be difficult for a government that is expected to behave in a discretionary manner. How can the correct set of expectations be generated?


 This shaping expectations is what is very difficult to do as Kazuo Ueda points in Japan’s case. The policies should be credible enough which leads to positive inflation expectations in the economy. Eggersson says government/central banks should follow a policy rule to stir expectations and it better be credible:

If the central bank, and the government as a whole, has a very low level of credibility, a mere announcement of future policy intentions through a new ‘policy rule’ may not be sufficient. This is especially true in a deflationary environment, for at least three reasons.

First, the deflation bias implies that the government has an incentive to promise to deliver future expansion and higher inflation, and then to renege on this promise.

Second, the deflationary shocks that give rise to this commitment problem are rare, and it is therefore harder for a central bank to build up a reputation for dealing with them well.

Third, this problem is even further aggravated at zero interest rates because then the central bank cannot take any direct actions (that is, cutting interest rate) to show its new commitment to reflation.


 It is like going in circles. What are the suggestions for way out?

Perhaps the most straightforward way to make a reflation credible is for the government to issue debt, for example by deficit spending. It is well known in the literature that government debt creates an inflationary incentive

Jeanne and Svensson (2006) and Eggertsson (2006a) show that foreign  exchange interventions also have this effect, for very similar reasons.The reason is that, if the government prints nominal liabilities (such as government bonds or money) and purchases foreign exchange, it will incur balance-sheet losses if it reneges on an inflation promise because this would imply an exchange rate appreciation and thus a portfolio loss.

Real government spending, that is, government purchases of real goods and services,can also be effective to this end (Eggertsson, 2005).




Very interesting paper.

P.S. One can even see Paul Krugman’s superb paper on liquidity trap. It is quite detailed though.

Assorted Links

December 12, 2008

1. Mankiw has an excellent post on various fiscal multipliers 

2. Krugman points Germany needs to coordinate on the fiscal response 

3. WSJ Blog points US Q4 GDP will be worse

4. MR points fin innovation continues

5. CMB says don’t blame Alan Greenspan

6. TTR points risk management is a governance issue and not rocket science

7. CTB points a new European institution to manage fin crisis


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