L-1 Macroeconomic Stability,
Macroeconomic Policies, and
Macro-Prudential Policies
Presenter
Clinton Shiells
Joint China-IMF Training Program
Course on Macroeconomic Management
and Financial Sector Issues
CT
Outline
What is macroeconomic stability and why do we care?
Policies for macroeconomic stability
Fiscal policy
Monetary policy
Exchange rate policy
The financial sector and macroeconomic stability
Macro-prudential policies
2This training material is the property of the International Monetary Fund (IMF) and is intended for use in IMF Institute courses. Any reuse requires the permission of the IMF Institute.”
What is Macroeconomic Stability
and Why Do We Care?
3MMF
What do we mean by “macroeconomic
stability”?
• Macroeconomic stability exists when key economic
relationships are in balance:
– Internal balance occurs when real output is at or close to its
capacity level and the inflation rate is low and non-accelerating
– External balance occurs when the current account position can
be sustained by capital flows on terms compatible with the
growth prospects of the economy without resort to restrictions on
trade and payments
4MMF
Why do we care about macro stability?
• “In practice, the concept of a stable macroeconomic
framework is used to mean a macroeconomic policy
environment that is conducive to growth.” Fischer (1993)
• “Conceptually, macroeconomic instability refers to
phenomena that decrease the predictability of the
domestic macroeconomic environment, and it is of
concern because unpredictability hampers resource-
allocation decisions, investment and growth.” Montiel
and Servén (2005)
5MMF
Volatility and growth
Source: Ramey & Ramey (AER, 1995)
92 countries, 1962-85
Growth = – Vol
()
R2 =
There appears to be a
negative relationship
between the average and
the standard deviation of
per capita GDP growth,
both calculated over long
periods.
6MMF
Volatility and growth
Source: Hnatkovska and Loayza (2005)
79 countries, 1960-2000
“Norm
al” vol
atility
vs. “c
risis”
volatil
ity?
7MMF
Crisis volatility
Source: WEO (Ch. IV, Oct. 2009)
8MMF
(Log scale)
Output costs of crises
Le
ve
l o
f o
ut
pu
t
Le
ve
l o
f o
ut
pu
t
Source: Cerra and Saxena (2008)
9MMF
Output costs of crises
Source: WEO (Ch. IV, Oct. 2009)
On average, output falls steadily
below its pre-crisis trend until the
third year after the crisis and does
not rebound thereafter.
First year of crisis at t=0
Mean difference from year t=-1
1 The interquartile range indicates the middle 50% of all crises
88 banking crises from early 1970s to 2002
222 currency crises from early 1970s to 2002
Output evolution after banking crises
(Percent of pre-crisis trend)
Output evolution after currency crises
(Percent of pre-crisis trend)
Year
Year
10MMF
GDP growth
Source: WEO (October 2013)
11MMF
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
0
2
4
6
8
10
-2
-4
-6
Real GDP growth
Annual percent change
Advanced economies Emerging market and developing economies
Output growth volatility
Source: WEO (Ch. V, Oct. 2007)
Before the global financial crisis, output growth volatility had been steadily
declining from its peak during the 1970s.
12MMF
Output growth volatility
Source: WEO (Ch. V, Oct. 2007)
(Rolling 10-year standard deviations of detrended growth)
13MMF
Volatility patterns
Source: WEO (Ch. V, Oct. 2007)
Growth takeoff
begins in time t=0
on the x-axis.
(1950 for Brazil,
Japan, Mexico,
W. Germany;
1963 for Korea;
1979 for China;
1984 for India)
14MMF
Policies for
Macroeconomic Stability
15MMF
What causes macroeconomic instability?
• Exogenous shocks
– ., terms of trade shocks, natural disasters, financial
contagion, etc.
• Inappropriate policies
– ., excessively loose fiscal policy
16MMF
What should policymakers do?
• Remove destabilizing policies that are themselves
sources of shocks
– ., tighten excessively loose fiscal policy
– Depends on the institutional setting
• Use policies as stabilizing instruments in response to
exogenous shocks
– ., countercyclical fiscal policy
– Depends on how vulnerable the economy is to shocks
17MMF
Policies for macroeconomic stability
• Fiscal policy
• Monetary policy
• Exchange rate policy
• Financial sector policies
18MMF
Fiscal policy
• If fiscal policy is the cause of macroeconomic instability,
strengthening the fiscal balance will promote internal
balance and external balance
CAB = S I = (Sg Ig) + (Sp Ip)
• Key measures:
– Expenditure restraint, expenditure reallocation
– Revenue-raising initiatives (tax and non-tax)
• Fiscal reform must be permanent in order to be credible
19MMF
Public sector solvency condition
• The present value (PV) of primary surpluses (T-G) and
seigniorage revenue (dM) should be at least as large as
the government’s outstanding stock of net debt (B):
PV { T-G + dM } = B
• Stability requires that the authorities choose a monetary
and fiscal policy stance that is consistent with
maintaining public sector solvency at low levels of
inflation, while leaving some scope for mitigating the
impact of real and financial shocks on macroeconomic
performance
20MMF
Fiscal policy over the cycle
• Old view: Limited role for fiscal policy relative to
monetary policy
– Focus on debt sustainability and fiscal rules to achieve this
• New view: Countercyclical fiscal policy is an important
tool
– Create more fiscal space in good times: lower target debt levels
– Design better automatic fiscal stabilizers: rules that allow some
transfers or taxes to vary based on pre-specified triggers tied to
the state of the economic cycle
21MMF
Fiscal balances
Source: WEO (Ch. I, Oct. 2009)
General government fiscal balances
(Percent of GDP)
22MMF
Fiscal volatility
(Unweighted averages)
4 Defined as the rolling 10-year standard deviation of cyclically adjusted government consumption as a
percent of GDP
Source: WEO (Ch. V, Oct. 2007)
23MMF
Fiscal volatility: East Asia
Source: Olaberria and Rigolini (PRWP 4989, 2009)
East Asia displays a high correlation
between the volatility of fiscal policy and
output growth volatility ()
Volatility of government spending is measured as the weighted average standard deviation of detrended
government consumption growth using a 10-year window. Output volatility is measured as the standard
deviation of per capita GDP growth using a 10-year window.
24MMF
Procyclical fiscal policy: Developing countries
Source: Ilzatzki and Vegh (NBER WP 14191, 2008)
A 10% shock to GDP leads to an increase of around 3% in
government consumption after 2 quarters.
27 developing countries, 1960-2006Response of
real
government
consumption
to GDP
shock
25MMF
Public debt
Source: WEO (October 2013)
26MMF
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
0
20
40
60
80
100
120
General Government Debt
Percent of GDP
Advanced economies Emerging market and developing economies
Monetary policy
• Fiscal dominance
– “The roots of inflation are ultimately fiscal.”
• Strengthening central bank independence may be
important for credibility
• Rules versus discretion
• Effectiveness of monetary policy for macroeconomic
stabilization depends on the exchange rate regime and
the degree of international financial integration
27MMF
Inflation
Source: WEO (October 2013)
28MMF
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
0
1
2
3
4
5
6
7
8
9
10
Consumer price inflation
Annual percent change
Advanced economies Emerging market and developing economies
The Great Moderation
Source: Bean (2009)
29MMF
Monetary policy credibility
Source: WEO (Ch. III, Apr. 2006)
Minimum = 0; Maximum = 1
30MMF
Central bank autonomy
Source: WEO (Ch. III, Oct. 2008)
This index captures the ability of a central bank to pursue independent monetary policy
31MMF
Monetary policy index
(Unweighted averages)
Source: WEO (Ch. V, Oct. 2007)
This index measures the success of the monetary framework in maintaining low inflation
3/ Defined as exp[– * (inflation – 2%)2]
32MMF
Credit expansion
Financial liabilities of household and business
(Percent of GDP)
• If monetary policy was so advanced in the advanced
economies, why was there a credit boom in the run-up to
the crisis?
Source: Bean (2009)
33MMF
Deviation of policy rates from Taylor rule
Source: Bean (2009)
• Was monetary policy too expansionary?
34MMF
Monetary policy and housing booms
Source: WEO (Ch. III, Oct. 2009)
Euro area economies are designated by blue squares. Other advanced economies are designated by red squares. Blue
lines are fitted to a subsample of euro area economies. Black lines are fitted to the whole sample of advanced economies.
• Did expansionary monetary policy lead to asset price booms?
35MMF
Exchange rate policy
• Goals of exchange rate policy:
– Promote competitiveness and a sustainable current account
position
– Serve as a credible nominal anchor (in the case of a peg)
• What is the appropriate level of the real exchange rate?
– One that ensures a sustainable current account balance
• When is an exchange rate adjustment needed?
Possible signals:
– Noticeable parallel market in foreign exchange
– Large and persistent current account deficits
– Large and sustained appreciation in the real effective exchange
rate
36MMF
Currency crashes
Source: Reinhart and Rogoff (2009)
Share of countries with
annual depreciation
greater than 15%,
1800-2006
Median Annual Depreciation,
All countries, 5-year moving average,
1800-2006
37MMF
Limitations of macroeconomic stabilization
• Macroeconomic stabilization can achieve low inflation
and external sustainability...
• ... But stabilization alone is often not enough to achieve
rapid growth and higher real incomes.
• Structural reform must usually accompany stabilization
to achieve higher incomes.
• Structural reform may also be needed for the credibility
of an adjustment program.
38MMF
Examples of structural reforms
• Financial sector policies
– Financial sector development and regulation
• External sector reforms
– Trade liberalization, capital account liberalization
• Price adjustment and liberalization
– Wage policy, administered prices, etc.
• Policies to promote competition
• Tax, expenditure, and budgetary reforms
• State enterprise reform, privatization, restructuring
39MMF
The Financial Sector and
Macroeconomic Stability
40MMF
Financial sector policy
• An efficient domestic financial system is important for
growth
• A sound domestic financial system is important for
macroeconomic stability
• A sound domestic financial system requires regulation
and oversight
• Financial liberalization should be a means to achieving
an efficient financial system, not an end in itself
41MMF
Financial system
An efficient financial
system allocates
capital to the most
productive uses and
continually monitors
the use of funds
Key services provided by the financial system
Lenders / Savers
Borrowers /
Spenders
Conveys information Increases liquidity
Reduces risk
42MMF
Financial development and growth
Financial
development
Higher income per
capita
Higher net worth lower monitoring
costs, thicker securities markets
More public goods that facilitate
financial intermediation
Higher investment
Higher productivity
More incentive to save
43MMF
Financial development and growth
Dependent variable DEPTH (1960) R2
Real per capita GDP growth, 1960-89
**
()
Real per capita capital growth, 1960-89
**
()
Productivity growth, 1960-89
**
()
Source: Levine (1997)
44MMF
Financial sector and macroeconomic stability
• Banking crises and financial market crises can directly
cause macroeconomic instability
• Financial market conditions can amplify real shocks and
the business cycle
– Financial accelerator
• Financial sector weakness can decrease the
effectiveness of macro policy tools during a crisis
– Disrupt transmission links between monetary policy and
operating targets
– Weaken supply response to exchange rate changes
45MMF
Systemic banking crises and recessions
Source: Reinhart and Rogoff (2008)
Spain, 1977
Japan, 1992
Norway, 1987
Philippines, 1997
Sweden, 1991
Hong Kong, 1997
Colombia, 1998
Korea, 1997
Historical Average
Malaysia, 1997
Finland, 1991
Thailand, 1997
Indonesia, 1997
Argentina, 2001
., 1929
%
Duration of downturn (in years)Percent decline in real GDP
Past Real Per Capita GDP Cycles and Banking Crises: Peak-to-trough
46MMF
Credit crunches, asset price busts, and
recessions
Recessions
associated with
credit crunches and
asset price busts
are longer and are
associated with
greater output
losses than
recessions without
such financial
stresses.
Source: Claessens, Kose, and Terrones (2008)
47MMF
Financial accelerator
• The effects of a real shock on financial conditions can
lead to persistent fluctuations in the economy.
– External finance (raising funds from lenders) is more expensive
than internal finance (using internally generated cash flows).
– The external finance premium that a borrower must pay depends
inversely on the strength of the borrower's financial position (net
worth).
– Positive shocks increase net worth, reduce the cost of credit,
and induce more investment and consumption; negative shocks
reduce net worth, increase the cost of credit, and induce less
investment and consumption. Hence shocks are amplified and
become more persistent.
48MMF
Bank-lending channel
• Shocks affecting the net worth and liquidity of banks, and
thus their creditworthiness, in turn affect the external
finance premium that banks face and will be reflected in
the cost and availability of funds to bank-dependent
borrowers.
49MMF
Financial regulation
• Old view: Financial regulation is outside the macro policy
framework; its objective is to keep individual institutions
and markets behaving prudently.
– Micro-prudential regulation
• New view: Financial regulation is not macroeconomically
neutral; it can be used as a cyclical policy tool.
– Macro-prudential regulation
Need for a policy approach that falls between macroeconomic
management and traditional prudential regulation of financial
institutions
50MMF
Macro stability and risk perceptions
“A tendency of people to underestimate future risks during periods of good
economic performance seems to be a recurring theme in the history of
financial markets. “ (Bean, 2009)
Implied volatilities from options
(standardized to zero mean and unit variance)
•Chicago Board Options
Exchange Volatility Index
(VIX) measures implied
volatility of S&P 500 index
options
•Merrill Lynch Option
Volatility Estimate Index
(MOVE) measures implied
volatility on 1-month
Treasury options
Source: Bean (2009)
51MMF
Feedback on the way up
• In the up-phase of the
economic cycle:
– Price-based measures of
asset values rise, price-based
measures of risk fall, and
competition to grow bank
profits increases.
– Market discipline encourages
financial institutions to
respond by increasing
leverage (using short-term
“wholesale” funding).
Increase
balance sheet size
Stronger
balance sheets
Increase leverage
Asset price boom
52MMF
Feedback on the way down
• In the down-phase of the
economic cycle:
– Probability of default on
assets rises balance
sheets weaken.
– Banks sell assets to satisfy
liquidity runs by investors or
to re-establish capital ratios
(“fire sale”).
– Sale of assets by one
institution decreases the
value of all similar assets held
by other institutions (mark-to-
market valuation)
downward price spiral.
Reduce
balance sheet size
Weaker
balance sheets
Decrease leverage
Asset price bust
53MMF
Countercyclical regulation?
• Overall goal: To maintain a stable provision of financial
services to the wider economy—payments services,
credit supply, and insurance against risk
– Specifically: To reduce the size, frequency, and damage created
by asset price bubbles linked to excessive credit booms
• 2 approaches:
– Increase the financial system’s resilience as cyclical risks rise
– Identify those institutions and markets that present substantial
systemic risk and increase their resilience across the board, not
just when cyclical risks seem most pressing
MMF 54
Macro-prudential policy tools
Old
• Limit the total amount of credit provided by banks
• Control the amount of leverage that can be employed in asset
purchases
– Margin requirements, maximum loan-to-value ratio for mortgages
• Limit the interest rate that banks and other depository
institutions can pay on their deposits
New
• Counter-cyclical bank capital requirements
– Adjust capital ratios up to reduce the incentives to provide credit
during booms that threaten to become bubbles
• Dynamic provisioning for loan loss reserves
– Require banks to set aside higher levels of reserves for future loan
losses during an upswing
MMF 55
Macro Prudential
Macroeconomic
Policies
Microprudential
Policy
Price Stability
Economic Activity
Idiosyncratic Risk
Policies and Objectives
How we see the world now
Macroprudential
Policy
Financial Stability
Systemic Risk
C C
