Output, exchange rates, earnings growth and stock markets (II)
Output, exchange rates, earnings growth and stock markets (II)
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FINC5090 Finance in The Global Economy
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Lecture 8 National income, exchange rate, earnings growth and stock markets (II)
Permanent changes in monetary and fiscal policy
Macroeconomic policies and the current account
Economic growth and stock markets
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1. Permanent changes in monetary and fiscal policy: monetary policy
“Permanent” policy changes are those that are assumed to modify people’s expectations about exchange rates in the long run.
A permanent increase in the quantity of monetary assets supplied has several effects:
It lowers interest rates in the short run and makes people expect future depreciation of the domestic currency, increasing the expected rate of return on foreign currency deposits.
The domestic currency depreciates (E rises) more than is the case when expectations are constant (overshooting).
The AA curve shifts up (right) more than is the case when expectations are held constant.
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Short-run effects of a permanent increase in the money supply
A permanent increase in the money supply, which shifts AA1 to AA2 and moves the economy from point 1 to point 2, has stronger effects on the exchange rate and output than an equal temporary increase, which moves the economy only to point 3.
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Long-run effects of a permanent increase in the money supply
In the long-run, price is flexible and will sufficiently adjust to the changes in monetary policy (higher wages and output prices).
After a permanent money supply increase, a steadily increasing price level shifts the DD and AA schedules to the left until a new long-run equilibrium (point 3) is reached.
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1. Permanent changes in monetary and fiscal policy: fiscal policy
A permanent increase in government purchases or reduction in taxes
increases aggregate demand
makes people expect the domestic currency to appreciate in the short run due to increased aggregate demand, thereby reducing the expected rate of return on foreign currency deposits and making the domestic currency appreciate.
The first effect increases aggregate demand of domestic products, the second effect decreases aggregate demand of domestic products (by making them more expensive).
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Effects of a permanent fiscal expansion
If the change in fiscal policy is expected to be permanent, the first and second effects exactly offset each other, so that output remains at its potential or natural (or long run) level.
We say that an increase in government purchases completely crowds out net exports, due to the effect of the appreciated domestic currency.
Because a permanent fiscal expansion changes exchange rate expectations, it shifts AA1 leftward as it shifts DD1 to the right. The effect on output (point 2) is nil if the economy starts in long-run equilibrium. A comparable temporary fiscal expansion, in contrast, would leave the economy at point 3.
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2. Macroeconomic policies and current account: XX curve
derive the XX curve to represent the combinations of output and exchange rates at which the current account is at its desired level.
As income from production increases, imports increase and the current account decreases when other factors remain constant.
To keep the current account at its desired level, the domestic currency must depreciate as income from production increases: the XX curve should slope upward.
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2. Macroeconomic policies and current account: XX curve
Along the curve XX, the current account is constant at the level CA = X. Monetary expansion moves the economy to point 2 and thus raises the current account balance. Temporary fiscal expansion moves the economy to point 3, while permanent fiscal expansion moves it to point 4; in either case, the current account balance falls.
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2. Macroeconomic policies and current account: XX curve
The XX curve slopes upward but is flatter than the DD curve.
DD represents equilibrium values of aggregate demand and domestic output.
As domestic income and production increase, domestic saving increases, which means that aggregate demand (willingness to spend) by domestic residents does not rise as rapidly as income and production.
As domestic income and production increase, the domestic currency must depreciate to entice foreigners to increase their demand of domestic products in order to keep the current account (only one component of aggregate demand) at its desired level—on the XX curve.
As domestic income and production increase, the domestic currency must depreciate more rapidly to entice foreigners to increase their demand of domestic products in order to keep aggregate demand (by domestic residents and foreigners) equal to production—on the DD curve.
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2. Macroeconomic policies and current account: the mechanism
Policies affect the current account through their influence on the value of the domestic currency.
An increase in the quantity of monetary assets supplied depreciates the domestic currency and often increases the current account in the short run.
An increase in government purchases or decrease in taxes appreciates the domestic currency and often decreases the current account in the short run.
If the volume of imports and exports is fixed in the short run, a depreciation of the domestic currency
will not affect the volume of imports or exports,
but will increase the value/price of imports in domestic currency and decrease the current account:
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2. Macroeconomic policies and current account: value effect
If the volume of imports and exports is fixed in the short run, a depreciation of the domestic currency
will not affect the volume of imports or exports,
but will increase the value/price of imports in domestic currency and decrease the current account:
The value of exports in domestic currency does not change.
The current account could immediately decrease after a currency depreciation, then increase gradually as the volume effect begins to dominate the value effect. (Check the J-curve on the next slide).
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2. Macroeconomic policies and current account: the J-curve
The J-curve describes the time lag with which a real currency depreciation improves the current account.
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2. Macroeconomic policies and current account: pass-through
Pass-through from the exchange rate to import prices measures the percentage by which import prices change when the value of the domestic currency changes by 1%.
In the DD-AA model, the pass-through rate is 100%: import prices in domestic currency exactly match a depreciation of the domestic currency.
In reality, pass-through may be less than 100% due to price discrimination in different countries.
Firms that set prices may decide not to match changes in the exchange rate with changes in prices of foreign products denominated in domestic currency.
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2. Macroeconomic policies and current account: pass-through
If prices of foreign products in domestic currency do not change much because of a pass-through rate less than 100%, then
the value of imports will not rise much after a domestic currency depreciation, and the current account will not fall much, making the J-curve effect smaller.
the volume of imports and exports will not adjust much over time, since domestic currency prices do not change much.
Pass-through of less than 100% dampens the effect of depreciation or appreciation on the current account.
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2. Macroeconomic policies and current account: a low-output liquidity trap
At point 1, output is below its full employment level. Because exchange rate expectations Ee are fixed, however, a monetary expansion will merely shift AA to the right, leaving the initial equilibrium point the same. The horizontal stretch of AA gives rise to the liquidity trap.
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3. Economic growth and stock markets
Is there a relationship between economic growth and equity market returns?
My favorite analogy for stocks vs the economy
“…the dog’s going walk in the general direction that the woman walks the dog. So the economy and the dog – or the economy the stock market are somewhat connected. But they do not look the same. They do not act the same even if they’re walking in the same direction.”
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3. Economic growth and stock markets
Stock market has almost always ignored the economy
The correlation between the market and the economy is -0.04 over the rolling 10 year period.
The U.S. stock market and the economy often diverge for long periods.
The S&P500 recorded around 16% increase in 2020 while the GDP of the US declined by 2.3%.
The U.S. stock market and the economy often diverge for long periods
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3. Economic growth and stock markets
How are economics growth and stock markets related?
Stock market development may influence the economy through (levine and Zervos 1996):
Liquidity: many high-return projects require a long-run commitment of capital but investors are generally reluctant to relinquish control of their savings for long period.
Risk diversification: diversification through internationally integrated stock markets encourages investment in projects with higher returns (or higher diversifiable risk).
Acquisition of information and corporate control: stock markets stimulate investors to research and monitor firms whereby improving resource allocation and spurring economic growth.
Empirical evidence (levine and Zervos 1996): stock market development is positively correlated with the long-run economic growth based on a sample of 41 countries during the period from 1976 to 1993.
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3. Economic growth and stock markets
How are economics growth and stock markets related?
2. There is no evidence supporting that the economic growth is a good predictor of stock market returns. There are many factors distorting the correlation between stock market returns and the economic growth.
Economic growth does result in a higher standard of living for consumers, but it does not necessarily translate into a higher present value of dividends per share for the owners of the existing capital stock.
The expected economic growth is already impounded into the prices, thus lowering future returns.
The aggregate earnings of an economy and the growth in earnings per share to which current investors have a claim do not necessarily match, since there are factors that can dilute aggregate earnings (e.g. IPOs and SEOs).
Please refer to Ritter (2005) for more discussions on the relation between the economic growth and stock market returns.
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3. Economic growth and stock markets
The chart is obtained from Ritter (2005).
Real returns seem unrelated to GDP growth, and statistically, the correlation is -0.27 for 1900–2000 and -0.03 for 1951–2000.
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