The Brexit-News Boom?

Start with a bog-standard second-year textbook Mundell-Fleming ISLMBP model. Start in equilibrium at Y*, then hit it with a negative shock to Net eXports. The IS curve shifts left initially, at the previous equilibrium exchange rate. But the central bank is sensible, and allows the exchange rate to depreciate sufficiently to shift the IS curve right again so the new ISLMBP equilibrium is back at Y*.

Now make one small change. The shock hits Net eXports next year, not this year. But people learn about the shock this year, one year in advance. It's a news shock.

If people expect that next year's exchange rate will be (say) 10% lower than they had previously expected (before hearing the news), that means the BP curve shifts up by 10%. Which means the ISLM intersection is now below the BP curve, which means the exchange rate depreciates today. It would take a 10% depreciation of today's exchange rate (relative to the previous equilibrium) to preserve uncovered interest rate parity and bring the BP curve back down to where it was before the news shock. But that depreciation of the exchange rate shifts the IS curve rightward today. And remember, the negative shock to Net eXports hasn't hit yet, so the rightward shift in the IS curve will cause a boom. Unless the central bank takes offsetting action by tightening monetary policy.

Second year textbook macro can be quite useful.

Comments

[athan]

BoE hike would amount to an eviction notice for 1/3 of the population. 40% of mortgages by number and 65% by value are interest-only, that's how stretched the housing market is. So you're right, we're going to get a phoney boom. And then BOOM!

[TorrensHume]

Good point. Guess the counter point would be that Brexit is an uncertainty shock hitting investment (firms have the option of waiting). Shift IS left.
Could also be some j curve effects, no? Just thinking aloud.

[Nick Rowe]

athan: That depends on a lot of things. And interest-only mortgages may or may not be safe. But the UK housing market is beyond the scope of this post.

TorrensHume: thanks. Yep, there's been some discussion in the blogosphere about uncertainty reducing investment (though Paul Krugman argued, correctly I think, that that effect could go either way).

The J-curve came up on Twitter, in reply to my post. I *think* it's not relevant to my results. Here's why:

Assume the Brits produce apples, consume some, export some, and import bananas. What we are interested in is the demand for apples (and the labour etc. that produces those apples). The Y on the horizontal axis should be read as quantity of apples produced. And if the relative price of apples to bananas falls, that will increase the demand for apples from Brits+foreigners (unless we have some very weird distribution of income effects). If the Marshall-Lerner conditions fail to hold (as they may in the very short run, if the elasticities are initially low), then it may be true that income *measured in consumption bundles* can fall at first, but we should still observe a boom in demand for apples and the labour that produces them.

[Avon Barksdale]

Why don't we see this reasoning in the upper year (graduate) textbooks like Ljungqvist and Sargent?

[TorrensHume]

Nick, it's been a long time since I was lucky enough to play with forward looking is lm models. Something is sitting uncomfortably with me. But it seems to me that the new equilibrium must involve expectations of a further depreciation, say once Brexit actually occurs.

IS shifts right due to new exports from the 10 per cent depreciation, pushed up the interest rate above i*, which can only be sustained if the market believes that the pound will fall even further in the future. That seems to make sense to me (and given the pound's behaviour today). The size of the expected future depreciation (additional to the 10 percent we already got) would seem to define how big the boom is. If the exchange rate has fully adjusted and i=i*, then we're done. No?

[Nick Rowe]

TorrensHume: What you say sounds right to me, if the LM curve slopes up. It depends on how the BoE responds to the rightward IS shift.