University of Ljubljana Faculty of Economics Master's Thesis

UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS MASTER'S THESIS JANA RADOVANOVIĆ UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS MASTER'S THESIS THE IMPACT OF MACROECONOMIC POLICIES IN ADVANCED ECONOMIES ON BRIC COUNTRIES Ljubljana, February 2015 JANA RADOVANOVIĆ AUTHORSHIP STATEMENT The undersigned Jana Radovanović, a student at the University of Ljubljana, Faculty of Economics, (hereafter: FELU), declare that I am the author of the master’s thesis entitled Impact of Macroeconomic Policies in Advanced Economies on BRIC Countries, written under supervision of Mojmir Mrak, PhD. In accordance with the Copyright and Related Rights Act (Official Gazette of the Republic of Slovenia, Nr. 21/1995 with changes and amendments) I allow the text of my master’s thesis to be published on the FELU website. I further declare the text of my master’s thesis to be based on the results of my own research; the text of my master’s thesis to be language-edited and technically in adherence with the FELU’s Technical Guidelines for Written Works which means that I o cited and / or quoted works and opinions of other authors in my master’s thesis in accordance with the FELU’s Technical Guidelines for Written Works and o obtained (and referred to in my master’s thesis) all the necessary permits to use the works of other authors which are entirely (in written or graphical form) used in my text; to be aware of the fact that plagiarism (in written or graphical form) is a criminal offence and can be prosecuted in accordance with the Criminal Code (Official Gazette of the Republic of Slovenia, Nr. 55/2008 with changes and amendments); to be aware of the consequences a proven plagiarism charge based on the submitted master’s thesis could have for my status at the FELU in accordance with the relevant FELU Rules on Master’s Thesis. Ljubljana, February 4th, 2015 Author’s signature: _____________________ TABLE OF CONTENTS INTRODUCTION ......................................................................................................................... 1 1 MACROECONOMIC POLICY MIX AND ITS EVOLUTION ....................................... 5 1.1 Macroeconomic Policy Mix Concept ............................................................................ 5 1.2 Evolution of the Concept Prior to the Crisis ................................................................ 7 2 CHANGES IN THE MACROECONOMIC POLICY MIX OF ADVANCED ECONOMIES DURING THE CRISIS ..................................................................................... 12 2.1 Before the Lehman Bankruptcy .................................................................................. 12 2.2 Since Lehman Bankruptcy .......................................................................................... 17 3 TRANSMISSION MECHANISMS FROM ADVANCED ECONOMIES ON EMERGING MARKET ECONOMIES AND THEIR POLICY RESPONSE ..................... 24 3.1 Channels through which the Emerging Economies are Affected............................. 25 3.2 Policy Responses Available to Emerging Market Economies .................................. 29 4 CASE STUDIES OF POLICY RESPONSES BY THE BRIC COUNTRIES .................... 33 4.1 BRICs Case Studies ........................................................................................................... 33 4.1.1 Federative Republic of Brazil: When Samba Stops ........................................... 33 4.1.2 The Russian Federation: Double-Headed Eagle ................................................ 41 4.1.3 Republic of India: Tiger, transformed into Elephant ........................................ 46 4.1.4 People's Republic of China: Great New Wheel of Global Growth ................... 54 4.2 Summary of BRIC Policy Response................................................................................. 61 CONCLUSION ............................................................................................................................ 64 REFERENCE LIST .................................................................................................................... 70 APPENDIXES i LIST OF FIGURES Figure 1. Schematic illustration of the main transmission channels of monetary decisions .......... 5 LIST OF TABLES Table 1. General comparison of key AEs and BRICs..................................................................... 4 Table 2. BRICs Policy Responses................................................................................................. 63 ii INTRODUCTION ... the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back... But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil (Keynes, 2011, p. 167). The crisis that began in the United States in August 2007 and intensified in September 2008 was dubbed the Great Recession and is believed to be the worst global recession since the Great Depression of the 1930s. Like global crises in the past it affected banking and financial systems as well as regulatory and supervisory entities throughout the world. However, this time it truly was different. Prior to the crisis, monetary policy was conducted in a relatively predictable and systematic way. Well-functioning arbitrage ensured changes in short-term interest rates were transmitted along the yield curve of sovereign bonds and across private asset classes, ultimately affecting real economic decisions like consumption and investment (International Monetary Fund, 2013b, p. 5). Moreover, monetary policy was considered as having one target (that is, stable and low inflation) and one instrument (the policy rate), while fiscal policy was of secondary importance, hindered by the lack of political consensus that limited its de facto usefulness (Blanchard, Dell’Ariccia & Mauro, 2010b, p. 3). On the international level, too, it was thought central bankers should focus on their individual objectives since international monetary coordination supposedly offered no benefits (Mohan & Kapur, 2014, p. 3). Economists consider financial investments as the main source of instability while the key institutions for establishing stability are financial institutions, inter alia banks, who manage the 'seductive allure of present credit and the crushing burden of future debt' on daily basis (Mehrling, 2011, p. 17). Any inclination toward fragility is bound to show itself in increasing difficulty of rolling over debt as it matures, which usually presents itself as increased demand for bank lending. Moreover, the inherent instability of credit appears as increased volatility of short- term interest rates. Consequently, the central bank (as the bankers' bank) can use its balance sheet and intervene in the money market either to impose discipline (by raising interest rates) or offer elasticity (by lowering interest rates) in the interbank payments system. Its actions are then translated across the bond and securities markets by arbitrage conditions. The unexpected shock of Lehman Brothers investment bank bankruptcy on September 15, 2008 (which served as the 1 proverbial Minsky moment) led to dysfunctional financial markets, evaporation of world liquidity and an increase in perceived risk, which in turn resulted in substantial TED spread jump that further increased counterparty risk between banks and led to sharp decrease in maturity of interbank loans, cash hoarding and decreased interbank borrowing. The real economy was affected through credit rationing and as unemployment soared and economic activity contracted, central banks undertook unprecedented responsibilities. Moreover, since central banks lowered their key interest rates to zero and could not go further, the zero lower bound (hereinafter: ZLB) constrained monetary policymaking and, in turn, led to the implementation of unconventional monetary policy (hereinafter: UMP) measures to provide additional monetary accommodation. It is nearly impossible to discuss economic policymaking without touching upon its inherent politicization. Policymaking can indeed be regarded as the perpetual market for different schools of thought that tend to make spurious claims of success (particularly during economic downturns), are full of intellectual dishonesty and are known to play to popular prejudices that often make no sense. Traditionally, macroeconomists have been broadly split between two conflicting and competing approaches with respect to their faith in the 'invisible hand'. Conservatives (nowadays known as ‘freshwater economists’) are vehemently opposed to any government activism and believe the price mechanism alone is capable of stabilizing a capitalist market economy that is prone to shocks. Meanwhile, the Keynesians (‘saltwater economists’) doubt in self-righting properties of the system at a satisfactory level of employment and propose implementing fiscal and monetary policies instead. Once the 'magical economy' of the postwar era faltered in the early 1970s, conservative ideology became increasingly influential in all advanced economies while Keynesianism seemed in demise. But since conservative policymaking failed to work as well as advertised (promising a productivity and employment miracle

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