Transcript Slide 1

The full dynamic short-run model
and macroeconomic controversies
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Paper topic
• Last problem is short paper (1000 words + tables,
figures)
• Topic will be to discuss economics of U.S. federal debt
and/or deficit
• Due December 9
• Get approval from TF or me for topic
• Broad latitude on particular topic, but narrow it down.
• Examples (verbally, but will be in posted assignment)
• Good style
• Acceptable references (not Internet junk)
• Don’t wait until last moment.
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The Dynamic Model
A nice new addition to Mankiw.
Combines
- IS
- LM (changed to reflect central bank targeting a la
Taylor)
- Phillips curve
Closed economy
Short-run of business cycles
Keynesian rather than classical
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Monetary policy rule
Taylor rule:
i t = πt + r* + θ π (πt - π*) +θY (Yt - Y* )
Rationale: a rule that incorporates both real and inflation
targets
But, also one that has good stability properties
Derived from minimizing loss function such as
L = λ π (πt - π*) 2 + λ Y (lnYt - lnY* ) 2
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Econometric estimate (for info purposes)
Dependent Variable: FYFF
Method: Least Squares
Date: 11/04/10 Time: 18:50
Sample: 1988Q1 2008Q4
Included observations: 84
Variable
Coefficient
Std. Error
t-Statistic
Prob.
C
PIPCECORE4Q(-1)
LHUR(-1)-NAIRU(-1)
1.458217
1.402713
-1.811719
0.350366
0.131758
0.162368
4.161983
10.64615
-11.15810
0.0001
0.0000
0.0000
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
0.735891
0.729370
1.140542
105.3678
-128.7097
112.8460
0.000000
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
4.648889
2.192419
3.135946
3.222761
3.170845
0.142920
FYFF = federal funds rate
PIPCECORE4Q = rate of core inflation, consumption deflator, 4 quarter
LHUR = unemployment rate
NAIRU = natural rate of unemployment
(-1) = lagged one quarter
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10
8
6
4
2
0
-2
Actual Fed Funds
Taylor rule forecast
-4
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Why is rate
below
target
today!?!
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90
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98
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02
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Fed funds =π +1.458 + 0.402*(π – 2) – 1.811*(u – natural rate)
π = 4 quarter PCE core inflation
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Algebra of Dynamic AS-AD analysis
Key equations:
1. Demand for goods and services:
2. Cost of capital:
3. Phillips curve:
4. Inflation expectations:
5. Monetary policy:
Yt = Y* - α (rt –r*) + μG + εt
rt = it – π e t + σt
π t = π e t + φ(Yt - Y* ) + vt
π e t = π t-1
i t = πt + r* + θ π (πt - π*) +θY (Yt - Y* )
Notes:
• Equation (1) is just our IS-LM solution
• Phillips curve substitutes output by Okun’s Law
• We add premium to capture long v. short rates and financial crises (σt )
• Mankiw uses slightly different version of (4)
• Mankiw doesn’t consider risk premium, so ignore for now
• Added r* to Taylor rule from last lecture (forgot it).
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Note on interest rates
r = real interest rate relevant for business decisions
= nominal long-run risky rate – expected inflation
Nominal long-run risky rate
= nominal long-run risk-free rate + risk premium
Nominal long-run risk-free (say Treasury bond rate)
= f(expected short rates) + term premium
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Solve for AS and AD
AD: Yt -Y* = -[α /(1+ α θ Y )] [(1+ θ π )π t + σt - π t-1 +…] + [ 1/(1+ α θ Y )](μG + εt )
AS: π t = π t-1 + φ(Yt - Y* ) + vt
NOTE:
AD is like IS-LM equilibrium except is substitutes the Fed
response for a fixed money supply
AS is Phillips curve with substitution for expected inflation
Note that we have moved up one derivative in prices from
introductory AS-AD because Phillips curve related to inflation.
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The graphics of dynamic AS-AD
π
AS(π t-1 , Y* , vt )
π t*
AD(π*, G , εt , σt )
Yt*
Y = real output (GDP)
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Inflationary shock
π
AS’
AS
πt**
AD
Yt**
Y = real output (GDP)
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Financial shock or cut in G
π
AS
πt**
AD
AD’
Yt**
Y = real output (GDP)
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Example by simulation model
This will be available on course web page.
You might download and do some experiments to see how
it works.
New kind of economics: computerized modeling.
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Screen shot
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Parameters
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Numerical simulation in base run
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Graph of base case
Forecast
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Some policy approaches
What should the Fed do today?
Has run out of conventional bullets.
Unconventional tool today is “quantitative easing 2” (QE2)
FOMC statement on Wednesday:
“To promote a stronger pace of economic recovery and to help ensure that inflation,
over time, is at levels consistent with its mandate, the Committee decided today to
expand its holdings of securities. …. In addition, the Committee intends to purchase
a further $600 billion of longer-term Treasury securities by the end of the second
quarter of 2011, a pace of about $75 billion per month.”
Impact:
- Remember, r = i – π + Expected future i + risk and term premiums
- Point of QE2 is to lower term premium
- Estimates are in the range of 50 basis points maximum
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Quantitative easing (lowers r by 50 basis points)
Forecast (base + QE2)
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What about raising inflation target?
Some have argued that Fed should raise target.
Would keep i at zero for longer period.
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Impact of higher inflation premium*
Forecast (base + raise
inflation target to 3 percent)
* Works by lowering the expected future short rates through Taylor rule and
then building that into current long rates by expectations theory.
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Balance the budget
One of the perennial concerns is budget deficits.
Deficit Commission:
“President Obama created the bipartisan National Commission on Fiscal Responsibility
and Reform to address our nation's fiscal challenges. The Commission is charged
with identifying policies to improve the fiscal situation in the medium term and to
achieve fiscal sustainability over the long run. Specifically, the Commission shall
propose recommendations designed to balance the budget, excluding interest
payments on the debt, by 2015.” (http://www.fiscalcommission.gov/ about/)
Republican platform on balanced budget amendement:
“Republicans … favor adoption of the Balanced Budget Amendment to require
a balanced federal budget except in time of war.”
What would be the effect of attempting to balance the
budget over the next 3 years? (For simplicity, I use the
full-employment budget.)
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Balanced federal budget by 2015
Forecast (base + balanced
budget)
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Summary
This now finishes our treatment of closed-economy
business cycles.
Key elements are
- IS elements in I, C, fiscal policy, and trade
- Financial markets and monetary policy
- Inflation dynamics
We now move on to long-run growth theory next week.
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