Transcript Slide 1

Econ 7920/Chatterjee
7/21/2015
Econ 7920/Chatterjee
7/21/2015
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We cannot predict the future with any degree
of certainty
But expectations about the future often
determine the future course of an economy
“Managing” the public’s expectations is
perhaps the most important objective of
public policy
Econ 7920/Chatterjee
7/21/2015
Econ 7920/Chatterjee
7/21/2015
Modeling the formation of expectations:
◦ Adaptive Expectations (AE):
People base their expectations of the future only on past
observations
◦ Rational expectations (RE):
People base their expectations on all available current
information, including information about prospective future
policies
◦ Critical difference: under RE, economic decisions change
ONLY if there is “news” or new information about the future.
Under AE, “news” has no impact on current decisions
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Expected inflation plays a crucial role in
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A principal objective of monetary policy:
determining current inflation and interest
rates
◦ to manage the public’s expectations of future
inflation
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How can this be achieved?
Econ 7920/Chatterjee
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For expected inflation to be low, the public must believe that
the Central Bank is committed to fighting inflation
The only way this can happen is if the Central Bank has
credibility with the private sector: it’s past actions confirm its
commitment to keeping inflation low
Credibility is difficult to attain: often requires significant
short-run sacrifices (high interest rates, unemployment and
recessions)
One factor to consider: does Central Bank independence
matter?
Econ 7920/Chatterjee
7/21/2015
Econ 7920/Chatterjee
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Can inflationary expectations be controlled by nonmonetary measures?
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A popular policy measure: impose wage and price
controls
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If the government mandates that it is illegal for
prices and wages to increase above a pre-specified
ceiling, wouldn’t that stabilize expectations of
future inflation?
Wage and Price controls simply do not work. Why?
Econ 7920/Chatterjee
7/21/2015
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Extremely difficult to commit to and monitor
such policies and punish violators
These policies inevitably create huge
shortages and involve a misallocation of
scarce resources  becomes selfperpetuating
Econ 7920/Chatterjee
7/21/2015
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Inflation targeting:
◦ Central Bank announces a target rate of inflation (usually
2-3 percent)
◦ It raises or lowers interest rates to keep inflation at the
target rate
Advantage: as long as there is credibility,
inflationary spirals can be avoided
Disadvantage: if the economy faces a large
supply-side shock (an oil price increase),
maintaining the target can be difficult
Econ 7920/Chatterjee
7/21/2015
Econ 7920/Chatterjee
7/21/2015
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Does “Say’s Law” always work?
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Consider the following sequence:
◦ For some reason, consumers suddenly expect bad times in the near
future  cut back on spending
◦ Firms face lower orders for goods and services  cut back on
employment and investment  lay off workers and keep machines
idle
◦ The rising unemployment causes a reduction household incomes 
further cut-backs in spending  further reduction in production of
goods
◦ Leads to a downward spiral in economic activity  severe recession
(self-fulfilling prophecy)
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“Paradox of Poverty in the Midst of Plenty” – Keynes (1936)
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How can monetary and fiscal policy correct this “paradox”?
Econ 7920/Chatterjee
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In a recession, the Central bank can
implement an expansionary monetary policy
◦ Increasing money supply and lowering interest rates
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Households
◦ Consumption more attractive than savings
◦ “Durable” consumption (houses, cars, appliances)
cheaper
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Firms
◦ Cost of investment (financing new capital
equipment, construction, etc) cheaper
Econ 7920/Chatterjee
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Expansionary monetary policy may not be
effective if
◦ Expectations of future demand are severely
depressed
◦ The gap between actual output and potential output
is small (can generate inflationary pressures)
◦ The economy is in a “liquidity trap”
◦ Prices are actually falling or expected to fall
(deflation)
Econ 7920/Chatterjee
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When nominal interest rates reach a critically
low level (positive but close to zero): people
might prefer holding money to assets (why?)
In such cases, injecting more money does not
affect interest rates and thereby the
incentives to spend and invest
Econ 7920/Chatterjee
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Deflation: price level declines over time
◦ Due to declining productivity and demand
◦ Gap between actual and potential output
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Monetary policy is ineffective in a deflation:
◦ Let r = real rate of interest
i = nominal rate of interest
 = rate of inflation
Then,
r=i- 
With deflation,  < 0  r > 0
Econ 7920/Chatterjee
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Consider an example:
◦ Suppose, due to an expansionary monetary policy, the nominal
interest rate is low, at i = 1%
◦ But prices are falling at the rate of 5%   = -5%
◦ Then, the real rate of interest is:
r = i -  = 1-(-5) = 6%
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Therefore, the real cost of borrowing is 6% even
though the nominal cost is only 1%
Facing a declining price level and a rising real
interest rate, households and firms postpone
spending
Monetary policy completely ineffective
Econ 7920/Chatterjee
7/21/2015
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1980s: Under pressure from the Ministry of
Finance, the Bank of Japan kept interest rates
low
◦ Economy “awash” with liquidity
◦ Created speculative bubbles in equities and real
estate
◦ Economy started over-heating towards the end of
1980s
◦ Inefficiencies in the corporate sector slowed
productivity
◦ Financial liberalization of 1980s: more competition
among banks  more risk-taking
Econ 7920/Chatterjee
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Yasushi Mieno takes over as Governor of the Bank
of Japan in 1989: promises to “cool” economy down
◦ Interest rate rises from 2.5% in Dec 1989 to 6% in Aug 1990
◦ Speculative bubble bursts in summer 1990: stock market
falls by more than 40%
◦ Firms and households significantly cut back on spending
◦ Sharp economic slowdown begins in 1990:Land prices fell
quickly, mortgage defaults and bankruptcies increased
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Throughout the 1990s, Japan experienced deflation
and was stuck in a liquidity trap, in spite of
monetary policy interventions
Econ 7920/Chatterjee
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Econ 7920/Chatterjee
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“Irresponsible Monetary Policy” was proposed
as a solution by Paul Krugman of MIT (1998):
◦ Set an inflation target of 2-4%
◦ Commit to the target and keep increasing money
supply in a sustained fashion
◦ Eventually, public start expecting future inflation
◦ Currency starts depreciating
◦ Spending, investment, and demand for exports
restart the growth process…
Econ 7920/Chatterjee
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Fiscal policy (government spending, taxation, and
subsidies) can be an effective tool in
◦ a recession
◦ when expectations of future demand are severely
depressed
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Keynes (1936): through deficit spending, a
government can influence expectations of the
private sector:
◦ Deficit spending: government spends more than it receives
in tax revenues (mainly financed through borrowing)
◦ Government spending creates new jobs  multiplier effect
on the economy
Econ 7920/Chatterjee
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Basic idea:
◦ An initial amount of government spending creates new
incomes (through jobs created in the public sector)
◦ A fraction of this new income is spent on goods and
services  generates new income and spending, and so
on…
◦ Similar to a “ripple” effect
◦ The final increase in income and spending is much
larger than the initial increase in government spending
 “multiplier effect”  economic expansion
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What about the deficit?
◦ The income generated increases tax revenues over time,
making the deficit sustainable
Econ 7920/Chatterjee
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Suppose people spend a “b” fraction of their
income (marginal propensity to consume)
◦ Example: b = 0.75  people spend $0.75 of every
$1 of new income
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The government increases spending by $1
Total spending and income generated:
Spending Iterations
Round 1 (government)
New spending/income ($)
1
Round 2 (private)
b(1)=0.75
Round 3 (private)
b(0.75)=0.56
Round 4 (private)
b(0.56)=0.42
Round 5 (private)
b(0.42)=0.32
And so on…
Total increase in
spending/income
…
1  b  b 2  b 3  ....
=1+0.75+0.56+0.42+…
Econ 7920/Chatterjee 7/21/2015
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In general, the multiplier effect is given by:
Increase in Income 
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Initial increase in government spending
1  Marginal propensity to consume (b)
In our example, b = 0.75. Then,
1
1
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◦ Increase in income =
1  0.75 0.25
◦ A $1 increase in government spending increases total
income by $4
◦ Also referred to as the “income multiplier”
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A multiplier effect can also be generated by
cutting taxes (the “tax multiplier”)
Econ 7920/Chatterjee
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If the economy’s capacity utilization rate (gap
between potential and actual output) is well
below 100%
◦ When resources are idle (high unemployment and
shut-down factories)  producers can increase
production without raising prices
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As capacity utilization nears 100%, deficit
spending can overheat the economy and
create inflationary pressures  smaller
multiplier effect
Econ 7920/Chatterjee
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Factors that can reduce the size of the multiplier
effect:
◦ Government spending financed by higher taxes
◦ New income is fully spent on imports (does not affect
GDP)
◦ New income is fully saved by households to provide for
future expected tax increases (“Ricardian Equivalence”)
◦ “Crowding Out” of private investment by raising market
interest rates
◦ Sometimes, the Central Bank may raise interest rates to
offset any inflationary expectations (say, if capacity
utilization is near 100%)
Econ 7920/Chatterjee
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Econ 7920/Chatterjee
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The U.S. government uses a forecasting model
developed by Data Resources Inc. (DRI) to estimate
the potential effects of fiscal policy
Estimates of Fiscal Policy Multipliers:
Assumption
Government
spending increase
Tax cut
No crowding out
1.93
1.19
Crowding out
0.60
0.26
Econ 7920/Chatterjee
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Unemployment
(right scale)
220
30
25
200
20
180
15
160
10
Real GNP
(left
scale)
140
120
1929
1931
1933
1935
1937
5
1939
0
percent of labor force
billions of 1958 dollars
240
Econ 7920/Chatterjee
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Econ 7920/Chatterjee
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Asserts that the Great Depression was largely
due to an exogenous fall in the demand for
goods & services
Supporting evidence:
◦ output, consumption, and investment declined
steadily from 1929-1934
◦ Government spending remained largely unchanged
during this period
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Stock market crash  exogenous fall in
consumption
◦ Oct-Dec 1929: S&P 500 fell 17%
◦ Oct 1929-Dec 1933: S&P 500 fell 71%
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Drop in investment
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Contractionary fiscal policy
◦ “correction” after overbuilding in the 1920s
◦ widespread bank failures made it harder to obtain
financing for investment (the FDIC did not exist
then)
◦ Congress raised tax rates and cut spending (deficits
were considered “bad” for economy)
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Asserts that the Depression was largely due
to huge fall in the money supply
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M1 fell 25% during 1929-33
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The severity of the Depression was due to a
huge deflation: the price level fell 25% during
1929-33
This deflation was probably caused by the fall
in money supply
Econ 7920/Chatterjee
7/21/2015