Transcript and unemployment

XVI. Oil shocks and disinflation
policies (1973-1985)
XVI.1 Stagflation of 1970s
• Stagflation: inflation + unemployment +
low growth
– US as well as Europe
• Trigger: oil shocks, 1973 and 1979
– In 1973-4 and in 1979-1982, two dramatic
increases in price of oil: 1960: 100, 1972: 93,
1974: 135, 1982: 264
– Increase in oil price → substantial increase
in P without a link to change in wages (and
unemployment)
• Economic policies were not able to react
immediately → problems lasted till 1980s
Main indicators, 1963-2005
63-72
73-82
83-92
93-02
03
04
05
inflation
USA
3.3
8.7
4.0
2.6
2.3
3.0
3.0
Europe
4.4.
10.7
5.1
2.4
2.0
2.2
2.0
Japan
5.6
8.6
1.8
0.2
-0.2
-0.2
-0.2
Unemployment
USA
4.7
7.0
6.8
5.2
6.0
5.5
5.4
Europe
1.9
5.5
9.4
9.6
8.9
9.0
8.7
Japan
1.2
1.9
2.5
3.9
5.3
4.7
4.5
per capita real GDP growth
USA
2.8
0.9
2.4
2.1
2.0
3.3
2.5
Europe
3.9
2.0
3.0
2.0
-0.1
1.9
1.9
Japan
8.5
2.9
3.4
0.7
2.3
4.3
2.3
US data
What policies?
• Stagflation: challenging framework for
policy decisions
• Keynesian: so far based on inflation vs.
unemployment trade-off, no use
• Monetarist: provided credible explanation
what happened, but the advice for stable
increase of money supply was not of
much help either
Rational expectations and policy
credibility
• Anticipated policies → immediate
adjustment towards new equilibrium,
consistent with natural values
• Un-anticipated → new equilibrium, but not
at natural values, i.e. with higher inflation
or higher unemployment
• Effective policy: must be credible, i.e.
agents must believe that authorities will
indeed pursue that policy that they
announce
Difficult policy options after
1973
• Oil shocks: un-anticipated, economy
reacted according new-classical theory
– Price increase, contraction, higher
unemployment
– Policy response: difficult, see Case study I
bellow
• Disinflation after 1979: mainly the
problem of credibility – will the
authorities hold monetary contraction?
– See Case study II bellow
XVI.2 Case study:
Oil shock, part I
1973-1979: Monetary expansion
Effect on prices
• Oil and energy inputs more expensive
→ all prices oil importing countries up
• Expectations: price increases will
continue
• Both in US and Europe – accumulated
inflationary pressures via wage
negotiations already from 1960s
• Speculative hoarding of commodities
stocks
Effect on output
• Sharp price increase → fall of AD → fall
of output
• Sharp increase of unemployment
• Stagflation: inflation with
unemployment
Effect on CA
• Oil importing developed countries: sharp
decrease (deficit), later improvement (as
spending on imports fell down)
• OPEC countries: sharp increase (surplus),
investing the revenues (“petrodollars”) in
developed countries
• Oil importing developing countries: mild
deficits (lower energy intensity)
• No problem how to finance deficits (out of
petrodollars)
Policy options
• Both internal and external disequilibria,
need for action, options
• Return to fix?
– Danger of speculative attacks
• Monetary contraction to fight inflation?
– It seemed as politically unfeasible
• Monetary expansion to fight
unemployment
– Selected policy, consequences?
Monetary expansion
• US immediately 1974, Europe much later
(1978)
• US:
–
–
–
–
Output recovery, unemployment improved
Further inflation, larger than Europe
Depreciation, both nominal and real
CA deficit: contrary to model, as depreciation
helps exports; here domestic expansion fostered
imports (despite that more expensive), due to
continuing recession in Europe, no demand for
exports → deterioration of the deficit
Crucial consequences for
developed countries
• Weak dollar – psychological impact on
US population
• Entirely different understanding about
scarcity of energy resources
• US – growth resumed and
unemployment – at least partially –
improved
• Europe – growth resumed as well (not
as in US), unemployment persistent
XVI.3 Case study:
Oil shock, part II
1980-1985: US Monetary Contraction
and Fiscal Expansion
The burden of inflation
• Very high US inflation through 1970s
– Due to monetary expansion when fighting
unemployment of 1970s
• Eroding the health of US economy
• 1979: new FED’s chairman Paul Volcker
– Strong commitment to monetary contraction to lower
inflation
– Credibility problem
• January 1981: President Ronald Reagan
– New economic policies, based on tax cuts, antiinflationary policies and support to private business
– Later (1983): fiscal expansion, mainly due to political
reasons (military expenditures)
Supply side economics
• Lower taxes ↔ incentives to private sector
to increase both effort and productivity
• Strategy: lower tax means higher budget
deficit now, but stronger growth in the
future and larger tax revenues with deficit
improvement in the future
• Supply side economic, Laffer curve
Tax
revenue
0%
100%
Tax
rate
The data
1980
1981
1982
1983
1984
GDP growth %
-0.5
1.8
-2.2
3.9
6.2
Unemployment %
7.1
7.6
9.7
9.6
7.5
Inflation – CPI %
12.5
8.9
3.8
3.8
3.9
Nominal interest %
11.5
14.0
10.6
8.6
9.6
Real interest%
2.5
4.9
6.0
5.1
5.9
Real ExR (73=100)
117
99
89
85
77
Trade surplus
-0.5
-0.4
-0.6
-1.5
-2.7
Budget surplus
-1.8
-2.0
-3.5
-5.6
-4.5
A detour: policies in large open
economies
• No longer small country assumption
– No prevailing world interest rate
– Changes in inflation and output do influence
inflation and output in other economies
• Changes to policy effects compared to M-F
model
– Monetary expansion: domestic output up,
domestic currency depreciates, foreign outputs
ambiguous
– Fiscal expansion: domestic output up (different
from standard M-F model in Lecture XII), home
currency appreciates, foreign output up
XVI.3.1 Reducing the inflation
The costs of disinflation
• Sacrifice ratio: the amount of lost output
during the period of reducing inflation
• Keynesian view: sacrifice ratio large, due to
price and wage rigidities
• Monetarist view:
– there is always some sacrifice ratio
– Probably much lower than Keynesians believe
– Depends on institutional adaptations and – mainly
– how quickly people adapt their expectations
(AEH)
• New classical school (rational expectations)
– If policies credible (anticipated) → sacrifice ratio
might be close to zero
– If policies not credible (un-anticipated) → sacrifice
ratio might be substantial
Monetary restriction after 1979
• Strong, convincing commitment to monetary
restriction, quick change of expectations and quick
impact:
– Real interest ↑, Y↓, P ↓, real (and nominal) appreciation of
USD
– The credibility problem: most people did not believe that
Reagan/Volcker team will be politically strong to reduce
inflation quickly
– Behaviour according rational expectation models: unanticipated policy → decrease of output and increase of
unemployment
– Whenever credibility established → growth resumed and
unemployment started to fall
• Strong monetary contraction and subsequent
volatility of macroeconomic parameters → impact on
the position of USD
• Originally, very strong commitment towards floating
ExR without intervention (“benign neglect”)
Other countries’ reaction
• Usually: appreciation of domestic currency
seen as welcome by foreign countries
(positive effect on exports)
• Different attitude in 1980-81: low US inflation
relatively increased inflation in foreign
(European) countries → additional
inflationary pressure in European economy
→ monetary contraction in Europe (and
Japan) as well
– Technically, contraction as a result of intervention
against USD’s appreciation → sale of USD assets
(to undermine USD), i.e. money restriction
Effects of Monetary Contraction
• 1980-1982 – US economic development
dominated by the effects of monetary
contraction
• M.-F. model’s prediction: in case of
flexible exchange rate monetary policy is
efficient, see data:
– Output contraction
– Real appreciation of USD
– Inflation sharply down
• Remark: US is large economy, interest
rate is not fixed on the “world” level
World recession after
shock
nd
2
oil
Difficult coincidence:
• Second oil shock
• Monetary restrictions in all major parts
of the world
• Lack of forex policy coordination
→ deep recession worldwide, the most
serious after Great Depression
Effects of Fiscal Expansion
• After 1982 – stronger effect of fiscal
expansion
– Reagan: additional military expenditures
• M.-F. model: fiscal policy less efficient, but
here model’s predictions did not come true
fully
– There was a further appreciation of USD, in
accord with M.-F.
– There was a strong expansion of output, contrary
to original version of M.-F. model
• US is a large economy, interest rate is not fixed and
appreciation is consistent with interest rate decrease →
stimulation of AD and output
XVI.3.2 Exchange rate
policies
Twin deficits and consequences
• Increased military expenditures
outweighed increased tax revenues due to
faster growth
– The budget deficit further deteriorated
• Continuing USD appreciation slowed
exports and increased imports
– Trade deficit started to increase
• Result: US economy started to mount both
trade and budget deficits → the problem
of twin deficits
• Strong deficit and strong USD → calls for
protectionism in the US, threat to overall
world trading system → need for ExR
adjustment, i.e. need for an intervention
Plaza Agreement
• September 22, 1985: officials from US, UK, France
and Germany announced a joint intervention to
depreciate USD
• Given strong commitment → change in expected
ExR → drop of USD immediately next day
• Accompanied by slight monetary expansion →
continuous decline of USD in 1986-87, US interest
rates down relative to other countries
• Second half of 1980s:
–
–
–
–
much stronger growth, world out of recession
lower unemployment
resumption of world trade
macroeconomic stabilization
XVI.4 Conclusions from oil shocks
• Stagflation – a phenomena, neither known
and expected by both economists and public
• Keynesian economics (and policies) on
retreat
• Disinflation policies of 1980s opened a new
era in economic policies
– Success in reducing the inflation
– International economics and coordination
– The role monetary policies and of Central Banks
• Twin deficits and period of weak USD
Open issues
• Fix of float? – never ending story
• Should there be an international coordination
on exchange rates policies?
• Anti-inflationary policies emerged as a
pivotal element in economic policy making
• Expectations as a central notion both in
economic theory and practice (see next
Lecture)
• The start of formation of the framework of
macroeconomic policies for 21st century (see
the last Lecture)
Literature to Ch. XVI
• Krugman, Obstfeld, ch.19
• Snowdon, Vane, Modern
Macroeconomics, Edvard Elgar, 2005
(part 5.5.3)
• Romer, Ch., Romer, D., Reducing
Inflation, The University of Chicago
Press, 1997