Transcript EC827_B4

EC 827
Macroeconomic Models III
Copyright 1998 R.H. Rasche
Macroeconomic Models
Conditional Forecasting
Copyright 1998 R.H. Rasche
Sources of Exogenous Shocks
to Macroeconomy

Fiscal Shocks - changes in government purchases (G) or
net taxes (T)

Monetary Shocks - Changes in the Nominal Money Stock
or its growth rate

Supply Shocks - changes in the level of “natural output”
Copyright 1998 R.H. Rasche
Macro Model - Basic Graphs
r
LM
IS = Commodity Mkt Equilibrium
LM = Asset Market Equilibrium
IS
SP = Short-Run Phillips Curve
LP = Long-Run Phillips Curve
Y
p
LP
SP
YN = “natural output”
YN
Y
Copyright 1998 R.H. Rasche
Macroeconomy - Initial
Conditions

Assume:
– Initial inflation rate = 0.0
– Initial Real Output = Natural Output
– Initially no unexpected inflation (actual and expected
inflation are equal)
– Nominal Money Stock is held constant at some value
M0 .

Alternative initial conditions are possible (e.g. positive
inflation and expected inflation); but these parameters keep
difficulties to a minimum.
Copyright 1998 R.H. Rasche
Unanticipated Fiscal Stimulus I
1. IS curve shift up (or
right) as a result of
increase in G or
decrease in T.
r
LM
IS
2. Economy moves
along fixed SP curve if
action is not anticipated.
3. Output increases, but
p must also increase.
4. p >0 means P
increases and M/P falls
inducing shift in LM
IS’
Y
p
LP
SP
YN
Y
Copyright 1998 R.H. Rasche
Unanticipated Fiscal Stimulus
II
1. Positive inflation
generates higher price
level.
r
LM’
2. Higher Price level
with fixed Nominal
Money Supply reduces
supply of Real Balances
3. LM curve Shifts up
4. Real interest rate
increases; real output
falls, inflation is lower,
but still higher than
initial value (0.0)
LM
IS’
Y
p
LP
SP
YN
Y
Copyright 1998 R.H. Rasche
Unanticipated Fiscal Stimulus
III
1. Left with a situation
where inflation turned
out to be different than
agents forecast it to be
(YN < Y).
2. State of the economy
can’t remain here
indefinitely unless we
assume that agents
never correct their
forecast errors!
r
LM’
IS’
Y
p
LP
SP
YN
Y
Copyright 1998 R.H. Rasche
Unanticipated Fiscal
Stimulus IV
Three Potential Outcomes:
1. The LM curve continues to adjust back towards the initial
level of income. Why? People would have to be continually
re-adjusting to the shock
2. The IS curve shifts left again, e.g. if there has been a
temporary government program which has now ended
3. The fiscal shock generated some positive effect on YN, e.g.
education spending.
Copyright 1998 R.H. Rasche
Anticipated Fiscal Stimulus I

What happens to the economy if the fiscal stimulus is
announced in advance of the action.

Depends on whether agents think that the announcement is
credible. Talk is cheap; if not believed then it is the same
as making no announcement.

If announcement is credible, then effect on economy
depends on how agents forecast.
Copyright 1998 R.H. Rasche
Anticipated Fiscal Stimulus II

If agents make forecasts based only on history of economy,
then the prospective fiscal change is not something they
consider in constructing their forecasts.

Their expectations of future inflation do not depend on
information about future fiscal policy.
– any changes in inflation resulting from the
preannounced policy are unexpected changes
– economy reacts as to the unanticipated stimulus

If so: at time of the stimulus, inflation expectations adjust,
SP curve shifts.
Copyright 1998 R.H. Rasche
Anticipated Fiscal Stimulus Perfect Foresight
1. At the announcement, the
SP shifts upwards, then the
policy shifts the IS out.
2. People forecast higher
inflation, which rapidly shifts
the LM curve left, until
output returns to natural
levels.
3. The inflation rate will
remain high until the policy
is reversed.
LM’
r
LM
IS
p
LP
Y
SP’
SP
Copyright 1998 R.H. Rasche
Fiscal Stimulus

What is the initial effect of a fiscal shock in an
environment where agents make perfect forecasts of
inflation, or the ultimate effect in a world where agents
make forecasting errors but eventually will correct them?

on real output?
– on the price level?
– on inflation?
– on real interest rates?
– on nominal interest rates?
Copyright 1998 R.H. Rasche
Deficits and Inflation

What is the impact of the deficit created by the fiscal
stimulus (anticipated or unanticipated) on:
–
interest rates?
–
sustained inflation?
–
the price level?
Copyright 1998 R.H. Rasche
Unanticipated Money Supply
Stimulus
1.LM curve shifts down
as nominal money supply is
increased.
r
LM
LM’
2. Economy moves along
fixed SP curve if action is
not anticipated
3. Output increases, but p
must also increase
4. p > 0 means P increases
and M/P is somewhat
reduced which induces an
offsetting shift in LM
IS
Y
p
LP
SP
YNCopyright 1998
Y
R.H. Rasche
Unanticipated Monetary
Stimulus II
1. Left with a situation wherer
inflation turned out to be
different than agents forecast
it to be (YN < Y).
2. State of the economy can’t
remain here indefinitely
unless we assume that agents
never correct their forecast
errors!
3. Will the policy be
cancelled? Will inflation cut
the LM back? Will YN
increase?
LM’
IS’
Y
p
LP
SP
YN
Y
Copyright 1998 R.H. Rasche
Anticipated Monetary
Stimulus I

Issues here are the same as in fiscal policy:
–
is the pre-announced policy taken seriously, so that
agents react to the information?
–
how do agents make forecasts of inflation (form
inflation expectations)
–
if agents make forecast conditional on future values of
exogenous (including fiscal and monetary policy
variables, how accurate are their forecasts and are they
free to act?
Copyright 1998 R.H. Rasche
Anticipated Monetary
Stimulus II

Any revision of inflation forecast based on policy
announcement means that SP curve will shift when policy
is implemented.

Perfect forecast of the inflation effects of the
announcement means that SP intersects LP at the new
actual inflation rate and Y = YN

IS-LM intersection will have to occur at. Y=YN for all
markets to be in equilibrium.
Copyright 1998 R.H. Rasche
Anticipated Monetary
Stimulus III
1. Since Y must = YN, new
IS-LM intersection must
occur at Y=YN.
2. Increase in P that results
from a perfect forecast of
inflation will shift the LM
back to its original position
(since IS is not shifted by
monetary stimulus).
r
LM
LM’
IS
p
LP
Y
SP’
SP
3. real rate unchanged
4. ex-post nominal rate
higher.
Copyright 1998 R.H. Rasche
Anticipated Monetary Stimulus
IV

Does this end the story of the response to a monetary
stimulus when conditional forecasts of inflation are
accurate?

Depends on the nature of the monetary shock
–
changes in the level of the nominal money stock.
–
changes in the growth rate of the nominal money stock.
Copyright 1998 R.H. Rasche
Anticipated Monetary Stimulus
V

Change in the level of Money Stock
–
agents who make perfect inflation forecasts will realize
that no future changes in price level are required to
maintain IS/LM intersection at YN
–
such agents will forecast zero inflation for future
periods.
Copyright 1998 R.H. Rasche
Anticipated Increase in Level
of Nominal Money Stock

Ultimate Effects in Expectational Equilibrium:
– real interest rate (r) is unchanged
– p = pe = 0 again
– Y = YN again
– implies that demand for real balances is unchanged

Conclusion: P must change proportional to the change in
M!
Copyright 1998 R.H. Rasche
Growth Rate of Nominal
Money Stock

Permanent change in the growth rate of the nominal money
stock.
–
Agents who make perfect conditional forecasts of
inflation based on this path for exogenous variable will
see that continuous inflation is required to keep real
balances unchanged so that LM curve will continue to
intersect IS at YN.
–
SP curve will remain permanently higher.
–
Inflation expectations will be validated.
Copyright 1998 R.H. Rasche
Sustained Inflation

Sustained inflation is always a monetary phenomenon!
–

other sources of shocks to the economy can change the
price level (transitory inflation) but a continuing
inflation requires continuous growth in the nominal
money stock.
p must be equal to M growth to keep IS/LM intersection at
Y = YN in expectational equilibrium
Copyright 1998 R.H. Rasche
Anticipated Shocks and
Forecasting Techniques

Initial reaction of economy to anticipated shocks depends
critically upon theory of how expectations are formed

Competing theories
– Adaptive or backward looking expectations - inflation
expectations (forecasts) are conditioned only on history
of economy
–
Rational or forward looking expectations - inflation
expectations (forecasts) are conditioned on future paths
of exogenous variables
Copyright 1998 R.H. Rasche