Transcript PowerPoint Slides

Inflation Targeting and International Finance
Review: Government Purchases
FP Question: What would the
real interest rate (r) equal, if the
inflation rate () were _______
percent, given that the Fed does
not change its inflation policy?
 (%)
AD Question: How many final goods
and services would be purchased, if the
inflation rate () were _______ percent,
given that all other factors relevant to
demand remained the same?
 (%)
FP
At a
given 2.0
inflation
rate ()
AD
AD
G&S
r (%)
3.0
2,000
Government
More goods
Aggregate
purchases  and services  demand (AD)
more
purchased
curve shifts right
Increases in Government Purchasing – No Inflation Targeting
Period
0
1
2.
..
7
8
GDP
2,000
2,100
2,040
Govt
Purch
500
600
600
2,000
2,000
600
600
 (%)
Deficit
0
100
100
Con
Purch
1,300
1,312
1,257
Invest
Purch
200
188
183
Int Rate
r (%)
3.0
4.2
4.7
Infl Rate
 (%)
2.0
2.6
2.8
100
100
1,220
1,220
180
180
5.0
5.0
3.0
3.0
FP
3.0
 Lab 13.1
 (%)
3.0
2.6
AS7…
AS2
AS0,1
AD1, 2,…
2.0
2.0
AD0
3.0
Inflation rate () up
 Taylor principle
Real interest rate (r) up
r (%)
5.0
Borrowing is more costly

C and I down
GDP
2,100
2,000
G increases AS dynamics

kick in.
AD curve shifts right
Increase in Government Spending
Govt
Purch
500
600
600
Con
Purch
1,300
1,312
1,257
Invest
Purch
200
188
183
Int Rate
r (%)
3.0
4.2
4.7
Infl Rate
 (%)
2.0
2.6
2.8
Period GDP
Deficit
0
2,000
0
1
2,100
100
2.
2,040
100
..
7
2,000
600
100
1,220
180
5.0
3.0
8
2,000
600
100
1,220
180
5.0
3.0
Possibility: The government could be financing
Bottom Line
infrastructure projects. This public investment would
increase the productivity of American workers.
Budget deficits resulting from
increased government purchases
In the long run: GDP = GDPP = 2,000

Real interest rate (r) increases

(Private ) Investment falls:
Crowding Out

In the future, U.S. workers will have
fewer tools, less modern factories,
etc. and will be less productive
In the long run, GDP = GDPP = 2,000
In the long run, GDP = GDPP = 2,000
Inflation Targeting
In 2012, the Fed adopted inflation targeting:
In historic shift, Fed sets inflation target
By Jonathan Spicer
Wed Jan 25, 2012 6:35 EST
(Reuters) - The Federal Reserve took the historic step on Wednesday of setting
an inflation target, a victory for Chairman Ben Bernanke that brings the Fed in
line with many of the world's other major central banks.
The U.S. central bank, in its first ever "longer-run goals and policy strategy"
statement, said an inflation rate of 2 percent best aligned with its
congressionally mandated goals of price stability and full employment.
Inflation targeting uses autonomous monetary policies to achieve a predetermined inflation
rate target:
First, the Fed chooses a target inflation rate.
Second, the Fed pursues autonomous monetary policies to meet the target. That is, the
Fed shifts the Fed policy (FP) curve and therefore the aggregate demand (AD) curve to
achieve its target inflation rate.
Review: Autonomous Monetary Policy: Shift of the Fed Policy (FP) curve
Autonomous Expansionary Monetary Policy
Autonomous Contractionary Monetary Policy

Fed becomes tougher on inflation

Fed shifts the FP curve right

At a given inflation rate (),
the Fed increases the real interest rate (r).

Fed becomes easier on inflation

Fed shifts the FP curve left

At a given inflation rate (),
the Fed decreases the real interest rate (r).
FP Question: What would the real
interest rate (r) equal, if the inflation rate
() were _______ percent, given that the
Fed does not change its inflation policy?
AD Question: How many final goods and
services would be purchased, if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
 (%)
 (%)
FP
FP curve shifts right

AD curve shifts left

Contractionary
 Lab 10.1
AD
FP
At a given
inflation
rate ()
AD
G&S
r (%)
Fed increases
Loans
Households
Fewer goods
Aggregate
the real
 become more  and firms  and services  demand (AD)
interest rate (r)
costly
purchase less
purchased
curve shifts left
Increases in Government Purchases – Inflation Targeting
Period
0
1
2
..
.
7
8
GDP
2,000
2,000
2,000
Govt
Purch
500
600
600
2,000
2,000
600
600
Deficit
0
100
100
Con
Purch
1,300
1,220
1,220
100
100
1,220
1,220
Invest
Purch
200
180
180
Int Rate
r (%)
3.0
5.0
5.0
Infl Rate
 (%)
2.0
2.0
2.0
180
180
5.0
5.0
2.0
2.0
Contractionary
Expansionary
autonomous
fiscalmonetary
policy policy

Fed becomes
G increases
tougher on inflation
 Lab 19.1
 (%)
SRAS0,1
 GDP = C + I + G
At ashifts
giventhe
r, GDP
increases
Fed
FP curve
right
 Borrowing costs up
Households and
AD firms
curve purchases
shifts rightfewer goods
2.0
AD1
AD0, AD1
GDP
2,000
2,100

C and I decrease
 GDP = C + I + G
At a given r, GDP decreases

AD curve shifts left
Classical Dichotomy
No
Inflation
Targeting
(No auto.
monetary
policy)
Inflation
Targeting:
2.0%
(Auto.
monetary
policy)
Period
GDP
Govt
Purch
0
1
2.
..
7
8
0
1
2
.
.
.
7
8
2,000
2,100
2,040
500
600
600
0
100
100
1,300
1,312
1,257
200
188
183
3.0
4.2
4.7
2.0
2.6
2.8
2,000
2,000
2,000
2,000
2,000
600
600
500
600
600
100
100
0
100
100
1,220
1,220
1,300
1,220
1,220
100
100
200
180
180
5.0
5.0
3.0
5.0
5.0
3.0
3.0
2.0
2.0
2.0
2,000
2,000
600
600
100
100
1,220
1,220
180
180
5.0
5.0
2.0
2.0
Deficit
Con
Purch
Invest
Purch
Int Rate
r (%)
Infl Rate
 (%)
In the long run, the Fed’s autonomous monetary policy:
Has no effect on the “real” economy. Has no effect on real
GDP
Consumption purchases
Interest rate
Investment purchases
Government purchases
Has an effect only on the inflation rate.
This phenomenon has
a fancy name:
Classical dichotomy.
International Finance
Foreign Exchange Rates – Wednesday, December 10 9:00 am
Japanese Yen
121
Yens per Dollar
British Pound
1.52
Dollars per Pound
1.10
Euro
Dollars per Euro
Exchange Rate for Euros is expressed as Dollar per Euro = 1.10
€1.00 “buys” $1.10
Exchange Rate for Euros can also be expressed as Euros per Dollar = .91
$1.00 “buys” €.91
Exchange Rates and Prices
Price of a BMW = €60,000
Price of a Chevy Volt = $30,000
Exchange Rate ( Euros per Dollar)
$30,000
€30,000
$30,000
€2.00 per $1.00
€60,000 $30,000
€60,000 $120,000
€60,000
$60,000
€60,000
€.50 per $1.00
Price of
a Volt
Price of
a BMW
€15,000
Weak Dollar
(Strong Euro)
Who does a weak dollar
hurt?
benefit?
European
consumers
American
consumers
€1.00 per $1.00
$30,000
Strong Dollar
(Weak Euro)
Question:
How is the exchange
rate determined?
Who does a strong dollar
hurt?
benefit?
American
consumers
European
consumers
Foreign Exchange Market for Dollars
Foreign Exchange Market for Dollars
€ per $
Claim: The demand
curve for dollars in the
foreign exchange market
is downward sloping.
Equilibrium:
S
D
Dollars
Quantity of Dollars
=
Demanded by
Europeans
Claim: The supply curve
for dollars in the foreign
exchange market is
upward sloping.
Quantity of Dollars
Supplied by
Americans
Foreign Exchange Market for Dollars
Exchange Rate ( Euros per Dollar)
€1.00 per $1.00
€2.00 per $1.00
€.50 per $1.00
Price of a Volt
€15,000
$30,000
€30,000
$30,000
€60,000
$30,000
Price of a BMW
€60,000 $120,000
€60,000
$60,000
€60,000
$30,000
As the exchange rate (Euros per Dollar) increases
Do U.S. produced goods and services become
more or less expensive for Europeans? More
Do European produced goods and services
become more or less expensive for Americans?
Less
Do European demand more or fewer U.S.
produced goods and services? Fewer
Do Americans demand more or fewer
European produced goods and services? More
Do European demand more or fewer U.S.
Dollars? Fewer
Do Americans supply more or fewer Dollars?
More
Is the demand curve for U.S. Dollars in the
foreign exchange market is downward or
upward sloping? Downward
Is the supply curve for U.S. Dollars in the
foreign exchange market is downward or
upward sloping? Upward
€ per $
Demand Curve:
European Demand
€ per $
DG&S
U.S. Exports
of G&S
European Purchases
of American
Goods and Services
Foreign Exchange
Market for Dollars
SG&S
€ per $
Supply Curve:
American Demand
SG&S
DG&S
Dollars
Dollars
U.S. Net Exports = 0
U.S. Imports
of G&S
American Purchases
of European
Goods and Services
Dollars
U.S. Net Exports
equals
U.S. Exports  U.S. Imports
Question: What are we missing?
U.S. Net Exports < 0

U.S. Exports < U.S. Imports

Net inflow of Goods into the U.S.

Net outflow of Assets into the U.S.
U.S. Net Exports = U.S. Exports  U.S. Imports
Question: How does the
U.S. pay for the goods?
Benchmark Case:
European
Purchases of
American
Assets
€ per $
equals
American
Purchases of
European
Assets
Demand Curve:
European Demand
€ per $
Foreign Exchange
Market for Dollars
€ per $
SG&S
SG&S+A
Supply Curve:
American Demand
SG&S SG&S+A
Eur
Assets
U.S.
Assets
DG&S DG&S+A
Dollars
U.S. Exports
of G&S
DG&S
U.S. Net Exports = 0
DG&S+A
Dollars
U.S. Imports
of G&S
Dollars
Net Exports and Real Interest Rates
U.S. real interest rates increase:
Europeans find
Americans find
American assets European assets less
more attractive
attractive

Demand curve for
Dollars shifts right
€ per $

Supply curve for
Dollars shifts left
Demand Curve:
European Demand
€ per $
DG&S
U.S. Exports
of G&S
Foreign Exchange
Market for Dollars
SG&S+A
DG&S+A
DG&S+A
Dollars
Dollars
U.S. Net Exports =
<0
€ per $
Supply Curve:
American Demand
SG&S+A
SG&S
U.S. Imports
of G&S
Dollars
Greek Debt Crisis
January 2011 – September 2011: Specter
of Greek Default Emerges
Became apparent that tax payments could not meet the government’s payments.
The bond rating agencies (Moodys, etc.) cut Greece’s credit ratings fearing that the Greek
Treasury would not be able to meet its bond commitments.
Question: How might the problem be resolved?
Answer: Austerity..
The basic problem was straightforward: More Euros were flowing out of the Greek
Nov 2011 – Jan 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout
The Socialist Greek Prime Minister, George Papandreou, calls for austerity moves: sharp
increases in taxes and spending cuts.
Violent protests erupt amid a 48-hour general strike.
Greek Prime Minister George Papandreou loses his majority in Parliament and resigns.
A unity government is formed by the opposing Conservative and Socialist parties naming
Lucas Papademos as prime minister.
Nationwide strike called to protest new cutbacks.
The unity Greek Prime Minister Papademos heads to Brussels to negotiate a bailout from the
European Central Bank.
Nov 2011 – Jan 2012:
Austerity, Protests,
Political Turmoil, and
Negotiations for a Bailout
European Bonds
Perceived as Riskier
Americans
Europeans find American
European
assets
assetsmore
less attractive
attractive

Demand
Supply curve shifts right
left
Demand Curve:
€ per $ European Demand
€ per $
Foreign Exchange
Market for Dollars
DG&S DG&S+A
Dollars
U.S. Exports
of G&S
SG&S+A
€ per $
Supply Curve:
American Demand
SG&S+A
SG&S
DG&S+A
Dollars
=0
U.S. Net Exports <
U.S. Imports
of G&S
Dollars
Nov 2011 – Jan 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout
The Socialist Greek Prime Minister, George Papandreou, calls for austerity moves: sharp
increases in taxes and spending cuts.
Violent protests erupt amid a 48-hour general strike.
Greek Prime Minister George Papandreou loses his majority in Parliament and resigns.
A unity government is formed by the opposing Conservative and Socialist parties naming
Lucas Papademos as prime minister.
Nationwide strike called to protest new cutbacks.
The unity Greek Prime Minister Papademos heads to Brussels to negotiate a bailout from the
European Central Bank.
Question: What’s a bailout?
Postpone the date at which Greece must pay the bonds.
Instead of paying the bonds in full, pay 75 percent of the bond or 50 percent of the bond.
Without a bailout, the Greek government would be bankrupt.
Speculation
Question: What would occur if individuals expect the Dollar to become dramatically stronger
and hence the Euro dramatically weaker in the near future?
have €8,000 deposited in a Paris bank that you plan to use in January when
you will be vacationing in France.
expect the dollar to strengthen with the exchange rate rising
from €.80 per $1.00 today to €1.00 per $1.00 in January
Claim: You would convert your
€8,000
Exchange Rate:
Euro assets into Dollar assets.

€.80 per $1.00
$10,000
Today: Exchange Euros for Dollars
Exchange Rate:

€1.00 per $1.00
Foreign Exchange
January: Exchange Dollars for Euros
€10,000
€ per $ Market for Dollars
If others share your view
Suppose you

They will also convert their
Euro assets into Dollar assets
Demand curve for
Dollars shifts right
SG&S+A
Supply curve for
Dollars shifts left
Exchange rate increases
This cycle could then continue.
DG&S+A
Dollars
Exh Rate of Euros per Dollar:
October 2011 - December 2014
0.82
0.80
0.78
0.76
0.74
0.72
0.70
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
January 2012 – February 2012: Austerity and a Tentative Bailout Agreement
A tentative agreement is reached between Greek leaders, bondholders and the ECB.
Greek elections scheduled for early May to seal the agreement.
March 2012 – April 2012: Relative Calm
May 2012 – June 2012: Greek Elections and the Return of Political Turmoil
Greek voters rejected the austerity program derailing the austerity program.
Greek leaders could not form a new government.
New elections were scheduled for June.
July 2012 – December 2012: New Government Formed and Austerity
June elections allow the Conservatives to form a new government.
The Conservative Prime Minister, Antonis Samaras, implements the austerity program.
Exh Rate of Euros per Dollar:
October 2011 - December 2014
0.82
0.80
0.78
0.76
0.74
0.72
0.70
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
January 2013 – December 2013: Austerity Continued
The Greek parliament abolishes 15,000 state jobs in April.
In July, the parliament passes a plan for thousands of more layoff and wage cuts for public
employees.
In November, Greece’s credit rating is raised by Moody.
January 2014 – May 2014: Progress of a Sort
In January, Greece posts a budget surplus
In May, Greece’s credit rating is raised by Fitch.
June 2014 – December 2014: More Political Turmoil
Unemployment rises to nearly 30 percent.
In December, the Conservative government resigns and a vote is scheduled for January.
Exh Rate of Euros per Dollar:
October 2011 - December 2015
0.95
0.90
0.85
0.80
0.75
0.70
Oct-11 Jan-12 Apr-12
Jul-12
Oct-12 Jan-13 Apr-13
Jul-13
Oct-13 Jan-14 Apr-14
Jul-14
Oct-14 Jan-15 Apr-15
Jul-15
Oct-15
January 2015– December 2015: More Turmoil
Syriza, the anti-austerity coalition party, wins the election in January. It ran on a platform
that the austerity program endorsed was too severe and it would negotiate a better deal.
For several months, negotiations took place, but Syriza failed to gain many concessions.
In July, an austerity program is put before Greek voters in a referendum that was not
substantially less austere. More than 60 percent of them vote against it.
In July and August attempts were made to agree on a new agreement. Much turmoil took
place: violent protests in the streets, Cabinet reshuffling, etc. Eletions are sheduled for
September.
Syriza wins again in November.
In November, Syriza proposed an austerity program that did not differ substantially from the
one it opposed in January. This program passed the Greek parliament in November.