Transcript L7 - Harvard University

(III) MONEY & INFLATION, CONTINUED
LECTURE 7:
THE RATIONAL EXPECTATIONS HYPOTHESIS
Question:
Continuing to account for the role of expectations πe in
AS (Lecture 6), what difference does it make if expectations
are rational: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 (𝜋) = πe ?
Answer:
It may mean that monetary policy cannot have
a systematic effect on GDP or other real variables.
An example
of predictable
inflation:
The
Mexican
sexenio
From 1976
through 1994,
inflation shot up
every 6th year
(presidential
election years)
and the peso
would devalue.
Why?
1976
1982
1988
1994
API-120 - Prof. J. Frankel, Harvard University
The Mexican sexenio, continued
Example of rational expectations: investors came to anticipate inflation
& devaluation after elections, and so would pull out ahead of time.
1982
1988
1994
J.Bianchi, J.C.Hatchondo, L.Martinez, 2013,
“International Reserves and Rollover Risk,”
FRB Richmond WP13-01R , NBER WP 18628
API-120 - Prof. J. Frankel, Harvard University
OVERVIEW OF AGGREGATE SUPPLY (continued)
SR supply
relationship:
𝑌
𝑌
=
𝑃 σ
(ω )
𝑊
Wage contract 𝑊 = ω𝑃𝑒 .
● Lucas supply relationship
𝑌
or in logs,
𝑌
=
𝑃
𝑃𝑒
σ
Robert Lucas
y - 𝑦 = σ (π − π𝑒 )
where π ≡ p – p-1
and πe ≡ pe – p-1 .
= σ ε,
where ε is the forecast error;
Rational expectations says ε is unforecastable: Expectationt (εt+1 ) = 0.
=> Monetary policy cannot have a systematic effect on y - 𝑦 .
API-120 - Prof. J. Frankel
If the public rationally expects stimulus each election year,
the government then has to deliver the inflation
just to keep Y from falling below 𝑌.
AS election year πe > 0
π
•
0
•
𝑌
y - 𝑦 = σ (π − π𝑒 )
AS
when πe =0: y - 𝑦 = σ π
AD election year
𝑌
AD
API-120 - Prof. J. Frankel, Harvard University
Intellectual History of the Increasing Ineffectiveness
of Monetary Policy at Stabilizing Output
y - 𝒚 = 𝝈 (𝝅 − 𝝅𝒆 ),
Monetary expansion can raise Y?
A.S. --
Yes, but at the cost of higher P.
Phillips curve (1958) --
…at the cost of higher inflation, .
Friedman & Phelps (1968)
Natural Rate Hypothesis. --
…at the cost of ever-accelerating 
(because πe adjusts over time to π).
Lucas, Sargent, Barro (1972-78)
Rational Expectations --
…only randomly
(because π-πe must be random).
Kydland-Prescott (1977) & Barroand, worse yet: monetary discretion
Gordon (1983). Time-inconsistency -=> inflationary bias.
E.g., Dornbusch-Fischer (1993)
& Bruno-Easterly (1998) --
High  (>40%) hurts growth
in the LR. (Table 2)
API-120 - Prof. J. Frankel, Harvard University
Inflation above a
threshold ≈ 40%
tends to have
a negative effect
on growth.
Source:
Inflation is usually > 0
and was a chronic problem during 1950-2000.
Source: Carmen Reinhart & Ken Rogoff, 2011,This Time is Different:
A Panoramic View of Eight Centuries of Financial Crises.
The highest inflation rate now is in Venezuela.
50
45
%
CPI Inflation, 2014
VEN = 75
(full-year projection)
40
35
30
25
ARG¹
20
15
10
5
URY
NIC
HND
BRA
0
Source: Cubeddu, Iakova, & Sosa, IMF, Feb.2015. Data from: IMF, World Economic Outlook July 2014 Update; and staff calculations.
¹ For Argentina, projected annual inflation is computed using cumulative inflation through July and assuming monthly inflation for the rest of the year will equal the
average of the last three months.
If monetary expansion can’t reduce unemployment
in the long run, why is inflation so common?
Four possible explanations:
 Governments think expansion can reduce
unemployment even in the long run.
 They give low weight to price stability,
or have high discount rates (e.g., political business cycle).
 Plans to set non-inflationary monetary policy are
perceived by the public to be time-inconsistent (Lecture 8).
 Governments want seigniorage, to pay for spending
that is not financed by taxes or borrowing (Lecture 9).
API-120 Prof. J.Frankel
Appendix: Targets & Instruments of Monetary Policymaking
OBJECTIVES
Inflation
Growth & Unemployment
TB, Balance of payments
INSTRUMENTS
Overnight interest rate
Open market operations
Reserve requirements
Foreign exchange intervention
INTERMEDIATE TARGETS
M1
Exchange rate
Core CPI
Nominal GDP
INDICATORS
Stock market, Commodity prices,
Consumer confidence, PMI …