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slide 1
CASE STUDY CASE STUDY
Volcker’s Monetary TighteningVolcker’s Monetary Tightening Late 1970s: > 10%
Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation.
Aug 1979-April 1980: Fed reduces M/P 8.0%
Jan 1983: = 3.7%
How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?
How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?
slide 2
Volcker’s Monetary Tightening, Volcker’s Monetary Tightening, cont.cont.
i < 0i > 0
1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%
flexiblesticky
Quantity Theory, Fisher Effect
(Classical)
Liquidity Preference(Keynesian)
prediction
actual outcome
The effects of a monetary tightening on nominal interest rates
prices
model
long runshort run
slide 3
EXERCISE:EXERCISE: Analyze shocks with the IS-LM modelAnalyze shocks with the IS-LM modelUse the IS-LM model to analyze the effects of
1. A boom in the stock market makes consumers wealthier.
2. After a wave of credit card fraud, consumers use cash more frequently in transactions.
For each shock, a. use the IS-LM diagram to show the effects
of the shock on Y and r .b. determine what happens to C, I, and the
unemployment rate.
slide 4
What is the Fed’s policy instrument?What is the Fed’s policy instrument?
What the newspaper says:“the Fed lowered interest rates by one-half point today”
What actually happened:The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points.
The Fed The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value,
and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve
as needed to attain its target rate. as needed to attain its target rate.
The Fed The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value,
and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve
as needed to attain its target rate. as needed to attain its target rate.
slide 5
What is the Fed’s policy instrument?What is the Fed’s policy instrument?
Why does the Fed target interest rates instead of the money supply?
1)They are easier to measure than the money supply
2)The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.
slide 6
Interaction between Interaction between monetary & fiscal policymonetary & fiscal policy
Model: monetary & fiscal policy variables (M, G and T ) are exogenous
Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.
Such interaction may alter the impact of the original policy change.
slide 7
The Fed’s response to The Fed’s response to GG > 0 > 0
Suppose Congress increases G.
Possible Fed responses:1. hold M constant2. hold r constant3. hold Y constant
In each case, the effects of the G are different:
slide 8
If Congress raises G, the IS curve shifts right
IS1
Response 1: hold Response 1: hold MM constant constant
Y
rLM1
r1
Y1
IS2
Y2
r2If Fed holds M constant, then LM curve doesn’t shift.
Results:2 1Y Y Y
2 1r r r
slide 9
If Congress raises G, the IS curve shifts right
IS1
Response 2: hold Response 2: hold rr constant constant
Y
rLM1
r1
Y1
IS2
Y2
r2To keep r constant, Fed increases M to shift LM curve right.
3 1Y Y Y
0r
LM2
Y3
Results:
slide 10
If Congress raises G, the IS curve shifts right
IS1
Response 3: hold Response 3: hold YY constant constant
Y
rLM1
r1
IS2
Y2
r2To keep Y constant, Fed reduces M to shift LM curve left.
0Y
3 1r r r
LM2
Results:
Y1
r3
slide 11
CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate1994-2000: 3.9% (average
annual)2001: 1.2%
2. Unemployment rateDec 2000: 4.0%
Dec 2001: 5.8%
slide 12
CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11• increased uncertainty • fall in consumer & business confidence
Both shocks reduced spending and shifted the IS curve left.
slide 13
The Great DepressionThe Great Depression
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
bill
ions
of 1
958 d
olla
rs
0
5
10
15
20
25
30
perc
ent o
f labor
forc
e
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
bill
ions
of 1
958 d
olla
rs
0
5
10
15
20
25
30
perc
ent o
f labor
forc
e
Unemployment (right scale)
Real GNP(left scale)
slide 14
The Spending Hypothesis: The Spending Hypothesis: Shocks to the IS CurveShocks to the IS Curve
asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve
evidence: output and interest rates both fell, which is what a leftward IS shift would cause
slide 15
The Spending Hypothesis: The Spending Hypothesis: Reasons for the IS shiftReasons for the IS shift
1. Stock market crash exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment “correction” after overbuilding in the
1920s widespread bank failures made it harder to
obtain financing for investment
3. Contractionary fiscal policy in the face of falling tax revenues and
increasing deficits, politicians raised tax rates and cut spending
slide 16
The Money Hypothesis: The Money Hypothesis: A Shock to the LM CurveA Shock to the LM Curve
asserts that the Depression was largely due to huge fall in the money supply
evidence: M1 fell 25% during 1929-33.
But, two problems with this hypothesis:1. P fell even more, so M/P actually rose
slightly during 1929-31. 2. nominal interest rates fell, which is the
opposite of what would result from a leftward LM shift.
slide 17
The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe Effects of Falling Prices
asserts that the severity of the Depression was due to a huge deflation:
P fell 25% during 1929-33.
This deflation was probably caused by the fall in M, so perhaps money played an important role after all.
In what ways does a deflation affect the economy?
slide 18
The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe Effects of Falling Prices
The stabilizing effects of deflation:
P (M/P ) LM shifts right Y
Pigou effect:
P (M/P )
consumers’ wealth
C
IS shifts right
Y
slide 19
The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe Effects of Falling Prices
The destabilizing effects of unexpected deflation:debt-deflation theory
P (if unexpected) transfers purchasing power from
borrowers to lenders borrowers spend less,
lenders spend more if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls
slide 20
The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe Effects of Falling Prices
The destabilizing effects of expected deflation:
e
r for each value of i I because I = I (r ) planned expenditure & agg.
demand income & output
slide 21
Why another Depression is unlikelyWhy another Depression is unlikely
Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let M fall
so much, especially during a contraction. Fiscal policymakers know better than to
raise taxes or cut spending during a contraction.
Federal deposit insurance makes widespread bank failures very unlikely.
Automatic stabilizers make fiscal policy expansionary during an economic downturn.
slide 22
Percentageof GDP
40
35
30
25
20
15
10
5
0Canada France Germany Italy Japan U.K. U.S.Imports Exports
Imports and Exports Imports and Exports as a percentage of output: 2000as a percentage of output: 2000
slide 23
Three experimentsThree experiments
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
slide 24
1. 1. Fiscal policy at homeFiscal policy at home
r
S, I
I (r )
1S
I 1
An increase in G or decrease in T reduces saving. 1
*r
NX1
2S
NX2
Results:
0I
0NX S
slide 25
NX and the Government Budget DeficitNX and the Government Budget Deficit
Budget deficit(right scale)
Net exports(left scale)
slide 26
2. 2. Fiscal policy abroadFiscal policy abroad
r
S, I
I (r )
1SExpansionary fiscal policy abroad raises the world interest rate.
1*r
NX1
NX2
Results: 0I
0NX I
2*r
1( )*I r2( )*I r
slide 27
3. 3. An increase in investment demandAn increase in investment demand
r
S, I
I (r )1
EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.
NX1
*r
I 1
S
slide 28
3. 3. An increase in investment demandAn increase in investment demand
r
S, I
I (r )1
ANSWERS:I > 0,S = 0,net capital outflows and net exports fall by the amount I
NX2
NX1
*r
I 1 I 2
S
I (r )2
slide 29
U.S. Net Exports and the U.S. Net Exports and the Real Exchange Rate, Real Exchange Rate, 1975-20021975-2002
-5
-4
-3
-2
-1
0
1
2
1975 1980 1985 1990 1995 2000
Per
cen
t o
f G
DP
0
20
40
60
80
100
120
140
1998
:2 =
100
Net exports (left scale) Real exchange rate (right scale)
slide 30
Four experimentsFour experiments
1. Fiscal policy at home
2. Fiscal policy abroad
3. An increase in investment demand
4. Trade policy to restrict imports
slide 31
1. 1. Fiscal policy at homeFiscal policy at homeA fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market…
…causing the real exchange rate to rise and NX to fall.
ε
NX
NX(ε
)
1 ( *)S I r
ε 1
NX 1NX 2
2 ( *)S I r
ε 2
slide 32
2. 2. Fiscal policy abroadFiscal policy abroad
An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market…
…causing the real exchange rate to fall and NX to rise.
ε
NX
NX(ε
)
1 1( *)S I r
NX 1
ε 1
21 ( )*S I r
ε 2
NX 2
slide 33
3. 3. An increase in investment An increase in investment demanddemand
An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market…
ε
NX
NX(ε
)…causing the real exchange rate to rise and NX to fall.
ε 1
1 1S I
NX 1
21S I
NX 2
ε 2
slide 34
4. 4. Trade policy to restrict importsTrade policy to restrict imports
ε
NX
NX (ε )1
S I
NX1
ε 1
NX (ε )2
At any given value of ε, an import quota IM NXdemand for
dollars shifts right
Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed.
ε 2
slide 35
4. 4. Trade policy to restrict importsTrade policy to restrict imports
ε
NX
NX (ε )1
S I
NX1
ε 1
NX (ε )2
Results:
ε > 0 (demand increase)
NX = 0(supply fixed)
IM < 0 (policy)
EX < 0(rise in ε )
ε 2
slide 36
Inflation and nominal exchange ratesInflation and nominal exchange rates
Percentage changein nominalexchange rate
10 9 8 7 6 5 4 3 2 1
0 -1 -2 -3 -4
Inflation differential
Depreciationrelative to U.S. dollar
Appreciationrelative to U.S. dollar
-1-2-3 10 2 3 4 5 6 87
France
Canada
SwedenAustralia
UK
Ireland
Spain
South Africa
Italy
New Zealand
NetherlandsGermany
Japan
Belgium
Switzerland
slide 37
no change
no change
no change
no change
129.4
-2.0
19.4
6.3
17.4
3.9
115.1
-0.3
19.9
1.1
19.6
2.2
closed economy
small open economy
actual change
ε
NX
I
r
S
G – T
1980s
1970s
Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index.
CASE STUDYCASE STUDYThe Reagan Deficits revisitedThe Reagan Deficits revisited