Part II of Course: Topic Outline

Economics 101b, Fall 2005, Part II

Consensus Flexible-Price Business-Cycle Model

Consensus Sticky-Price Business-Cycle Model

The Phillips Curve, inflation Expectations, and the Natural Rate of Unemployment

Monetary Policy Reaction Functions: From the Short Run to the Long Run

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Japan

• Needed extensions to consensus model:
  • The liquidity trap: financial distress and expected deflation mean that the central bank cannot push interest rates low enough to attain full employment.
  • Connection between macroeconomic slack--shortfalls of output beneath potential--and slow growth of potential output.
    • Mechanisms for the connection of macroeconomic slack to slow potential output growth? A surprisingly close connection between slack and an absence of pressure on firms to innovate in their organizations.
• Policies to make things better:
  • Create expectations of future inflation--and devaluation
  • Large budget deficits to stimulate demand
  • Recapitalize the banking system to reduce risk and default premia in financial markets

European Unemployment

• Needed extensions to consensus model:
  • "Hysteresis": somehow a high actual rate of unemployment in the past generates a high natural rate of unemployment in the present.
  • Effects of productivity slowdown on the natural rate of unemployment.
• Policies to make things better:
  • The "two handed approach"
  • Easier monetary policy to create more demand
  • Labor market reforms to boost labor supply to ensure that more demand produces higher employment and not higher inflation

Financial Crises

• Needed extensions to consensus model:
  • A large, sudden devaluation leads to large scale bankruptcies and greatly depresses investment.
  • Such large scale bankruptcies are produced first by "currency mismatch" and second by "maturity mismatch"
  • Government foreign exchange reserves--and IMF reserves--capable of affecting the exchange rate in the first place
• Policies to make things better:
  • Don't get into the situation in the first place--don't let your exchange rate become potentially overvalued
  • Don't get into the situation in the first place--don't let your national savings rate get low
  • Have lots of foreign exchange reserves
  • Act quickly to resolver banking-system difficulties
  • Get help
• Unanswered question: is the U.S. now close to the edge as far as such a major financial crisis is concerned?