Z: **Inactive**: Berkeley Economics 101b Fall 2005

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?

International Financial Crises and the State of the Dollar

Lecture notes on international financial crises:

http://www.j-bradford-delong.net/movable_type/pdf/hard_landing.pdf

Lecture: October 12: Stabilization Policy and Expectations: Extensions

Stabilization Policy and Expectations: Extensions: Handout

Lecture: October 10: The Phillips Curve, Expectations, and Monetary Policy

• The Phillips curve, expectations, and monetary policy

  • Aggregate supply and the Phillip curve
    • Unemployment
      • Unemployment and Okun's Law
      • (Y - Y)/Y = 2.5(u* - u)
      • Where Y* is potential output and u* is the "natural" rate of unemployment
      • Costs of high unemployment
    • Aggregate supply
      • The modern Phillips curve: π = π^e - B(u - u*) + S
      • Where: π is the inflation rate, π^e is expected inflation, u* is the natural rate of unemployment, and S is a supply-shock term.
      • What is expected inflation? We will deal with that later...
      • When unemployment is at its natural rate u*, inflation is at its expected value π^e, and vice versa
  • Monetary policy, aggregate demand, and inflation
    • Think of the Federal Reserve choosing three numbers--a "normal" level of unemployment, a target level of inflation, and a degree of aggressiveness in response to deviations of inflation from the target--as follows:
    • The Federal Reserve chooses a value of the interest rate r
      • (A gross shortcut, but let's make it)
    • When the Federal Reserve's choice of the interest rate r is at its normal value, then we go to the IS curve:
      • Y = A₀/[1-MPE] - (I_r + X_ee_r)/[1-MPE]
        • Where A₀ = C₀ + I₀ + G + X_fY^f + X_ee₀ + X_ee_rr^f
      • And find that Y is at some value Y₀, and thus that the unemployment rate is at value u₀--what the Federal Reserve thinks is the "normal" value of the unemployment rate
        • This should be, but may not be, the natural rate of unemployment u*
    • When inflation is higher than the Federal Reserve's desired target value π^T, the Federal Reserve gets nervous and pushes interest rates up--pushing investment and exports down, pushing output down, and pushing unemployment up above u₀
    • When inflation is higher than the Federal Reserve's desired target value π^T, the Federal Reserve gets nervous and pushes interest rates down--pushing investment and exports up, pushing output up, and pushing unemployment down below u₀
    • We model this with John Taylor's Monetary Policy Reaction Function (MPFRDF):
      • u = u₀ + o(π - π^T)
  • Equilibrium
    • We have:
      • u = u₀ + o(π - π^T)
      • π = π^e - B(u - u*) + S
    • And thus:
      • π = π^e/(1+Bo) + π^T/(1+Bo) - B(u₀ - u*)/(1+Bo) + S/(1+Bo)
    • Give us a rule for understanding how inflation expectations are formed, and we will be done.

• Inflation expectations

  • Three kinds:
    • Static
    • Adaptive
    • Rational
  • Static inflation expectations
    • Will exist only if fluctuations in inflation are small
    • Produces an economy that moves back and forth along a stable downward-sloping Phillips curve
      • π = π^e/(1+Bo) + (Bo)π^T/(1+Bo) - B(u₀ - u*)/(1+Bo) + S/(1+Bo)
      • u = u₀ + o(π - π^T)
    • With static expectations, only the sticky-price model is relevant
    • The U.S. in the 1950s and 1960s
  • Rational inflation expectations
    • Will exist in a sophisticated economy if the variation in government policy and in inflation is large
    • Produces an economy with a vertical Phillips curve (except for supply shocks): unemployment = u* plus supply-shock terms; changes in government policy and in the economic environment affect the rate of inflation only
    • π = π^T - (u₀ - u*)/o + S/(Bo)
    • Mitterand 1981
    • Only the flexible price model is relevant
  • Adaptive inflation expectations
    • Exponential convergence
      • [π_t - (π^T - (u₀ - u*)/o)] = (1/(1+Bo))[π_t-1 - (π^T - (u₀ - u*)/o)]

• The natural rate of unemployment

  • Natural rate vs. NAIRU
  • Demography
  • Institutions
  • Productivity growth
  • Past unemployment rates

Lecture: October 7: Optional: The Money Market and the LM Curve

• Optional: The money market and the LM curve
  • The money market and the money stock
    • Wealth, bonds, and the demand for money
    • Money supply
    • Money supply and money demand
      • Liquidity preference and the quantity theory of money: what's the relation? 8 Bond prices and interest rates
  • The LM curve
    • Interest rates and the LM curve
    • Drawing the LM curve
    • When is the LM curve relevant
      • When central banks are passive--or target money stocks
      • When the supply of money is given--as under a gold standard
  • The IS-LM framework
    • IS-LM equilibrium
    • IS shocks
    • LM shocks
    • Classifying disturbances
• Optional: Aggregate supply and aggregate demand
  • The price level and aggregate demand
  • The price level and aggregate supply
  • Prices: stuck? sticky? flexible?
  • The AS-AD diagram
    • Understanding demand and supply shocks

Lecture: October 5: The IS Curve

October 5: Investment, Net Exports, and the Real Interest Rate: The IS Curve

Last time we started with our behavioral relationships:

C = C₀ + C_y(1-t)Y; consumption function
I = I₀ - I_rr; business investment demand
G = G; government purchases
IM = IM_yY; import demand
X = X_fY^f + X_ee; export demand
e = e₀ + e_r(r^f - r)

And we made the key sticky-price assumptions:

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

And we derived:

Output as a function of autonomous spending A:

A = I + G + X + C₀
Y = A/(1-(C_y(1-t) - IM_y))

The multiplier: 1/(1-(C_y(1-t) - IM_y))

Now let's go one step further...

Investigating the dependence of autonomous spending on the real interest rate r, and thus of output on the real interest rate r...

• Interest Rates and Planned Expenditure

  • The importance of investment spending
  • The interest rate is not set in the loanable funds market in the sticky-price model
  • The interest rate is set by a combination of
    • Demand and supply for liquidity--money, and
    • The term structure of interest rates
  • Hence no presumption that fluctuations in investment--whether driven by "animal spirits" or movements in interest rates--are stable or stabilizing
  • Why investment depends on the real interest rate
    • The long-term, risky, real interest rate
  • Exports and autonomous spending
    • The exchange rate depends on the interest rate
    • Exports depend on the exchange rate
    • Hence exports are another interest-sensitive component of autonomous spending
  • The stock market as an indicator of investment

• The IS Curve

  • Autonomous spending and the interest rate
  • From the interest rate to investment to planned expenditure
  • The slope and position of the IS curve
    • (Inverse) Slope: (1-MPE)/(I_r + X_ee_r)
    • Position: A₀/((1-MPE)

• Equilibrium

  • Moving the economy to the IS curve
  • Interest rates adjust immediately
  • Inventories: output and demand levels adjust more slowly
  • Shifting the Is curve
    • Example: a change in government purchases
  • Moving along the IS curve
    • A change in monetary policy: open market operations
    • Difficulties in monetary management

• Using the IS curve to understand the U.S. economy

  • The 1960s: Federal Reserve keeps interest rates stable; Great Society and Vietnam War shift the IS curve outward
  • The late 1970s: The Volcker disinflation--raising real interest rates
  • The early 1980s: The Reagan deficits
  • The late 1980s: easing monetary policy as inflation dangers recede
  • The 1990s: initial sharp inward shift of IS curve; subsequent "new economy" boom
  • The 2000s: inward shift of IS curve coupled with substantial reduction in real interest rates...

Lecture: October 3: Sticky-Price Unemployment Business-Cycle Model

October 3: Sticky-Price Unemployment Business-Cycle Model

We now consider a time span too short for wages and prices to adjust to guarantee "full employment"...

So output Y is not necessarily equal to full-employment potential-output Y*...

We need a new equilibrium condition. Here it is: businesses adjust employment and production to keep their inventories stable--to match aggregate demand...

Other than this change of equilibrium condition, the model remains pretty much the same--but it behaves very differently.

We still have our behavioral relationships:

C = C₀ + C_y(1-t)Y; consumption function
I = I₀ - I_rr; business investment demand
G = G; government purchases
IM = IM_yY; import demand
X = X_fY^f + X_ee; export demand
e = e₀ + e_r(r^f - r)

But there are two differences:

r is now a fixed, given variable--the result of Federal Reserve policy (or of the current money stock and money demand) plus other influences
C + I + G + (X - IM) = Y is now an equilibrium condition--not an identity

• Sticky prices
  • Consequences of sticky prices
    • Flexible-price logic: prices adjust
    • Sticky-price logic: quantities adjust
    • Expectations and sticky-price logic
      • If expectations are fulfilled, then there will never be cases when price stickiness matters: it's only price stickiness plus surprising changes to economic policy or the economic environment that causes deviations from the full-employment model of chapters 6 and 7 *Why are prices sticky?
    • Menu costs
    • Lack of information--confusion of real and nominal magnitudes
    • Sociology: the social consequences of wage cuts
    • Simple "money illusion"
• Income and expenditure
  • Building up total planned expenditure
    • Consumption function
    • Investment spending
    • Government purchases
    • Net exports: exports minus imports
  • Autonomous spending A
  • The marginal propensity to expend on domestic goods: C_y(1-t) - IM_y
  • Sticky-price equilibrium: Y = A/(1-(C_y(1-t) - IM_y))
  • The multiplier: 1/(1-(C_y(1-t) - IM_y))
    • The multiplier used to be much more important than it is today...
• The process of inventory adjustment

September 30: Lecture: First Midterm

September 30: Lecture: First Midterm

September 28: Lecture: Review

September 28: Lecture: Review

September 26: Lecture: Money, Prices, and Inflation

September 26: Lecture: Money, Prices, and Inflation

• Money

  • "Outside" money

  • "Inside" money

  • Money as readily-spendable wealth

    • Its convenience yield

    • Avoids the problem of the coincidence of wants

  • Medium of exchange

  • Store of value

  • Unit of account

• The Quantity Theory of Money

  • Demand for money

  • The quantity equation: MV = PY

  • Supply of money: reserves, cash, and the banking system
    • Definitions of money...

• Money and prices

  • The price level
  • Measuring the price level
  • The inflation rate
  • Inflation and the nominal interest rate: the Fisher effect
• The costs of moderate inflation
  • Disrupting the tax system
  • Degrading the efficiency of the price system
  • Expected and unexpected inflation
• The costs of hyperinflation
  • The sources of hyperinflation
    • If the government doesn't balance its budget, the market will--by levying the inflation tax...
• When money demand depends on the interest rate...
  • Stopping hyperinflation then requires a large increase in the real money stock--a neat trick if credibility depends on not printing too much money...