### ISMP_2013_L2_v4a_post

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Schools of Macroconomics
longrun
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.
Short run or long run?
capital,
expectations, etc.)
shortrun
yes
no
yes
Classical
or non-classical?
(sticky wages
and prices, rational
expectations, etc.
no
Neo-classical
growth
model
Marxist theories?
Behavior growth theories?
Malthusian trap models?
Real business cycle (RBC);
supply-side economics;
structural models;
misperceptions models
Keynesian model
(inflexible w and p,
Suboptimal behavior,
PC, IS-MP, etc.)
2
REVIEW: IS curve (expenditures)
Basic idea: describes equilibrium in goods market.
Finds Y where planned I = planned S or planned
expenditure = planned output.
Basic set of equations:
1.
2.
3.
4.
5.
Y=C+I+G
C = a + b(Y-T)
T = T0 + τ Y
I = I0 – dr
G = G0
[note assume income tax, τ = marginal tax rate]
[note i = r because zero inflation]
3
REVIEW: MP curve with the dual mandate
The Taylor Rule
Begin with a monetary policy equation in the form of a “Taylor rule”:
(TR)
i = π + r* + b(π-π*) + cy
r* is the equilibrium real interest rate, π inflation rate, π* is inflation
target, y is log output gap [log(Y/Yp)], b and c are parameters.
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MP curve with inflation
Now add inflation to the MP curve.
Assume that inflation is a function of output (this will be covered later):
(PC)
π = π*+φ y + η (η =inflation shock)
(TR)
i = π + r* + b(π-π*) + cy
So new MP curve is:
i = π + r* + b(φ y + η ) + cy
or
(MP)
i = π + r* + (bφ+c) y + bη
(MP’)
i = π + r* + λy [λ = bφ+c for η = 0].
So adding inflation makes the MP curve steeper, but does not change
the basic structure..
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Algebra of IS-MP Analysis
• The analysis looks at simultaneous equilibrium in goods
market and financial markets (Main St and Wall St).
• The algebraic solution for equilibrium Ye is:
Ye = μ*A0 – μ* d r*
where μ* = μ/(1 + λμd) = multiplier with monetary policy.
μ = simple multiplier > μ* ; A0 = autonomous spending
= a - bT0 + G0 + I0 + demand shocks,
Note impacts on output:
Positive: G, I0, NX, demand shocks
Negative: risk premium, inflation shocks
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IS-MP diagram
r = real
interest rate
MP(r*, inflation shocks)
E
re
IS(G, T0, demand
shocks …)
Ye
Y = real output (GDP)
7
Monetary v. fiscal policy
Monetary policy: Actions by central bank that affect
interest rates and asset prices by balance sheet operations
and regulations.
- Open market operations, asset purchases, reserve
requirements. Do not directly affect incomes.
Fiscal policy: Actions by governments that affect incomes
and output directly through purchases and taxes.
- Government purchases (military, teachers, roads,…)
- Taxes (income taxes, corporation taxes, …)
- Transfers or negative taxes (social security benefits, UI, …)
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Important historical examples
Monetary policy:
Fed raised discount rate in Great Depression to defend gold
reserves, and deepened Depression.
Fed engaged in forward guidance and asset purchases in
Great Recession to stimulate output.
Fiscal policy:
Huge US military spending in 1941-45 brought economy out
of recession.
Kennedy-Johnson tax cuts of 1963 were first explicitly
Keynesian stimulus policy.
Reagan “supply side” tax cuts of 1981 were designed to
increase potential output growth.
Obama stimulus package in 2009 spurred growth but became
highly controversial.
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1. What are the effects of fiscal policy?
• Consider a fiscal policy holding monetary policy constant.
• In normal times, because MP curve slopes upward,
expenditure multiplier is reduced due to crowding out.
10
IS shock (as in fiscal expansion)
MP
i
IS(G’)
IS(G)
Y = real output (GDP)
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Multiplier Estimates by the CBO
3.0
Multiplier from G,T on GDP
2.5
2.0
1.5
1.0
0.5
0.0
G: Fed
G: S&L
Trans: indiv
Tax:
Mid/Low
Income
Tax: High
Income
Congressional Budget Office, Estimated Impact of the ARRA, April 2010
Bus Tax
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Quizlet in class:
Can you explain why the multipliers are different
3.0
Multiplier from G,T on GDP
2.5
2.0
1.5
[λ
1.0
0.5
0.0
G: Fed
G: S&L
Trans: indiv
Tax:
Mid/Low
Income
Tax: High
Income
Bus Tax
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Inflationary shock
and stagflation
MP(ηt > 0)
MP(ηt = 0)
i
it**
IS
Yt**
Y = real output
14
Can we understand divergent fortunes EU and US?
14
12
unemploy rate EU
unemploy rate US
10
8
6
4
2
2000
2002
2004
2006
2008
2010
2012
15
Dual v single mandate
What are MP curves with different mandates?
(Dual: Fed)
i = π + r* + b(π-π*) + cy
(Single: ECB) i = π + r* + b(π-π*)
(MP: Fed)
i = π + r* + (bφ+c) y + bη
(MP: ECB)
i = π + r* + (bφ) y + bη
So the MP curve of Fed is steeper. This means:
- Fed tolerates greater volatility of inflation, but stabilizes
unemployment.
- ECB tolerates more unemployment but very averse to inflation
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ECB Single Mandate
In accordance with Article 127(1) and Article 282(2) of the Treaty on the
Functioning of the European Union, the primary objective of the ESCB
shall be to maintain price stability
While the Treaty clearly establishes the primary objective of the ECB, it
does not give a precise definition of what is meant by price stability.
The ECB’s Governing Council has announced a quantitative definition
of price stability:
"Price stability is defined as a year-on-year increase in the Harmonised
Index of Consumer Prices (HICP) for the euro area of below 2%."
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Dual v single mandate
MP(Fed)
i
MP(ECB)
ECB
Fed
IS
IS’
Y = real output (GDP)
18
What about in the “liquidity trap”
or “zero interest rate bound”
19
6
US short-term interest rates, 1929-45 (% per year)
Liquidity
trap in US in
Great
Depression
5
4
3
2
1
0
1930
1932
1934
1936
1938
1940
1942
1944
20
Japan short-term interest rates, 1994-2012
Liquidity trap from 1996 to today:
16 years and counting.
21
US in current recession
Federal funds rate (%)
Policy has
hit the
“zero lower
bound” five
years ago.
20
16
12
8
4
0
1975
1980
1985
1990
1995
2000
2005
2010
22
Conventional monetary expansion in liquidity trap
i = nominal
interest rate
IS
MP
MP’
re
Y = real output (GDP)
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Fiscal policy in liquidity trap
r = real
interest rate
IS
IS’
MP
re
Y = real output (GDP)
24
Can you see why macroeconomists emphasize the
importance of fiscal policy in the current environment?
“Our policy approach started with a major commitment to fiscal
stimulus. Economists in recent years have become skeptical about
discretionary fiscal policy and have regarded monetary policy as a
better tool for short-term stabilization. Our judgment, however, was
that in a liquidity trap-type scenario of zero interest rates, a
dysfunctional financial system, and expectations of protracted
contraction, the results of monetary policy were highly uncertain
whereas fiscal policy was likely to be potent.”
Lawrence Summers, July 19, 2009
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Monetarism
Older approach emphasize the supply of money (Mankiw’s
IS analysis).
Extreme version is “monetarism,” which holds that
demand for money does not depend on interest rate.
- Very influential in 1960s through 1983 or so.
- When tried, led to very poor predictions
Very important tradition, particularly Friedman and
Schwartz, A Monetary History of the United States.
Deemphasized in Econ 122, but still important in many
other views of macro (warning about dissensus)
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Summary on IS-MP Model
This is the workhorse model for analyzing short-run
impacts of monetary and fiscal policy
Key assumptions:
- Inflexible prices
- Unemployed resources
Now on to analysis of
- Panics
- Great Depression in IS-MP framework.
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