Download Macroeconomic problems

Macroeconomic problems
• In this lecture we will use our economic models
to study two persistent economic problemsdepression and hyperinflation.
• An economic depression is an extended period
of output below the natural rate and
unemployment above the natural rate.
• Hyperinflation (or just high inflation) is an
extended period of very high levels of inflation,
where price levels may be doubling monthly or
even weekly.
What is supposed to happen?
• When we have output below the natural rate, the
economic models that we have used so far in
the class have always had equilibrating forces
driving the economy back to the natural rate.
• In most of our stories, there is a shock to the
economy in the short-run, but the economy
moves back to its natural levels in the mediumrun.
• But in a depression, the economy is “stuck” in
the short-run equilibrium. What happens to the
equilibrating force?
Equilibrating force
• If we have a shock to the
economy, we wind up at
point A, where output is
below the natural rate
and unemployment is
above the natural rate.
• High unemployment
causes workers’ wages to
be bid down, which
causes firms to drop
prices.
• AS shifts so we move
towards point B.
Equilibrating force
• As prices falls, the AS
curve shifts down,
and the real stock of
money rises.
• As the real stock of
money rises, interest
rates are bid down,
and investment rises.
• As the LM curves
shifts down we move
towards equilibrium.
Open economy model
• Assume we have a
negative terms of trade
shock in an open
economy with fixed
exchange rates.
Domestic prices have
risen, so the real
exchange rate increases
and the domestic AD
curve shifts to the left.
• Higher unemployment
causes domestic wages
and also prices to fall.
Open economy model
• As prices fall, we can not have interest rates
falling, as uncovered interest parity must hold,
so monetary policy must maintain the real stock
of money.
• But the real exchange rate will fall as domestic P
falls, so NX will rise assuming the MarshallLerner condition holds. The IS curve shifts to
the right, so we move down the AD curve
towards B.
• What about the floating exchange rate case?
Open economy model
• However if the exchange
rate is floating, a fall in
domestic terms of trade
and high domestic P
leads to trade deficit. The
trade deficit will lead to a
drop in the price of the
A$, so E rises.
• A rise in E leads to a shift
rightward of the AD curve,
assuming M-L, back to
equilibrium.
Depression
• In an economic depression, this equilibrating
force is not working. There is no tendency for
the economy to move back to equilibrium, so we
are “stuck” at point A.
• So a depression requires that this equilibrating
mechanism has been blocked. That’s the only
way a depression can persist.
• The key point then is to concentrate on the
factor blocking the equilibrating mechanism in
these models.
Liquidity trap
• The equilibrating mechanism we saw was the
falling prices pushed down the interest rate.
• Currency earns a nominal interest rate of zero,
so bonds can not offer a lower rate than zero.
So there is a minimum rate to which nominal
interest can be pushed.
• Equilibrium in the money market was given by:
Supply = (M/P)s = Demand = YL(i)
• We used this relationship to map out our LM
curve for (Y and i).
Liquidity trap
• As Y drops, we see
the money demand
curve shifting left.
• However if Y falls
below Y’’, the
equilibrium interest
rate drops to zero,
and bonds and
money become
equivalent.
• LM is flat at i=0.
Liquidity trap
• Our short-run equilibrium
is at point A, where Y <
Yn.
• Falling prices and wages
push the LM curve down,
but after we reach point
B, interest rates are zero.
Further falls in the LM
curve (to LM’’) do not shift
the equilibrium from B.
• Our equilibrating
mechanism fails.
Deflation
• Deflation is the opposite of inflation. Under
deflation, average prices in an economy fall.
• In a deflation, real interest rates will be higher
than nominal interest rates, as inflation is
negative.
• So even if the nominal interest rate has been
driven down to zero, the interest rate facing
investors is still positive under deflation.
The Great Depression (1929-1939)
• The Great Depression which lasted about 10
years was a combination of the above two
effects.
• The stock market crash was not the cause of the
Great Depression. Far more important were the
bank crises that followed.
• Many firms failed and went into bankruptcy
which meant that banks’ incomes went down.
• At the same time, there was a run on cash at
banks with many people withdrawing their cashto hide it under their beds etc.
The Great Depression
• An enormous number of banks simply failed.
They could not honour the cash withdrawals
people were requesting. At this point, there was
no government-regulated banking insurance
system.
• As the banks failed and as people stuffed cash
under their mattresses, the money multiplier in
the economy fell (money velocity dropped).
• So the nominal money supply shrank, which led
to deflation.
The Great Depression
• The RBA in Australia responded to the banking
crisis in precisely the wrong manner. The RBA
talked of “belt-tightening” and cut the money
supply.
• This raised nominal interest rates and reduced
output further, but it also meant that combined
with deflation, real interest rates were very high.
• With high real interest rates, investments
ceased, and demand fell still further.
• The economy did not start to recover until
starting in 1933 when money supply was
increased.
The Great Depression- that wasn’t
• In October 19, 1987, on “Black Monday”, the US
Dow Jones experienced its worst-ever day,
losing 22% of value in one day. This was almost
twice the percentage drop on October 28, 1929.
• However, no Great Depression followed Black
Monday. Why?
– Banking insurance (most governments now have
systems under which depositors at banks have their
deposits insured), so no bank runs
– US Federal Reserve increased M in response to the
drop in the DJIA, so no deflation
How to get out of a depression?
• Monetary policy becomes ineffective if we are
stuck in a liquidity trap.
– Note that the Great Depression was probably NOT a
liquidity trap, but rather was a result of completely
misjudged monetary policy- tightening money when it
should have been loosened.
– Note also that monetary policy is still used to control
deflation, so the correct response is to loosen money
even if nominal interest rates are zero.
• Government spending can still be effective, even
if in a liquidity trap.
• The Japanese economy
has been in an extended
depression since the
early 1990s.
• Nominal interest rates
have been driven to zero.
Deflation has occurred,
so real interest rates are
positive.
• Government spending
should be used now,
right?
Nominal & real rates of interest (percent)
The Japanese slump
8
Nom inal interest rate
6
4
2
Real interest rate
0
-2
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
The Japanese slump
– Deflation, so need to pump
money supply even though
interest rates are zero.
– Banks, Japanese banks
still have billions in bad
loans
18
16
Percent of GDP
• But Japan has
dramatically increased
government spending, yet
has not come out of its
depression.
• Problems/solutions:
Governm ent Spending
14
12
Governm ent revenues
10
8
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Hyperinflation
• The root cause of high inflation is always a
government budget deficit. Government
spending exceeds government tax revenues.
• The sources of government funds are:
– Taxes (politically unpopular)
– Debt (after a while, people will not buy any more of
the government debt)
– Printing money (called “seignorage”)
• So facing a choice of cutting spending or raising
taxes (both politically painful) or printing money,
some government have chosen to print money.
Printing money
• When the government prints money, it adds ΔM
to the money supply. The RBA turns the new
money over to the government, which uses the
money to pay for spending.
• This is different from simply replacing existing
worn-out money. The government is adding to
the money supply.
• Resources gained by the government are ΔM/P.
But raising the money supply will lead to a rise in
the price level, so ΔM has to be higher next time
to get the same real resources.
Printing money
• Printing money is a cheap way of financing a deficit as
money costs only cents to print.
Budget deficit = BD = ΔM/P
• Or if we think as a proportion of GDP:
BD/Y = ΔM/(PY)
BD/Y = (ΔM/M) (M/PY)
• Where M/PY is the ratio is money supply to yearly
output, let’s say this is 0.25.
(ΔM/M) = 4 (BD/Y)
• So the money supply must increase at a percentage rate
4 times the budget deficit as a percent of output.
Printing money
• From the Quantity Theory of Money:
vM = PY
• If v and Y are assumed fixed in the short-run,
then:
Inflation = π = (ΔP/P) = (ΔM/M)
• So the rate of inflation must be 4 times the
budget deficit rate.
• Seignorage is a tax on holding money. It is also
called the “inflation tax”, since
Seignorage = (ΔM/M) (M/P) = π (M/P)
Seignorage
• In some cases, printing money can be a sensible
way of raising taxes, ie. if the government is so
inefficient that income or sales tax will not work.
• But high levels of seignorage typically are
unsustainable. What happens?
• The required level of inflation for a budget deficit
BD is:
π = (BD/Y) / (M/PY)
• But as π rises, i rises, so people restrict their
holding on real balances, so M/PY falls.
Hyperinflation
• As M/PY falls, so π must rise further.
• How do people economize on M/PY?
– Reduce the cash they carry around.
– Hold other currencies, such as US$.
– Resort to barter instead of using cash for
transactions.
• So π rises, which causes M/PY to drop further,
and the economy enters a spiral of higher and
higher inflation- hyperinflation.
• Money is driven to worthlessness, and the
government passes silly laws banning holding
foreign currency etc.
Costs of hyperinflation
• Typically economists assume away prices in
models and look only at “real values”.
• If prices do not matter, and hyperinflation is
simply rapidly rising prices, why should we worry
about hyperinflation?
• Costs of hyperinflation:
– Minimizing cash balances has costs
– Impoverishes people on fixed incomes
– Requires constant rewriting of prices in contracts and
on menus etc
– Using foreign currency is giving away the inflation tax
to other governments
Curing hyperinflation
• The root cause of the hyperinflation is the
unwillingness of the government to cut spending
or raise taxes to reduce its budget deficit.
• The hyperinflation will only end when the
government credibly commits to cutting
spending or raising taxes. Typically this does
not work, as the government was too weak to do
this in the first place, such as occurred in Brazil.
• But note that we have the problem of credibility
of the stabilization.
Curing hyperinflation
• People write contracts in advance. If the
government is not believed, all the contracts will
be written assuming the hyperinflation
continues.
• If the government is not believed, but it does
reduce inflation, all the prices in all the contracts
will be “wrong”. We will have a severe
recession, as all the contracts are “too
expensive”.
• If the government is believed, and does reduce
inflation, then all the prices are right, and we will
have no inflation.
Curing hyperinflation
• But it was the weakness of the government that
caused the problem in the first place. What
makes this government believable now? This
was the principle problem faced by the Brazilian
government.
• One option has been to adopt a new currency,
such as abandoning your own currency and
using the US$.
• Another option has been to “fix” the value of your
currency to another currency, such as the US$.
But how do you make this promise credible?