Download Macro Handout 19: Inflation Targeting and

Amherst College
Department of Economics
Economics 111 – Section 5
Fall 2015
Macro Handout 19: Inflation Targeting and International Finance
Inflation Targeting
Review: Increase in Government Spending – No Inflation Targeting
An increase in government purchases directly increases the final goods and services. At a given inflation
rate (), final goods and services purchased increase. Geometrically, an increase in government purchases
shifts the aggregate demand (AD) curve right:
FP Question: What would the real
interest rate (r) equal, if the inflation rate
() were _______ percent, given that the
Fed does not change its inflation policy?
AD Question: How many final goods and
services would be purchased if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
π (%)
π (%)
FP
At a given
inflation
rate ()
AD’
AD
G&S
r (%)
Government
purchases
more

More goods and
services (G&S)
purchased

Aggregate
demand (AD)
curve shifts right
2
FP Question: What would the real
interest rate (r) equal, if the inflation rate
() were _______ percent, given that the
Fed does not change its inflation policy?
π (%)
AD Question: How many final goods and
services would be purchased if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
π (%)
LRAS
FP
AS0
2.0
AD0
3.0
r (%)
G$S
2,000
Then, government purchases equal taxes initially and the deficit equals 0. To create a deficit we increase
government purchases in period 1.
Infl
Govt
Con
Invest Int Rate
Rate
Period
GDP
Purch
Deficit
Purch
Purch
r (%)
 (%)
2,000
500
0
1,300
200
3.0
2.0
0
2,100
600
100
1,312
188
4.2
2.6
1
2,040
600
100
1,257
183
4.7
2.8
2
..
.
2,000
600
100
1,220
180
5.0
3.0
7
2,000
600
100
1,220
180
5.0
3.0
8

Pieces of the Pie:
No Deficit
Govt
Macro Lab 18.1:
Crowding Out
Pieces of the Pie:
Deficit
Con
Govt
500
200
Inv
Con
600
1220
1300
In the long run, GDP = GDPP = 2,000
Inv
180
In the long run, GDP = GDPP = 2,000
3
Inflation Targeting
In 2012, the Fed adopted inflation targeting.
In historic shift, Fed sets inflation target
By Jonathan Spicer
Wed Jan 25, 2012 6:35 EST
(Reuters) - The Federal Reserve took the historic step on Wednesday of setting an
inflation target, a victory for Chairman Ben Bernanke that brings the Fed in line with
many of the world's other major central banks.
The U.S. central bank, in its first ever "longer-run goals and policy strategy"
statement, said an inflation rate of 2 percent best aligned with its congressionally
mandated goals of price stability and full employment.
..
.
Inflation targeting uses autonomous monetary policies to achieve a predetermined inflation rate target:
 First, the Fed chooses a target inflation rate.
 Second, the Fed pursues autonomous monetary policies to meet the target. That is, the Fed shifts the
Fed policy (FP) curve and therefore the aggregate demand (AD) curve to achieve its target inflation
rate.
Review: Autonomous monetary policies. Shifts of the entire Fed policy (FP) curve:
 Autonomous contractionary monetary policy: The Fed becomes tougher on inflation by shifting the
entire Fed policy (FP) curve right. At a given inflation rate (), the Fed increases the real interest rate
(r).
 Autonomous expansionary monetary policy: The Fed becomes easier on inflation by shifting the entire
Fed policy (FP) curve left. At a given inflation rate (), the Fed decreases the real interest rate (r).
We illustrate the effect of an autonomous contractionary monetary policy below:
FP Question: What would the real
interest rate (r) equal, if the inflation rate
() were _______ percent, given that the
Fed does not change its inflation policy?
AD Question: How many final goods and
services would be purchased if the inflation rate
() were _______ percent, given that all other
factors relevant to demand remained the same?
π (%)
π (%)
FP
FP’
At a given
inflation
rate ()




r (%)

Fewer goods
Households
Real interest
Loans
and services
and firms
rate (r)
become



purchased
purchase less
more costly
increases
Autonomous contractionary monetary policy
AD’

AD
G&S
Aggregate
demand (AD)
curve shifts left
4
Review: Increase in Government Spending – Inflation Targeting:

Macro Lab 19.1: Inflation Targeting
Inflation Targeting: The Fed chooses a target inflation rate and then pursues autonomous monetary
policies to meet the target. That is, the Fed shifts the monetary policy (MP) curve to achieve its target
inflation rate.
Govt
Con
Invest
Int Rate
Infl Rate
Period
GDP
Purch
Deficit
Purch
Purch
r (%)
 (%)
2,000
500
0
1,300
200
3.0
2.0
0
2,000
600
100
1,220
180
5.0
2.0
1
2,000
600
100
1,220
180
5.0
2.0
2
..
.
2,000
600
100
1,220
180
5.0
2.0
7
2,000
600
100
1,220
180
5.0
2.0
8
In this case, the Fed counters the increases in government purchases, an expansionary fiscal policy, with a
contractionary monetary policy.
To illustrate AD curve shifts we keep the inflation rate () constant
Expansionary
Contractionary autonomous
fiscal policy
monetary policy



Fed
becomes
________ on


inflation




Fed
_______
the
real interest

rate(r)





Households and firms

purchase


________ goods



G increases
C and I ___________
GDP = C + I + G


GDP ___________
GDP ___________


AD curve shifts
AD curve shifts
_________
_________
π (%)
AD
GDP
5
Macro labs 18.1 and 19.1 both create a deficit by increasing government purchases while leaving taxes
unchanged. The labs differ in the Fed’s response:
 Macro lab 18.1: The Fed does not target inflation; that is, the Fed does not respond with an
autonomous contractionary monetary policy in response the expansionary fiscal policy. The Fed only
applies the Taylor principle.
 Macro lab 19.1: The Fed targets inflation; that is, the Fed responses with an autonomous
contractionary monetary policy in response the expansionary fiscal policy to prevent the inflation rate
from rising.
The table below compares the results from the two labs to determine the long run impact of inflation targeting
and more generally the long run impact of autonomous monetary policies.
No
Inflation
Targeting
Inflation
Targeting:
2.0%
Period
0
1
2
..
.
7
8
0
1
2
..
.
7
8
GDP
2,000
2,100
2,040
Govt
Purch
500
600
600
2,000
2,000
2,000
2,000
2,000
600
600
500
600
600
2,000
2,000
600
600
Con
Purch
1,300
1,312
1,257
Invest
Purch
200
188
183
Int Rate
r (%)
3.0
4.2
4.7
Infl Rate
 (%)
2.0
2.6
2.8
100
100
0
100
100
1,220
1,220
1,300
1,220
1,220
100
100
200
180
180
5.0
5.0
3.0
5.0
5.0
3.0
3.0
2.0
2.0
2.0
100
100
1,220
1,220
180
180
5.0
5.0
2.0
2.0
Deficit
0
100
100
Focus on the long run effect of inflation targeting. In the long run, the Fed’s autonomous monetary policy:
 Has no effect on the “real” economy. Has no effect on real

o
___________________________
o
___________________________
o
___________________________
o
___________________________
o
___________________________
Has an effect only on the ____________ rate. When the Fed targets it remains at 2.0 percent; when the
Fed does not target it rises from 2.0 to _____ percent.
These results illustrate an important macroeconomic principle which has a fancy name:
Classical dichotomy: In the long run, monetary policy:

Does not affect the ___________ economy.

Does affect _____________________.
6
Foreign Exchange Rates – Friday, December 11, 2015 9:00 am:
Japanese Yen
121
______________________
British Pound
1.52
______________________
Euro
1.10
______________________
We are going to focus on the Euro. To keep the arithmetic straightforward:
Exchange Rate in Dollars per Euro = 1.10
€1.00 “buys” $1.10
Exchange Rate in Euros per Dollar = .91
$1.00 “buys” €.91
We must choose one of the two ways to express the exchange rate and then stick with it:
Euros per Dollar
Exchange Rates and Prices
Price of a Chevy Volt = $30,000
Price of a BMW 740i = €60,000
€.50 per $1.00
Exchange Rate
€1.00 per $1.00
€2.00 per $1.00
Price of Volt
€_______ $30,000
in Europe
in U.S.
€_______ $30,000
in Europe
in U.S.
€_______ $30,000
in Europe in U.S.
Price of BMW
€60,000 $_______
in Europe
in U.S.
€60,000 $_______
in Europe
in U.S.
€60,000 $_______
in Europe in U.S.
__________ Dollar
__________ Dollar
(__________ Euro)
(__________ Euro)
Who benefits from a weak dollar
benefit?
hurt?
___________
consumers
___________
consumers
Question: How is the exchange rate determined?
Claim: In the market for foreign exchange.
Who benefits from a strong dollar
benefit?
hurt?
___________
consumers
___________
consumers
7
Foreign Exchange Market for Dollars
Foreign Exchange Market
for Dollars
Euros per Dollar
Europeans Demand American Goods and Services
SG&S
Demand
Europe
Dollars
Foreign
Exchange
Market
United States
Supply
Dollars
Equ
Exch
Rate
Americans Demand Europoean Goods and Services
DG&S
Dollars
€.50 per $1.00
Exchange Rate
€1.00 per $1.00
€2.00 per $1.00
Price of Volt
€15,000 $30,000
in Europe
in U.S.
€30,000 $30,000
in Europe
in U.S.
€60,000 $30,000
in Europe in U.S.
Price of BMW
€60,000 $120,000
in Europe
in U.S.
€60,000 $60,000
in Europe
in U.S.
€60,000 $30,000
in Europe in U.S.
As the exchange rate in terms of
Euros per Dollar increases.
ã
é
Do U.S. produced
Do European produced
goods and services become
goods and services become
more or less expensive for
more or less expensive for
Europeans? _______________.

Do Europeans demand
more or fewer U. S. produced
Americans? _______________.

Do Americans demand
more or fewer European produced
goods and services? _________.

Do Europeans “demand”
goods and services? _________.

Do Americans “supply”
more or fewer Dollars? __________.

Is the demand curve for Dollars
in the foreign exchange market
upward or downward sloping?
more or fewer Dollars? __________.

Is the supply curve for Dollars
in the foreign exchange market
upward or downward sloping?
________________ sloping.
________________ sloping.
8
Foreign Exchange Market and Net Exports
Foreign Exchange Market
Demand Curve: European Demand
for Dollars
Euros per Dollar
Euros per Dollar
Supply Curve: American Demand
Euros per Dollar
SG&S
SG&S
Equ
Exch
Rate
DG&S
U.S. Exports
of G&S
DG&S
Dollars
Dollars
U.S. Imports
of G&S
Dollars
U.S. Net Exports = ___
Demand Curve: How many Dollars would
Europeans “demand,” if the exchange rate
were ______ Euros per Dollar given that all
else relevant to demand remains the same?
Supply Curve: How many Dollars would
Americans “supply,” if the exchange rate
were ______ Euros per Dollar given that all
else relevant to supply remains the same?
Question: Why do Europeans demand Dollars?
Question: Why to Americans supply Dollars?
Answer: To purchase American goods and
Answer: To obtain Euros in order to
and services.
European goods and services.


European Purchases
American Purchases
of American
of European
Goods and Services
Goods and Services


U.S. Exports
U.S. Imports
In equilibrium:
European Purchases
American Purchases
of American
_____________
of European
Goods and Services
Goods and Services


U.S. Exports
U.S. Imports
U.S. Net Exports = ______
9
Question: What are we missing?
U.S. Net Exports < 0

U.S. Exports < U.S. Imports

Net __________ of Goods into U.S.

Net __________ of Assets from U.S.
U.S. Net Exports = U.S. Exports  U.S. Imports
Question: How does the U.S. pay for the goods?
Sources of Demand and Supply in Foreign Exchange Markets
 Purchase of Goods and Services (Imports and Exports)
 Purchase of Assets: Stocks, Bonds, …
Europeans Demand American Assets
Europeans Demand American Goods and Services
Demand
Foreign
Exchange
Market
Dollars
Europe
United States
Supply
Dollars
Americans Demand Europoean Goods and Services
Americans Demand European Assets
In equilibrium:
U.S. Purchases
of European
Assets
+
U.S. Purchases
of European
Goods and Services

U.S. Imports
=
European Purchases
of American
Goods and Services

U.S. Exports
+
European Purchases
of American
Assets
Benchmark Case: European Purchase of American Assets Equals U.S. Purchases of European Assets
Foreign Exchange Market
Demand Curve: European Demand
for Dollars
Euros per Dollar
Euros per Dollar
SG&S
SG&S+A
Supply Curve: American Demand
Euros per Dollar
SG&S
SG&S+A
Eur
Assets
Equ
Exch
Rate
U.S.
Assets
DG&S
U.S. Exports
of G&S
DG&S+A
DG&S
Dollars
DG&S+A
Dollars
U.S. Net Exports = 0
U.S. Imports
of G&S
Dollars
10
Net Exports and the Real Interest Rate
Question: What would occur if real interest rates rose in the U.S.?
Europeans find
American Assets
Americans find
European Assets
__________ attractive

The demand curve for Dollars
__________ attractive

The supply curve for Dollars
___________________________
___________________________
Foreign Exchange Market
Demand Curve: European Demand
for Dollars
Euros per Dollar
Euros per Dollar
S’
Europeans demand more U.S. assets
G&S+A
SG&S+A
Equ
Exch
Rate
DG&S
U.S. Exports
of G&S
D’G&S+A
DG&S+A
G&S+A
SG&S
Dollars
Dollars
U.S. Real Interest Rate Increases

Exchange Rate _________

U.S. Net Exports _______
SG&S+A
Americans demand
fewer European assets
D’G&S+A
DG&S+A
U.S. Net Exports < 0
Summary
Supply Curve: American Demand
Euros per Dollar
S’
U.S. Imports
of G&S
Dollars
Amherst College
Department of Economics
Economics 111 – Section 5
Fall 2015
Macro Handout 20: Greek Crisis
Greek Debt Crisis
Greek Treasury promises to
pay the owner x,xxx Euros
on January 15, 2011
Greek Treasury promises to
pay the owner x,xxx Euros
on February 15, 2011
Greek Treasury promises to
pay the owner x,xxx Euros
on March 15, 2011
Greek Government Finances
Tax Revenue
Euros
Euros
Greek
Treasury
Bondholders
Euros
Purchases of
Goods and Services
Transfer
Payments
January 2011 – September 2011: Specter of Greek Default Emerges
 Became apparent that tax payments could not meet the government’s payments.
 Moody's cuts Greece's credit rating.
Questions: What is the basic problem and how can it be solved?
2
Exh Rate of Eur per Dol:
November 2011 – January 2012: Austerity, Protests, Political Turmoil,
and Negotiations for a Bailout from the European Central Bank
 The Socialist Greek Prime Minister George Papandreou calls for
austerity moves: sharp increases in taxes and spending cuts.
 Violent protests erupt amid a 48-hour general strike.
 Greek Prime Minister George Papandreou loses his majority in
Parliament and resigns.
 A unity government is formed by the opposing Conservative and
Socialist parties naming Lucas Papademos as prime minister.
 Nationwide strike called to protest new cutbacks.
 The unity Greek Prime Minister Papademos heads to Brussels to
negotiate a bailout from the European Central Bank.
Nov 1,2011‐Jan 19, 2012
0.80
0.78
0.76
0.74
0.72
1‐Nov
Benchmark Case: Net Exports = 0
Foreign Exchange Market
Demand Curve: European Demand
for Dollars
Euros per Dollar
Euros per Dollar
2‐Dec
2‐Jan
Supply Curve: American Demand
Euros per Dollar
SG&S+A
SG&S
SG&S+A
Eur
Assets
Equ
Exch
Rate
U.S.
Assets
DG&S
U.S. Exports
of G&S
DG&S+A
DG&S+A
Dollars
Dollars
U.S. Imports
of G&S
Dollars
U.S. Net Exports = 0
Question: What effect did the crisis have on the attractiveness of European and American assets?
Europeans find
Americans find
American Assets
European Assets
__________ attractive

The demand curve for Dollars
__________ attractive

The supply curve for Dollars
___________________________
___________________________
Foreign Exchange Market
Demand Curve: European Demand
for Dollars
Euros per Dollar
Euros per Dollar
S’
Europeans demand more U.S. assets
G&S+A
U.S. Exports
of G&S
G&S+A
SG&S
SG&S+A
Equ
Exch
Rate
DG&S
Supply Curve: American Demand
Euros per Dollar
S’
Americans demand
fewer European assets
D’G&S+A
DG&S+A
D’G&S+A
DG&S+A
Dollars
Dollars
SG&S+A
U.S. Imports
of G&S
U.S. Net Exports < 0
The equilibrium exchange rate in terms of Euros per Dollar __________.
Dollars
3
Danger of Speculation
Question: What would occur if individuals expected the Dollar to become dramatically stronger and hence the
Euro dramatically weaker in the near future?
Suppose that you
 have €8,000 deposited in a Paris bank that you plan to use in January when you will be
vacationing in France.
 expect the dollar to strengthen with the exchange rate rising
from €.80 per $1.00 today to €1.00 per $1.00 in January.
Claim: You would convert your Euro assets into Dollar assets
€8,000
Today: Exchange Euros for Dollars

January: Exchange Dollars for Euros
$________

Exchange Rate €.80 per $1.00
Exchange Rate €1.00 per $1.00
€________
If others share your view

They will also convert their
Euro assets into Dollar assets
ã
é
Demand curve for
Supply curve for
Dollars shifts to the _______
Dollars shifts to the ______
é
ã
Exchange rate ____________
This cycle could then continue.
Foreign Exchange Market
for Dollars
Euros per Dollar
SG&S+A
Equ
Exch
Rate
DG&S+A
Dollars
Question: Who is hurt by a strong dollar?
January 2012 – February 2012: Austerity and a Bailout Agreement
 An tentative agreement is negotiated:
o Greece's leaders agree on austerity moves.
o Bondholders agree to a “bond swap” which would
reduce the payments that Greece must make to the
bondholders.
o European Central Bank (ECB) support the Greek
Treasury with short term loans.
 New Greek elections are scheduled for early May to seal the
agreement.
4
March 2012 – April 2012: Relative Calm
 Relative calm emerges before May
elections to form a new government.
May 2012 – July 2012: Greek Elections and the Return of Political Turmoil
 Greek voters rejected the austerity programs advocated derailing its implementation.
 Greek leaders could not form a new government.
 New elections were scheduled for June.
5
July 2012 – December 2012: New Government Formed and More Austerity
 The June elections allow the Conservatives to form a government.
 The Conservative Prime Minister, Antonis Samaras, implements the austerity program.
 In November,Greek parlliment passed an austerity package that included pension cuts for retired public
employees, and increase in the retirement age from 65 to 70, and wage cuts for current public
employees.
January 2013 – December 2013: More Austerity and a Little Progress
 The Greek parliament abolishes 15,000 state jobs in April.
 In July, the parliament passes a plan for thousands of more layoff and wage cuts for public employees.
 In November, Greece’s credit rating is raised by Moody.
January 2014 – May 2014: More Progress of a Sort
 In January, Greece posts a budget surplus
 In May, Greece’s credit rating is raised by Fitch.
Exh Rate of Euros per Dollar:
October 2011 ‐ May 2014
0.82
0.80
0.78
0.76
0.74
0.72
0.70
6
June 2014 – December 2014: Turmoil
 Unemployment rises to nearly 30 percent.
 Samaras austerity program is under attack and he reshuffles his cabinet in June.
 In December, Stavros Dimas, the government’s candidate for Greek president fails to win majority supply in
parliament.
 In December, the Conservative government falls as a result of the austerity measures it advanced.
Exh Rate of Euros per Dollar:
October 2011 ‐ December 2014
0.82
0.80
0.78
0.76
0.74
0.72
0.70
7
January 2015 – December 2015: More Political Turmoil and a Deal
 Syriza, the anti-austerity coalition party, wins the election in January. It ran on a platform that the
austerity program endorsed was too severe and it would negotiate a better deal.
 For several months, negotiations took place, but Syriza failed to gain many concessions.
 In July, an austerity program is put before Greek voters in a referendum that was not substantially less
austere. More than 60 percent of them vote against it.
 In July and August Syriza tried to negotiate a new agreement. Much turmoil took place: violent
protests in the streets, Cabinet reshuffling, etc. Eletions are sheduled for September.
 Syriza wins again in November.
 In November, Syriza proposed an austerity program that did not differ substantially from the one it
opposed in January. This program passed the Greek parliament in November.
Exh Rate of Euros per Dollar:
October 2011 ‐ December 2015
0.95
0.90
0.85
0.80
0.75
Oct‐15
Jul‐15
Apr‐15
Jan‐15
Oct‐14
Jul‐14
Apr‐14
Jan‐14
Oct‐13
Jul‐13
Apr‐13
Jan‐13
Oct‐12
Jul‐12
Apr‐12
Jan‐12
Oct‐11
0.70