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Lecture 6: Macromodel Exercises Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class South Class Room #600 February 3, 2007 Policy Experiments With The Integrated Macro Model Policy Experiments are comparisons of simulated time paths of all endogenous variables to changes in the values of some of the exogenous variables representing macroeconomic policy, such as government spending, taxes, or money supply. Three policy experiments are discussed in this Guide: 1. A Monetary-Stimulus (Inflation) Policy Experiment: Simulated response to an increase in the growth of money supply from zero to a chosen rate of inflation (1 to 20 percent range). 2. A Fiscal-Stimulus Policy Experiment: Simulated response to an increase in real government spending by $50 billion increments without any change in taxes. 3. A Neutral-Budget Policy Experiment: Simulated response to two coordinated fiscal policy changes: a. An increase in real government spending, (the same as in the second experiment). b. An increase in tax rates high enough to “crowd out” an exactly offsetting amount of consumption. 1A: Monetary-Stimulus (Inflation) Experiment Money Growth Stops in 2010 Rate of growth of the money supply is increased from 0% to 5% in 2006. This is done for 4 years from 2006 to 2009, and then money supply growth drops to 0% in 2010 and thereafter. Money Supply $4,500 $4,000 $3,500 $ Billions $3,000 $2,500 $2,000 $1,500 $1,000 $500 $- 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Years Money Supply (Simulation) Money Supply (Base) • Money supply growth rate is a constant 5% for four years from 2006 – 2009 Money Supply Growth (in Percentage %) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Money Supply Growth (Base) Money Supply Growth (Simulation) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years GDP versus Potential GDP vs GDP Potential $7,150 $7,100 $ Billions $7,050 $7,000 $6,950 $6,900 $6,850 $6,800 Same as $6,750 GDP Potential in Long Run $6,700 2031 2030 2029 2028 2027 2026 Years GDP Potential 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 GDP Q&A Q: Why does GDP values fluctuate around the potential? A: Interest Rate becomes cyclic which makes Investment cyclical Q: So? A: Interest rate is cyclical because inflation rate in the model at first is smaller than or lags the money supply growth rate, and then later overshoots it. The important thing to note is that if the inflation rate is equal to the money growth rate, then there will be no dynamics! Q: Why does Inflation lag the money growth rate initially? A: By construction, based upon historical evidence, there is a lag or slowness in people’s adjustment of their inflation expectations. However, this adjustment is complete i.e. expectations are equal to actual inflation rate in the long run, which is equal to the growth rate of money supply. Inflation is always a monetary phenomenon. Inflation follows the money growth path, lagging behind at first but then overshooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run Money Supply Growth Vs. Inflation 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 -1.0 2012 2011 2010 2009 2008 2007 2006 2005 2004 (in Percentage %) • -2.0 -3.0 Years Inflation Money Supply Growth •The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M! (In Percentage %) Real Interest Rate 4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 2030 2028 Real Interest Rate (Base) 2026 Real Interest Rate (Simulation) 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value Investment $1,040 $1,020 $1,000 $ Billions • $980 $960 $940 $920 Investment (Simulation) Investment (Base) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Comparison of Inflation and Nominal Interest Rates Nominal = Real + Inflation Rate Inflation vs. Nominal Interest Rate 12.0 10.0 (In Percentage %) 8.0 6.0 4.0 2.0 0.0 Years Inflation Nominal Interest Rate 2031 2030 2029 -4.0 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 -2.0 Comparison of Real Interest Rate and Nominal Interest Rate Real Vs Nominal Interest Rate 12.0 (In Percentage %) 10.0 8.0 6.0 4.0 2.0 0.0 2031 2030 2029 Nominal Interest Rate 2028 Real Interest Rate 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years •As R drops it pulls down the real exchange rate Real Exchange Rates 1.020 1.015 Real Interest Rate 1.010 1.005 (In Percentage %) 4.6 1.000 4.4 0.995 4.2 0.990 4.0 3.8 0.985 2030 2029 2028 2027 2026 2025 2024 2023 Real Interest Rate (Simulation) 2022 2021 Years Years Real Exchange Rates (Simulation) 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 3.6 0.980 3.4 0.975 3.2 Real Exchange Rates (Base) Real Interest Rate (Base) •Exports increase in the short-run due to a drop in the real exchange rate α9 < 0 Exports Vs. Real Exchange Rate Real Interest Rate 1.2 1.0 $1,770 4.6 $1,760 4.4 0.8 (In Percentage %) Exports $1,780 0.6 4.2 $1,750 4.0 $1,740 3.8 0.2 0.0 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) Real Exchange Rate 2029 2030 2028 Exports 2027 2028 2026 Years Years 2025 2026 2024 2023 2024 2022 2021 2022 2020 2019 2020 2018 2017 2018 2016 2016 2015 2014 2014 2013 2012 2012 2011 2010 2010 2009 2008 2008 2007 2006 2006 2005 2004 2004 2003 3.6 $1,730 3.4 $1,720 3.2 0.4 Real Exchange Rate Billions $1,790 •Exports increase in the short-run due to a drop in the real exchange rate Exports Billions $1,790 $1,780 Real Interest Rate $1,770 (In Percentage %) $1,760 4.6 4.4 $1,750 4.2 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2020 Exports (Base) Real Interest Rate (Base) 2030 Exports (Simulation) Real Interest Rate (Simulation) 2028 Years Years 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 2004 3.4 $1,720 3.2 2003 $1,740 4.0 3.8 $1,730 3.6 •Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased! α12 > 0 Imports Vs. Real Exchange Rate Billions $2,040 1.2 Real Interest Rate $2,030 0.8 $2,010 4.6 (In Percentage %) Imports $2,020 4.4 $2,000 0.6 4.2 $1,990 4.0 0.4 3.8 $1,980 0.2 3.6 $1,970 3.4 0.0 2030 2030 2029 Real Interest Rate (Base) 2028 2028 2027 Years Years Real Exchange Rate 2026 2026 2025 2024 2024 2023 2022 2022 2021 2020 2020 2019 2018 2018 2017 Real Interest Rate (Simulation) 2016 2016 2015 Imports 2014 2014 2013 2012 2012 2011 2010 2010 2009 2008 2008 2007 2006 2006 2005 2004 2004 2003 $1,960 3.2 Real Exchange Rate 1.0 •Imports increase in the short-run due to a rise in GDP which overpowers the negative effect of a weak exchange rate on imports Imports Billions $2,040 $2,030 Real Interest Rate $2,020 $2,010 4.6 (In Percentage %) $2,000 4.4 $1,990 4.2 4.0 $1,980 3.8 3.6 $1,970 Real Interest Rate (Base) 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Real Interest Rate (Simulation) Imports (Base) 2030 Imports (Simulation) 2028 Years Years 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 2003 3.4 $1,960 3.2 2031 2030 2030 2029 2029 2028 2028 2027 2027 2026 2025 2024 2024 2023 2023 2022 2022 2021 2021 2020 2020 2019 2018 2019 2016 2017 2017 2018 2015 2016 2014 2015 2013 2014 2012 2013 2011 2012 2010 2011 2009 2010 2008 2009 2007 2008 2006 2007 2005 2006 2004 2005 Trade Deficit Vs. Real Exchange Rate Exports $1,790 $(230) 1.2 $1,780 $(235) 1.0 $1,770 $(240) 0.8 $1,760 $(245) 0.6 $1,750 $(250) 0.4 $(255) $1,730 0.2 $(260) $1,720 0.0 $1,740 Years Years Exports (Simulation) Trade Deficit Exports (Base) Exchange Rate Exchange Rate ($ Billions) Trade Deficit 2003 2004 Billions 2026 2025 •Trade deficit increases in the short-run because the increase in real exports is less than the increase in real imports (based upon values of alphas!) • Real GDP shoots above the base case value, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value GDP Real Interest Rate $7,150 Unemployment Drops $7,050 4.6 $7,000 4.4 (In Percentage %) $ Billions $7,100 $6,950 4.2 4.0 $6,900 3.8 $6,850 2030 GDP (Simulation) GDP (Base) Real Interest Rate (Base) 2030 2029 Real Interest Rate (Simulation) 2028 Years Years 2027 2028 2026 2026 2025 2024 2024 2023 2022 2022 2021 2020 2020 2019 2018 2018 2017 2016 2016 2015 2014 2014 2013 2012 2012 2011 2010 2010 2009 2008 2008 2007 2006 2006 2005 2004 2004 2003 3.6 $6,800 3.4 $6,750 3.2 $6,700 Unemployment Rises •Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant. Surplus / Deficit Billions Real Interest Rate $310 $300 (In Percentage %) $290 4.6 $280 4.4 4.2 $270 4.0 3.8 $260 3.6 $250 3.4 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) Surplus / Deficit (Base) 2029 2030 Surplus / Deficit (Simulation) 2028 Years Years 2027 2028 2026 2025 2026 2024 2023 2024 2022 2021 2022 2020 2019 2020 2018 2017 2018 2016 2015 2016 2014 2013 2014 2012 2011 2012 2010 2009 2010 2008 2007 2008 2006 2005 2006 2004 2003 2004 3.2 $240 •Consumption rises as GDP has risen! Consumption Billions $5,600 Real Interest Rate $5,550 $5,500 (In Percentage %) 4.6 $5,450 4.4 $5,400 4.2 4.0 $5,350 3.8 3.6 $5,300 3.4 2030 2030 2029 2028 2028 2027 Real Interest Rate (Base) 2026 2026 2025 Years Years Consumption (Base) 2024 2024 2023 2022 2022 2021 2020 2020 2019 2018 2018 2017 Real Interest Rate (Simulation) 2016 2016 2015 Consumption (Simulation) 2014 2014 2013 2012 2012 2011 2010 2010 2009 2008 2008 2007 2006 2006 2005 2004 2004 2003 $5,250 3.2 Comparison of Government Surplus and Nominal Interest Rate Surplus Vs. Nominal Interest Rate Billions 12.0 Real RealInterest InterestRate Rate $300 10.0 $290 8.0 (In (In Percentage Percentage %) %) $280 4.6 4.6 6.0 4.4 4.4 $270 4.2 4.2 4.0 4.0 $260 3.8 3.8 4.0 3.6 3.6 $250 3.4 3.4 $240 3.2 3.2 2.0 0.0 2030 2030 2029 2030 2028 Real RealInterest InterestRate Rate(Base) (Base) 2028 2027 2028 Nominal Interest Rate 2026 2026 2025 2026 2024 2024 2023 2024 2022 2022 2021 2022 2020 Years Years Years 2020 2019 2020 2018 2018 2017 2018 2016 Real RealInterest InterestRate Rate(Simulation) (Simulation) 2016 2015 2016 2014 2014 2013 2014 2012 2012 2011 2012 2010 2010 2009 2010 2008 2008 2007 2008 2006 2006 2005 2006 2004 2004 2003 2004 Surplus Nominal Interest Rates (in%) $310 Cont… Comparison of Government Surplus and Real Interest Rate Surplus Vs. Real Interest Rate Billions 4.6 $300 4.4 Real Interest Rate 4.2 Surplus (In Percentage %) $290 Real Interest Rate Real Interest Rate (Base) 2030 Surplus Real Interest Rate (Simulation) 2030 2029 2028 Years Years 2028 2027 2026 2026 2025 2024 2024 2023 2022 2022 2021 2020 2019 2020 3.2 2018 3.4 $240 3.2 2017 2018 2016 3.4 2015 2016 2014 $250 3.6 2013 2014 2012 3.6 2011 2012 2010 4.0 $260 3.8 2009 2010 2008 3.8 2007 2008 2006 4.4 $270 4.2 2005 2006 2004 4.0 2003 2004 $280 4.6 Real Interest Rates (in%) $310 (Growth stops in 2009) A Somewhat “Sequential” Working of the Model (Monetary Policy) As Money Supply goes up (M↑), Inflation goes up (P↑), but not as much which implies that Real Interest Rate falls (R↓) which stimulates the Investment (I↑). Also as Real Interest Rate falls (R↓), the Real Exchange Rate falls (EXCH↓) which boost Exports (EX↑) but hurts Imports (IM↓) Rise in Investment and Exports by GDPO identity means GDP increases (GDP↑). Consumption also rises (C↑) as GDP rises. However a rise in GDP also stimulates Imports and the neteffect is that Imports rise overall (IM↑). Trade Deficit (NETEX↑) increases because the rise in Imports is greater than the rise in Exports. Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant. In the Long Run… Inflation rate is exactly equal to the money growth rate. This means there is no change in the value of real interest rate which in turn implies no change in the other variables of the model, and hence no change in GDP!! Summary of Reactions Inflation follows the money growth path, lagging behind at first but then overshooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M! Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value As R drops it pulls down the real exchange rate Exports increase in the short-run due to a drop in the real exchange rate Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased! Trade deficit increases in the short-run because the increase in real exports is less than the increase in real imports (based upon values of alphas!) Real GDP shoots above the base case value, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value. Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant. Consumption rises as GDP has risen! 1B: Monetary-Stimulus (Inflation) Experiment When Money Growth Stops Slowly by 2013 • e Rate of growth of the money supply is increased from 0% to 5% in 2006, and then kept at 5% until 2009, and then decreased slowly to 0% by 2013 (stays at 0% afterwards) Real Interest Rate Money Supply 2030 2029 2028 2027 2026 2025 2030 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Rate $5,000 $4,500 4.6 8.0 $4,000 4.4 $3,500 6.0 4.2 $3,000 $2,500 4.0 4.0 $2,000 3.8 2.0 $1,500 3.6 $1,000 0.0$500 3.4 $3.2 (In Percentage %) $ Billions 10.0 Nominal Interest Rates (in%) 12.0 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Years Years Money Supply (Simulation) Real Interest Rate (Simulation) Money Supply (Base) Real Interest Rate (Base) 6.0 6.0 5.0 4.0 4.0 3.0 2.0 2.0 1.0 0.0 Money Supply Growth 10.0 Years Years 2031 2030 2030 2029 2029 2028 2028 2027 2027 2026 2026 2025 2025 2024 2024 2023 2023 2022 2021 2022 2021 2020 2019 2020 2018 2019 Nominal Interest Rate Real Interest Rate Money Supply Growth (Simulation) Money Supply Growth (Base) 2017 2018 2016 2017 2015 2016 2014 2015 2013 2014 2012 2013 2011 2012 2010 2011 2009 2010 2008 2009 2008 2007 2007 2006 2006 2005 2005 2004 2004 2003 0.0 (in Percentage %) 8.0 (In Percentage %) Real Vs Nominal Interest Rate 12.0 Inflation follows the money growth path, lagging behind at first but then overshooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run Money Supply Growth Vs. Inflation 7.0 6.0 (in Percentage %) • 5.0 4.0 3.0 2.0 1.0 0.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 -1.0 -2.0 Years Inflation Money Supply Growth •The real interest rate becomes cyclic. At first it drops which helps investment and then when it rises it hurts investment. 4.3 4.2 4.1 4.0 3.9 3.8 3.7 3.6 3.5 3.4 2030 Real Interest Rate (Simulation) 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Investment $1,040 $1,030 Real Interest Rate (Base) $1,020 $1,010 $ Billions (In Percentage %) Real Interest Rate $1,000 $990 $980 $970 $960 $950 $940 Investment (Simulation) Investment (Base) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years $1,785 $1,780 $1,775 0.800 $1,770 ($ Billions) 0.600 0.400 0.200 $1,765 $1,760 $1,755 $1,750 $1,745 0.000 2030 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 $1,735 Years Exports (Simulation) Real Exchange Rate (Simulation) Real Exchange Rate (Base) Imports 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2006 2004 $1,740 Years $2,040 $2,030 $2,020 $ Billions (In Percentage %) 1.000 $2,010 $2,000 $1,990 $1,980 $1,970 Years Imports (Simulation) Imports (Base) Exports (Base) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2017 2018 2016 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 1.200 2015 Exports Real Exchange Rate • Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP Real Vs Nominal Interest Rate GDP 12.0 10.0 $7,150 Unemployment Drops (In Percentage %) $ Billions $7,100 8.0 $7,050 6.0 $7,000 $6,950 4.0 $6,900 Unemployment Rises 2.0 $6,850 $6,800 0.0 2030 2031 2030 2029 Nominal Interest Rate 2028 2029 2027 2028 Real Interest Rate 2026 2027 2025 2026 2024 2025 2023 2024 2022 2023 2021 2022 2020 2021 2019 2020 2018 2019 2017 2018 2016 2017 2015 2016 2014 2015 2013 2014 2012 2013 2011 2012 2010 2011 2009 2010 2008 2009 2007 2008 2006 2007 2005 2006 2004 2005 2003 2004 Years Years GDP (Base) GDP (Simulation) 1C: Monetary-Stimulus (Inflation) Experiment When Money Growth Never Stops! • Rate of growth of the money supply is increased from 0% to 5%. • This is done forever (till the end of simulation period in 2030!) Real Vs Nominal Interest Rate 12.0 12.0 Nominal Interest Rates (in%) 10.0 Money Supply $14,000 10.0 (In Percentage %) $12,000 8.0 8.0 ($ Billions) $10,000 6.0 $8,000 6.0 4.0 $6,000 4.0 2.0 $4,000 2.0 $2,000 0.0 2030 2029 2028 2027 2026 2025 2031 2030 Nominal Interest Rate Money Supply (Base) 2029 Real Interest Rate Money Supply (Simulation) 2028 Years Years 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 2004 te $- 0.0 • Money Supply Growth Rate is a constant 5% forever starting in year 2005 Money Supply Growth (in Percentage %) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Money Supply Growth (Base) Money Supply Growth (Simulation) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run Money Supply Growth Vs. Inflation 7.0 6.0 (in Percentage %) • 5.0 4.0 3.0 2.0 1.0 0.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Inflation Money Supply Growth Real Interest Rate 4.1 4.0 3.9 3.8 3.7 3.6 3.5 2030 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Real Interest Rate (Simulation) Real Interest Rate (Base) Investment $1,040 $1,030 $1,020 $ Billions (In Percentage %) 4.2 $1,010 $1,000 $990 $980 $970 Investment (Simulation) Investment (Base) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Comparison of Real and Nominal Interest Rates Real Vs Nominal Interest Rate 12.0 (In Percentage %) 10.0 8.0 6.0 4.0 2.0 0.0 2031 2030 2029 Nominal Interest Rate 2028 Real Interest Rate 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years • Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to the potential GDP GDP vs GDP Potential $7,150 $ Billions $7,100 $7,050 $7,000 $6,950 $6,900 $6,850 2031 2030 2029 2028 2027 2026 Years GDP Potential 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 GDP Lessons From the Three Monetary (Inflation) Experiments Money Supply Growth (in Percentage %) 6.0 5.0 1c 4.0 3.0 1b 2.0 1a 1.0 0.0 Money Supply Growth (1b) Money Supply Growth (1a) 2031 Money Supply Growth (1c) 2030 2029 Money Supply Growth (Base) 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Inflation Response Depends on How Long Monetary Stimulus Lasts Inflation 1c 6.00 4.00 1b 1a 2.00 0.00 Years Inflation (1c) Inflation (Base) Inflation (1a) Inflation (1b) 2030 -4.00 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 -2.00 2004 (In Percentage %) 8.00 Interest Rate Overshooting Depends on How QUICKLY Monetary Growth Returns to Normal Real Interest Rate (In Percentage %) 4.6 4.4 1b 4.2 4.0 1c 3.8 1a 3.6 3.4 3.2 Real Interest Rate (1c) Real Interest Rate (Base) Real Interest Rate (1b) Real Interest Rate (1a) 2030 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Depth of the Recession Depends Upon How Quickly the Monetary Stimulus is Withdrawn! GDP $7,150 1b $7,100 $ Billions $7,050 1c $7,000 $6,950 $6,900 $6,850 1a $6,800 $6,750 $6,700 GDP (1c) GDP (Base) GDP (1a) GDP (1b) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years 2a. Fiscal-Stimulus Policy Experiment 2a. Fiscal-Stimulus Policy Experiment In this experiment real government spending is increased in steps of $100 billion higher from 2006 to 2009, and then spending stays elevated at that level forever. NO INCREASE IN TAX RATE: A deficit-financed war provides the historical context for large increases in government spending. Government Spending $1,400 $1,200 $ Billions $1,000 $800 $600 $400 $200 $0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Govt. Spending (Simulation) Govt. Spending (Base) Government Spending and Tax Rate $1,400 16.0% $1,200 14.0% 12.0% $1,000 10.0% $800 8.0% $600 6.0% $400 4.0% $200 2.0% $- 0.0% 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Government Spending Tax Rate Tax Rate Government Spending Government Spending vs. Tax Rate •Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state $7,100 GDP GDP Unemployment Drops $ Billions $7,050 $7,000 $6,950 Unemployment Rises $6,900 $6,850 $6,800 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years GDP (Simulation) GDP (Base) Inflation follows the a cyclic path. Why? Because GDP has risen. So initially it shoots up and then drops, but eventually settles to the steady state values Inflation 4.00 3.00 2.00 1.00 0.00 Inflation (Simulation) Inflation (Base) 2030 Years 2028 -2.00 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 -1.00 2004 (In Percentage %) • The booming economy raises the demand for money and forces the real interest rate higher. Real Interest Rate (In Percentage %) 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Rise in interest rate hurts investment $1,020 $1,000 $980 $960 $940 $920 $900 $880 $860 $840 $820 $800 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Investment Real Interest Rate Real Interest Rate Investment Investment Vs. Real Interest Rate Real Exchange Rate Real Exchange Rate 1.010 1.005 (In Percentage %) 1.000 0.995 0.990 0.985 0.980 0.975 0.970 0.965 0.960 2030 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Real Exchange Rate (Simulation) Real Exchange Rate (Base) Higher real interest rates also raise the exchange rate relative to the domestic price level and the restof-the-world price level. That is, the real exchange rate rises. This lowers real exports. $1,800 ($ Billions) $1,750 $1,700 $1,650 $1,600 $1,550 $1,500 Years Exports (Simulation) Exports (Base) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2017 2018 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Exports The imports rise as exchange rate rises. 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Imports $2,200 $ Billions $2,150 $2,100 $2,050 $2,000 $1,950 $1,900 Years Imports (Simulation) Imports (Base) Higher imports and lower exports cause net exports (trade deficit) to drop. $- $ Billions $(100) $(200) $(300) $(400) $(500) $(600) Years Trade Deficit (Simulation) Trade Deficit (Base) 2031 2030 2029 2028 2027 2026 2024 2025 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2010 2011 2009 2008 2007 2006 2004 Billions 2005 Trade Deficit (Net Exports) (in %) Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values Consumption $5,560 $5,540 $5,520 $ Billions $5,500 $5,480 $5,460 $5,440 $5,420 $5,400 $5,380 $5,360 2031 2030 Consumption (Base) 2029 Consumption (Simulation) 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Comparison of Government Spending and Consumption Govt. Spending vs. Consumption $1,400 $5,560 $5,540 $5,520 $5,500 $800 $5,480 Consumption ($ Billions) $1,000 $5,460 $600 $5,440 $400 $5,420 $5,400 $200 $5,380 $- $5,360 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Govt. Spending ($ Billions) $1,200 Years Govt. Spending Consumption Even though the tax rate is constant, higher GDP levels result in increased tax revenues Tax Revenues $1,065 $1,060 $ Billions $1,055 $1,050 $1,045 $1,040 $1,035 $1,030 $1,025 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Tax Revenues (Simulation) Years Tax Revenues (Base) Government Deficit/Surplus and the Real Interest Rate Surplus Vs. Real Interest Rate 7.0 $300 6.0 $200 5.0 $100 4.0 3.0 $$(100) $(200) 2.0 1.0 0.0 Years Surplus Real Interest Rate Real Interest Rate (in %) 8.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Surplus ($ Billions) $400 A Somewhat “Sequential” Working of the Model (Fiscal Policy) As Government Spending goes up (G↑), GDP goes up (GDP↑) which causes price level to go up too (P↑). Real Interest Rate rises (R↑) which depresses Investment (I↓). Also as Real Interest Rate rises the Real Exchange Rate rises (EXCH↑) which hurts Exports (EX↓) but boosts Imports (IM↑) causing the Trade Deficit to rise (NETEX ↑). As GDP goes up the tax collections rise but not by as much as the increase in government spending causing the Government deficit to increases. Summary of Reactions In this experiment real government spending is increased in steps of $100 billion higher from 2006 to 2009, and then spending stays elevated at that level forever. Inflation follows the a cyclic path. Initially shoots and then drops, but eventually settles to the steady state values Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state The booming economy raises the demand for money and forces the real interest rate higher. Higher real interest rates also raise the exchange rate relative to the domestic price level and the rest-of-the-world price level. That is, the real exchange rate rises. This lowers real exports and raises real Imports, causing net exports (trade deficit) to drop for both the reasons. Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values Even though the tax rate is constant, higher GDP levels result in increased tax revenues Data Table 2 (a): Govt. Spending 2b: When…Govt. Spending is Reduced to its Original Spending Value by 2013 •Government Spending increases for four years and then gradually reduced back to the original spending by 2013 Government Spending $1,400 $1,200 $ Billions $1,000 $800 $600 $400 $200 $0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Govt. Spending (Simulation) Govt. Spending (Base) •Government Spending increases for four years and then gradually reduced back to the original spending in 2012 whereas the tax rats remain constant $1,400 16.0% $1,200 14.0% 12.0% $1,000 10.0% $800 8.0% $600 6.0% $400 4.0% $200 2.0% $- 0.0% 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Government Spending Tax Rate Tax Rate Government Spending Government Spending vs. Tax Rate •Because the government spending is reduced and brought back to the original level in 2012, the real interest rates are forced to come back to the original as the stimulus is taken away. Real Interest Rate (In Percentage %) 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Inflation Behavior Inflation 4.00 2.00 1.00 0.00 -5.00 Years Inflation (Simulation) Inflation (Base) 2030 -4.00 2028 -3.00 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 -2.00 2006 -1.00 2004 (In Percentage %) 3.00 •As inflation wears off and the real interest rate returns to normal implies that the nominal interest rate will drop Real Vs Nominal Interest Rate 12.0 10.0 (In Percentage %) 8.0 6.0 4.0 2.0 0.0 2031 2030 Nominal Interest Rate 2029 Real Interest Rate 2028 Years 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 -2.0 Comparison of Government Spending and Consumption $5,600 $1,200 $5,550 $1,000 $5,500 $800 $5,450 $600 $5,400 $400 $5,350 $200 $5,300 $- $5,250 Consumption ($ Billions) $1,400 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Govt. Spending ($ Billions) Govt. Spending vs. Consumption Years Govt. Spending Consumption •Higher government spending adds directly to real GDP from the national accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillation toward the long run steady state GDP vs GDP Potential $7,150 $7,100 $ Billions $7,050 $7,000 $6,950 $6,900 $6,850 $6,800 $6,750 $6,700 2031 2030 2029 2028 2027 2026 Years GDP Potential 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 GDP 3. Neutral-Budget Policy Experiment – In this experiment real government spending is increased by the same one-step increase imposed in the fiscal-stimulus experiment. – Instead of running a deficit, the government raises the tax rate high enough to crowd out the exact amount of increase in government spending by reducing consumption. Billions Government Spending vs. Tax Rate $880 (in %) 17.0% $860 $820 16.0% $800 15.5% $780 $760 15.0% $740 14.5% $720 $700 14.0% 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Government Spending Tax Rate Tax Rate Government Spending 16.5% $840 Tax Revenues Billions $1,180 $1,160 $1,140 $ Billions $1,120 $1,100 $1,080 $1,060 $1,040 $1,020 $1,000 $980 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Tax Revenues (Simulation) Years Tax Revenues (Base) •Higher taxes via higher tax rate leads to drop in consumption Consumption Billions $5,500 $5,480 $5,460 $ Billions $5,440 $5,420 $5,400 $5,380 $5,360 $5,340 $5,320 2031 2030 Consumption (Base) 2029 Consumption (Simulation) 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Government Spending vs. Consumption $5,500 $860 $5,480 $840 $5,460 $820 $5,440 $800 $5,420 $780 $5,400 $760 $5,380 $740 $5,360 $720 $5,340 $700 $5,320 Years Govt. Spending Consumption Consumption ($ Billions) $880 20 200 4 200 5 200 6 200 7 200 8 200 9 201 0 201 1 201 2 201 3 201 4 201 5 201 6 201 7 201 8 201 9 202 0 202 1 202 2 202 3 202 4 202 5 202 6 202 7 202 8 202 9 203 0 31 Govt. Spending ($ Billions) Govt. Spending vs. Consumption No Change in Interest Rate! Real Interest Rate (In Percentage %) 5.0 4.0 3.0 2.0 1.0 0.0 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years Increased G and Decreased C => Constant GDP GDP Billions $8,000 $ Billions $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $- GDP (Base) 2031 2030 2029 GDP (Simulation) 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Second half of the data Neutral Experiment Table 4: Stop and Go Experiment Money Supply Growth (in Percentage %) 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Money Supply Growth (Base) Money Supply Growth (Simulation) 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years 4.0 2.0 0.0 Money Supply Growth Inflation 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 -2.0 2012 2011 2010 2009 2008 2007 2006 2005 2004 (in Percentage %) Money Supply Growth Vs. Inflation 8.0 6.0 -4.0 Years 20 0 20 4 0 20 5 0 20 6 0 20 7 0 20 8 0 20 9 1 20 0 1 20 1 1 20 2 1 20 3 1 20 4 1 20 5 1 20 6 1 20 7 1 20 8 1 20 9 2 20 0 2 20 1 2 20 2 2 20 3 2 20 4 2 20 5 2 20 6 2 20 7 2 20 8 2 20 9 3 20 0 31 $ Billions Money Supply $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $- Years Money Supply (Simulation) Money Supply (Base) Real Interest Rate (In Percentage %) 4.6 4.4 4.2 4.0 3.8 3.6 3.4 Real Interest Rate (Base) 2030 Real Interest Rate (Simulation) 2028 2026 2024 2022 2020 2018 2016 2014 2012 2010 2008 2006 2004 Years 8.0 6.0 4.0 (In Percentage %) Real Vs Nominal Interest Rate 12.0 10.0 2.0 0.0 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 Nominal Interest Rate Real Interest Rate 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years $980 $ Billions Investment $1,040 $1,020 $1,000 $960 $940 $920 2031 2030 2029 2028 2027 2026 2025 2024 Investment (Base) Investment (Simulation) 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years $310 4.6 $300 4.4 $290 4.2 $280 4.0 $270 3.8 $260 $250 3.6 $240 3.4 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years Surplus Real Interest Rate Real Interest Rate (in %) Surplus ($ Billions) Surplus Vs. Real Interest Rate $7,150 $7,100 $7,050 $7,000 $6,950 $6,900 $6,850 $6,800 $6,750 $6,700 $ Billions GDP 2031 2030 2029 2028 2027 2026 2025 2024 2023 GDP (Base) GDP (Simulation) 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Years