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(III) MONEY & INFLATION, CONTINUED LECTURE 7: THE RATIONAL EXPECTATIONS REVOLUTION Question: Taking as given the role of expectations Οe in AS (Lecture 6), what difference does it make if expectations are rational: πΈπ₯ππππ‘ππ (Ο) = Οπ ? Answer: It may mean that monetary policy cannot have a systematic effect on GDP or other real variables. An example of predictable inflation: The Mexican sexenio From 1976 through 1994, inflation shot up every 6th year (presidential election years) and the peso would devalue. 1976 1982 1988 1994 API-120 - Prof. J. Frankel, Harvard University The Mexican sexenio, continued Example of rational expectations: investors came to anticipate inflation & devaluation after elections, and so would pull out ahead of time. 1982 1988 1994 J.Bianchi, J.C.Hatchondo, L.Martinez, 2013, βInternational Reserves and Rollover Risk,β FRB Richmond WP13-01R , NBER WP 18628 API-120 - Prof. J. Frankel, Harvard University OVERVIEW OF AGGREGATE SUPPLY (continued) SR supply π relationship: π = Οπ Ο π Wage contract π = Οππ . β Lucas supply relationship π or in logs, π = π ππ Ο Robert Lucas y - π¦ = Ο (Ο β Οπ ) where Ο β‘ p β p-1 and Οe β‘ pe β p-1 . = Ο Ξ΅, where Ξ΅ is the forecast error; Rational expectations says Ξ΅ is unforecastable: Expectationt (Ξ΅t+1 ) = 0. => Monetary policy cannot have a systematic effect on y - π¦ . API-120 - Prof. J. Frankel If the public rationally expects stimulus each election year, the government then has to deliver the inflation just to keep Y from falling below π. AS election year Οe > 0 Ο β’ β’ π y - π¦ = Ο (Ο β Οπ ) AS y-π¦ = ΟΟ when Οe =0: AD election year π AD API-120 - Prof. J. Frankel, Harvard University Intellectual History of the Increasing Ineffectiveness of Monetary Policy at Stabilizing Output y - π = π (π β π π ), Monetary expansion can raise Y? A.S. -- at the cost of higher P. Phillips curve (1958) -- at the cost of higher inflation, ο°. Friedman & Phelps (1968) Natural Rate Hypothesis. -- at the cost of ever-accelerating ο° (because Οe adjusts over time to Ο). Lucas, Sargent, Barro (1972-78) Rational Expectations -- only randomly (because Ο-Οe must be random). Kydland-Prescott (1977) & Barroand, worse yet: monetary discretion Gordon (1983). Time-inconsistency -=> inflationary bias. E.g., Bruno-Easterly (1998) & Dornbusch-Fischer (1993) -- High ο° (>40%) hurts growth (Table 2) in the LR. API-120 - Prof. J. Frankel, Harvard University Inflation above a threshold β 40% tends to have a negative effect on growth. Source: Inflation is usually > 0 and was a chronic problem during 1950-2000. Source: Carmen Reinhart & Ken Rogoff, 2011,This Time is Different: A Panoramic View of Eight Centuries of Financial Crises. The highest inflation rates are now in Venezuela & Argentina. 50 45 % CPI Inflation, 2014 VEN = 75 (full-year projection) 40 35 30 25 ARG¹ 20 15 10 5 URY NIC HND BRA 0 Source: Cubeddu, Iakova, & Sosa, IMF, Feb.2015. Data from: IMF, World Economic Outlook July 2014 Update; and staff calculations. ¹ For Argentina, projected annual inflation is computed using cumulative inflation through July and assuming monthly inflation for the rest of the year will equal the average of the last three months. If monetary expansion canβt reduce unemployment in the long run, why is inflation so common? Four possible explanations: ο§ Governments think expansion can reduce unemployment even in the long run. ο§ They give low weight to price stability, or have high discount rates (e.g., political business cycle). ο§ Plans to set non-inflationary monetary policy are perceived by the public to be time-inconsistent (Lecture 8). ο§ Governments want seigniorage, to pay for spending that is not financed by taxes or borrowing (Lecture 9). API-120 Prof. J.Frankel Appendix: Targets & Instruments of Policymaking OBJECTIVES Inflation Growth & Unemployment TB, Balance of payments INSTRUMENTS Overnight interest rate Open market operations Reserve requirements Foreign exchange intervention INTERMEDIATE TARGETS M1 Exchange rate Core CPI Nominal GDP INDICATORS Stock market, Commodity prices, Consumer confidence, PMI β¦