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CASE STUDY Volcker’s Monetary Tightening Late 1970s: > 10% Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation. Aug 1979-April 1980: Fed reduces M/P 8.0% Jan 1983: = 3.7% How do you think this policy change would affect interest rates? slide 0 Volcker’s Monetary Tightening, cont. The effects of a monetary tightening on nominal interest rates model short run long run Liquidity Preference Quantity Theory, Fisher Effect (Keynesian) (Classical) prices sticky flexible prediction i > 0 i < 0 actual outcome 8/1979: i = 10.4% 4/1980: i = 15.8% 1/1983: i = 8.2% slide 1 EXERCISE: Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. A boom in the stock market makes consumers wealthier. 2. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r . b. determine what happens to C, I, and the unemployment rate. slide 2 What is the Fed’s policy instrument? What the newspaper says: “the Fed lowered interest rates by one-half point today” What actually happened: The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points. The Fed targets the Federal Funds rate: it announces a target value, and uses monetary policy to shift the LM curve as needed to attain its target rate. slide 3 What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1) They are easier to measure than the money supply 2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. slide 4 Interaction between monetary & fiscal policy Model: monetary & fiscal policy variables (M, G and T ) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change. slide 5 The Fed’s response to G > 0 Suppose Congress increases G. Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different: slide 6 Response 1: hold M constant If Congress raises G, the IS curve shifts right If Fed holds M constant, then LM curve doesn’t shift. r LM1 r2 r1 IS2 IS1 Results: Y Y 2 Y1 Y1 Y2 Y r r2 r1 slide 7 Response 2: hold r constant If Congress raises G, the IS curve shifts right r To keep r constant, Fed increases M to shift LM curve right. r2 r1 LM1 IS2 IS1 Results: Y Y 3 Y1 LM2 Y1 Y2 Y3 Y r 0 slide 8 Response 3: hold Y constant If Congress raises G, the IS curve shifts right To keep Y constant, Fed reduces M to shift LM curve left. LM2 LM1 r r3 r2 r1 IS2 IS1 Results: Y 0 Y1 Y2 Y r r3 r1 slide 9 CASE STUDY The U.S. economic slowdown of 2001 ~What happened~ 1. Real GDP growth rate 1994-2000: 3.9% (average annual) 2001: 1.2% 2. Unemployment rate Dec 2000: 4.0% Dec 2001: 5.8% slide 10 CASE STUDY The U.S. economic slowdown of 2001 ~Shocks that contributed to the slowdown~ 1. Falling stock prices From Aug 2000 to Aug 2001: -25% Week after 9/11: -12% 2. The terrorist attacks on 9/11 • increased uncertainty • fall in consumer & business confidence Both shocks reduced spending and shifted the IS curve left. slide 11 The Great Depression 30 Unemployment (right scale) 220 25 200 20 180 15 160 10 Real GNP (left scale) 140 5 120 1929 percent of labor force billions of 1958 dollars 240 0 1931 1933 1935 1937 1939 slide 12 The Spending Hypothesis: Shocks to the IS Curve asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve evidence: output and interest rates both fell, which is what a leftward IS shift would cause slide 13 The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% 2. Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending slide 14 The Money Hypothesis: A Shock to the LM Curve asserts that the Depression was largely due to huge fall in the money supply evidence: M1 fell 25% during 1929-33. But, two problems with this hypothesis: 1. P fell even more, so M/P actually rose slightly during 1929-31. 2. nominal interest rates fell, which is the opposite of what would result from a leftward LM shift. slide 15 The Money Hypothesis Again: The Effects of Falling Prices asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33. This deflation was probably caused by the fall in M, so perhaps money played an important role after all. In what ways does a deflation affect the economy? slide 16 The Money Hypothesis Again: The Effects of Falling Prices The stabilizing effects of deflation: P (M/P ) LM shifts right Y Pigou effect: P (M/P ) consumers’ wealth C IS shifts right Y slide 17 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of unexpected deflation: debt-deflation theory P (if unexpected) transfers purchasing power from borrowers to lenders borrowers spend less, lenders spend more if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls slide 18 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of expected deflation: e r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output slide 19 Why another Depression is unlikely Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let M fall so much, especially during a contraction. Fiscal policymakers know better than to raise taxes or cut spending during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic stabilizers make fiscal policy expansionary during an economic downturn. slide 20 Imports and Exports as a percentage of output: 2000 Percentage40 of GDP 35 30 25 20 15 10 5 0 Canada France Germany Imports Exports Italy Japan U.K. U.S. slide 21 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand slide 22 1. Fiscal policy at home r An increase in G or decrease in T reduces saving. r * 1 S2 S1 NX2 NX1 Results: I 0 I (r ) NX S 0 I1 S, I slide 23 NX and the Government Budget Deficit 4 Percent of GDP 3 8 Percent of GDP 6 Budget deficit (right scale) 2 4 1 2 0 0 -1 -2 -2 -4 Net exports (left scale) -3 -4 1950 -6 -8 1960 1970 1980 1990 2000 slide 24 2. Fiscal policy abroad Expansionary fiscal policy abroad raises the world interest rate. r NX2 r2* S1 NX1 r * 1 Results: I 0 I (r ) NX I 0 I (r ) * 2 I (r1* ) S, I slide 25 3. An increase in investment demand r S r* EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX1 I (r )1 I1 S, I slide 26 3. An increase in investment demand r ANSWERS: I > 0, S = 0, S NX2 r* net capital outflows and net exports fall by the amount I NX1 I (r )2 I (r )1 I1 I2 S, I slide 27 2 140 1 120 0 100 -1 80 -2 60 -3 40 -4 20 -5 0 1975 1980 1985 1990 1995 1998:2 = 100 Percent of GDP U.S. Net Exports and the Real Exchange Rate, 1975-2002 2000 Net exports (left scale) Real exchange rate (right scale) slide 28 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports slide 29 1. Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. ε S 2 I (r *) S 1 I (r *) ε2 ε1 NX(ε ) NX 2 NX 1 NX slide 30 2. Fiscal policy abroad An increase in r* ε reduces investment, increasing net ε1 capital outflows and the supply of ε 2 dollars in the foreign exchange …causing the market… real exchange rate to fall and NX to rise. S 1 I (r1 *) S 1 I (r2 *) NX(ε ) NX 1 NX 2 NX slide 31 3. An increase in investment demand An increase in investment ε reduces net capital outflows ε2 and the supply of dollars in the ε1 foreign exchange market… …causing the real exchange rate to rise and NX to S1 I 2 S1 I 1 NX(ε ) NX 2 NX 1 NX slide 32 4. Trade policy to restrict imports At any given value ε of ε, an import quota ε2 IM NX demand for ε1 dollars shifts right Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed. S I NX (ε )2 NX (ε )1 NX1 NX slide 33 4. Trade policy to restrict imports Results: ε > 0 (demand increase) NX = 0 (supply fixed) IM < 0 (policy) EX < 0 (rise in ε ) ε S I ε2 ε1 NX (ε )2 NX (ε )1 NX1 NX slide 34 Inflation and nominal exchange rates Percentage 10 change 9 in nominal exchange 8 rate 7 6 5 4 3 2 1 0 -1 -2 -3 -4 South Africa Depreciation relative to U.S. dollar Italy New Zealand Australia Spain Sweden Ireland Canada Belgium Germany UK France Appreciation relative to U.S. dollar Netherlands Switzerland Japan -3 -2 -1 0 1 2 3 4 5 6 7 8 Inflation differential slide 35 CASE STUDY The Reagan Deficits revisited actual closed small open 1970s 1980s change economy economy G–T 2.2 3.9 S 19.6 17.4 r 1.1 6.3 no change I 19.9 19.4 no change NX -0.3 -2.0 ε 115.1 129.4 no change no change Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. slide 36