Download Week 10

Credibility and long-run
reform
Credibility and expectations
Changing the long run
Credibility and long-run reform
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Last week we saw how stabilisation policies can
be used to try an keep the economy at the long
run macroeconomic equilibrium and minimise
the impact of transitory shocks
This week we examine how policy can attempt
to modify the long run macroeconomic
equilibrium
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We will not be examining economic growth just yet
(week 13)
Rather, we will be examining the conditions under
which policy can influence the long run equilibrium of
the AS-AD model (i.e. structural reforms)
Credibility and long-run reform
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The main argument we will focus on is the
credibility of economic policy
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This has become central to policy-making and is
the result of the debate on expectations.
Because the Phillips and AS curves depend on
expectation, their location can shift just by
shifting people’s beliefs!
Such “self-fulfilling prophecies”, will be seen in
all the examples of policies.
It can be a useful policy tool, but is double
edged!
Credibility and long-run reform
Expectations and the issue of credibility
Reducing long run inflation
Influencing long run unemployment
and potential output
Expectations and the issue of credibility
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The first historical application of expectations is the
debate on expected inflation mentioned in week 8
This debate occurred because central banks were
trying to reduce the relatively high inflation levels
of the 1970’s
The main consequence was the introduction of the
notion of credibility as a main aspect of how central
banks carried out monetary policy
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These issues will be clarified in the next section
Expectations and the issue of credibility
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After this, the “rational expectations revolution” also
attempted to integrate agent expectations into
aggregate demand (not just aggregate supply)
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Z  C  I G
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Permanent income theory (Friedman) : Consumption is not
a function of current income Y, but of permanent income,
which is the expected averge value of Y.
Life cycle theory (Modigliani) : Similar, but takes into
account the fact that the income of agents varies during
their life, with alternating periods of saving (active life)
and dissaving (university, retirement, etc.).
Ricardian equivalence : if the government increases its spending,
(∆G>0), agents will expect a future increase in taxes (∆T>0) to pay back
the debt and will increase their savings (fall in the mpc). The net effect on
output is unclear (higher G, lower multiplier)
Expectations and the issue of credibility
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The central consequence of the « Lucas critique » in terms of
economic policy have been :
A redefinition of the way policies are carried out : Credibility is
important
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The expectations of agents have a very large impact on the final
outcome of policies
The objective of a policy is not only to modify the value of an
economic variable, (π, U, C, I, etc.), but also to modify the
expectations on these variables.
The modifications in the way economic policies are carried out in the
80’s-90’s (particularly monetary policy)
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Independence of central banks
More transparency in decision-making (ex. publication of minutes)
Credibility and long-run reform
Expectations and the issue of credibility
Reducing long run inflation
Influencing long run unemployment
and potential output
Reducing long run inflation
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High inflation is a problem in macroeconomics...
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In micro we saw that in theory, pure inflation is
not a problem: all prices go up by the same
amount.
So why is it a problem in macro?
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Prices of goods and factors don’t go up at the
same speed (wages are agreed by contract)
Inflation distorts production incentives (see
Zimbabwe)
Also, remember the Fisher equation: rt  it   t
Reducing long run inflation
rt  it   t
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Unexpected inflation transfers wealth from
lenders to borrowers (Why unexpected?)
 Because borrowers pay lenders a lower real
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interest rate than agreed initially
If the unexpected inflation is high enough real
rates can even be negative...
In particular, there can be an incentive for
States to generate unexpected inflation: it
reduces the real value of their debt...
 This is called the inflation tax
Reducing long run inflation
Volatile inflation
Difficult to fomulate
expectations
Persistent/stable inflation
French inflation (1902-2007)
Reducing long run inflation
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The central bank wants to reduce inflation permanently from π h to π l
   e   u  u n 
The bank carries out the policy, and
reduces money supply
What happens if the policy is not
credible ?
πh
The CB carries out its
deflationary policy and
unemployment increases
πl
Agents do not revise their
expectations, and the Phillips
curve does not shift.
un
Sacrifice
The economy ends up where it
started…
Reducing long run inflation
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Imagine now that the agents believe the policy to be credible
   e   u  u n 
Assumption : Expectations adjust
slowly :
The CB carries out its
deflationary policy and
unemployment increases
πh
Then agents update their
expectations
πl
Assumption : Expectations adjust
instantaneously (Lucas) :
un
Sacrifice
The Phillips curve adjusts at
the same time as the CB
carries out its policy : No
sacrifice! (remember the
vertical Phillips curve)
Reducing long run inflation
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This shows that it is also important to take into account the speed of
adjustment of expectations when the deflationary policy is carried out
     u  u
e
n

Even with rational expectations, it can
be some time before variables adjust
(for exemple, nominal rigidities on
wages, à la Taylor)
If the policy is carried faster than the
rate of adjustment of expected
variables, the initial movement will be
along the SR curve: the sacrifice is
high
πh
πl
Ideally, you want a policy that is
applied at the same rate as the
expected variables adjust:
un
Sacrifice
The downwards shift of the Phillips
curve compensates exactly the
downward movement on the curve
Reducing long run inflation
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Therefore, a disinflationary policy that wants to
permanently reduce inflation and minimise the
social cost of the policy (employment sacrifice), you
need to account for
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The interaction between agents and policy-makers
(Central bank and government) in terms of credibility.
The expectations of agents (they may be
heterogeneous!)
The existence of nominal rigidities that will affect the
agents’ capacity to adjust their expectations through
time.
Reducing long run inflation
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Empirical evidence :
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Disinflation policies always lead to an increase in
unemployment: even taking into account
expectations, it does not seem possible to avoid the
short-run Phillips curve (no “silver bullet”)
However; faster disinflations have a lower sacrifice
ratios, slower ones have a higher sacrifice ratio: it
seems the effect of credibility on expectations is
validated.
The faster wages are re-negotiated (or the shorter the
contracts), the smaller the sacrifice ratio: nominal
rigidities are important in slowing down the
adjustment of expectations.
Reducing long run inflation
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What about the opposite case: credibly
committing to inflation ?
This situation is outlined by Paul Krugman (NYT
articles)
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Historical case of Japan in the 90’s (the “lost
decade”)
Is it applicable to the current case?
This is the problem: how does a central bank
historically committed to low inflation get out
of a deflation situation?
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It’s the opposite case to the previous one !
Reducing long run inflation
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Deflation can be an even bigger problem than
inflation !
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With deflation, money becomes an asset
Remember the Fisher equation
rt  it   t
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The nominal interest on money is zero, but with
deflation, the real interest is positive !
This is because agents expect prices to be lower
in the future, so hold up their spending plans
Money is now a good investment !
Reducing long run inflation
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Coupled with a preference for liquidity this
means that money will be hoarded for itself.
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Typically, a deflation prolongs the duration of a
depression through a liquidity trap situation
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If nominal rates are low (the case in a recession),
agents are indifferent to money and assets.
This will depress aggregate demand even more!
It is therefore important to find a way out of
them.
How does a central bank increase prices ?
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Print money! But will it work? Not necessarily!
Reducing long run inflation
The economy is in a deep recession/depression : un is high, inflation
is negative (we’ll see in the next section how this may occur)
The CB wants to push inflation from π - to π + and prints lots of cash
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   e   u  u n 
π+
What happens if agents don’t think
the bank wants to permanently
increase inflation?
Agents do not revise their
expectations, and the Phillips
curve does not shift.
0
π-
The economy ends up where it
started…
un
Reducing long run inflation
Only if the central bank can credibly commit to higher inflation in the
future will the policy be successful!
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   e   u  u n 
π
Agents will revise their
expectations, and the Phillips
curve will shift upwards, taking
the economy out of deflation
According to Paul Krugman, it
is just as hard for the ECB, the
BoE or the FED to commit
credibly to inflation as it is for
Zimbabwe to commit to low
inflation...
+
0
π-
Which is why “quantitative
easing” policies are being
introduced, as well as the
“ZIRP”
un
Credibility and long-run reform
Expectations and the issue of credibility
Reducing long run inflation
Influencing long run unemployment
and potential output
Long run unemployment and output
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As outlined previously, the Phillips curve and
the AS-AD model (which includes the PC on the
supply side) tend to return to a “natural” long
run equilibrium
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These are vertical, and are not affected by prices
in the long run.
But they are affected by other variables
How can macro policy influence these?
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Reduce the natural rate of unemployment
Increase the natural level of output (discounting
growth for the moment)
Long run unemployment and output
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A first element is the “structural reform”
policies on the labour market.
Remember the WS-PS model: The structural rate
of unemployment is a function of
1
 F un , z 
1 
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The mark-up on the goods markets μ
The labour market conditions z (unemployment
benefits, etc.)
Long run unemployment and output
Structural rate of unemployment un (long run)
1
 F un , z 
1 
W
Real Wage
P
1
1 '
1
1 
B
1st aspect: reducing the mark-up on
the goods market. μ‘ < μ
2nd aspect: reducing the market
conditions parameter z (smaller
unemployment benefits, etc.)
PS’
A
PS
WS
WS’
un
un
Unemployment
rate u
Long run unemployment and output
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Such policies have been put in place in many
countries.
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They are not necessarily ultra-liberal policies
For example, reducing “z” is not just cutting
benefits.
Benefits can be made conditional to re-training,
with extra funding allocated (Denmark)
In many cases, they have lead to more flexible
labour markets, with lower rates on
unemployment
But right now, they’re not the “best” policies
Long run unemployment and output
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A more important aspect is the question of the
endogeneity of the “natural” rates
In other words, what if short run shocks could
have long-run effects ?
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Then short run policy becomes important in the long
run!
This is linked to the idea of persistence and
hysteresis
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Persistence : a short-run shock has long-run effects
Hysteresis : when a phenomenon continues after its
cause has been removed
Long run unemployment and output
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Illustration with a labour market example:
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When unemployed, the probability of finding a job
decreases with the length of the unemployment spell
This is because your skills/employability deteriorates
with time
A negative shock to the economy
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Will increase the short-run unemployment
If nothing is done (or too little), then the “natural”
rate will increase, and the shock will be persistent.
The “natural” rate follows an error-correcting
process:
n
n
n


ut  ut 1   ut 1  ut 1 ,   1
The AS-AD equilibrium
π
LRAS2
A large negative demand shock
shifts the AD curve to the left, which
reduces output pushes the economy
into deflation
LRAS
SRAS
The government does not intervene
in time, or too little.
A
π1
π3
In the mean time, the LRAS shifts
left :
0
C
The “natural” rate of unemployment
increases because of hysteresis
π2
B
AD
If the hysteresis is large enough,
the economy can end up in
structural depression (Japan’s
lost decade)
AD3
AD2
Y1
Y2n
Yn
Y