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Lecture 5: Macroeconomic Model Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class Buckhead Center April 4, 2009 Important Macro Lessons To Be Learnt Today GDP cannot grow beyond its potential in the long run Loose Monetary Policy can create only a short-run stimulus in GDP. In long-run it only creates inflation! Net-Net money growth determines inflation Government spending can create only a short-run stimulus in GDP. In the long-run it leads to a rise in the real interest rate with no gain in GDP but higher deficits Balanced budget spending just redistributes the share of GDP attributed to consumption & government spending ~Typical Macro-Model~ world interest rate world price price level lag 1 world GDP IMPORTS inflation lag 1 EXPORTS EXCHANGE RATE NET EXPORTS money PRICE LEVEL INTEREST RATE INFLATION government INVESTMENT REAL GDP CONSUMPTION tax rate capital stock lag 1 TAX REVENUES investment lag 1 DISPOSABLE INCOME CAPITAL STOCK EXPECTED INFLATION UNEMPLOYMENT POTENTIAL GDP labor force Macroeconomic Model The Macroeconomic Model simulates the working of the US Economy using explicit equations to model consumption, investment, exports, imports, exchange rate, price level and inflation rate. Classification and Listing of Equations 1. Accounting Identities: Real GDP (GDP); Tax Revenues (T) Disposable Income (YDP), Net Exports (NETEX) Price Level (P) Example: Disposable Income (YDP) = GDP – Tax Revenues (T) Accounting Identities have the following properties: As forecasting equations, they are PERFECT! Don’t have parameters to be fitted No error term No theoretical disputes about their truth, only about their relevance 2. Behavioral Equations: Consumption (C), Real Interest Rate (R), Investment (I), Exchange Rate (EXCH), Exports (EX), Imports (IM), Inflation (P%) Example: Consumption (C) = α0 * Disposable income (YDP) (Where α0 = marginal propensity to consume = 0.9215686) Behavioral Equations have the following properties: Estimated parameter values change as behavior changes Source of all forecasting errors Theoretical disputes concerning these equations, e.g., are consumers myopic or forward looking? Endogenous and Exogenous Variables Accounting Identity Define: A = B + C ……………………(1) Where B = A/2 ………………..…..(2) and C = 5 (given) Behavioral Equation Then equation (1) becomes A = B +5 which using definition of B becomes the following: A = (A/2) + 5 Thus, A/2 = 5 or A = 10 and using (2) B=5 In the above example, A & B are endogenous variables and C is an exogenous variable Macroeconomic Model The Exogenous Factors in the model are: – GDP Potential (GDP@FULL) which is GDP value at full employment level – Domestic Policy Variables: Money Supply (M) Government Spending (G) Tax Policy (T%) – Rest-of-the-World (ROW) factors such as Foreign Interest Rate (R@ROW) Foreign Price Level (P@ROW) ROW GDP Potential (GDP@ROW) Model Simulation Approach 1. 2. 3. 4. 5. 6. 7. 8. State macroeconomic theory as a complete set of algebraic equations. Estimate/postulate numerical values of all parameters. Assume initial conditions for the history of all lagged variables. Assume “base case” values over future time periods for all exogenous variables. Solve the model under base case assumptions. Change some of the exogenous variable assumptions. Solve the model again under alternative assumptions. Compare model solutions Base Case and the alternative policy Simulation. Advantages of the Model Simulation Approach 1. Integrates short run and long run analysis into one coherent story of the dynamic reactions of an economy to macroeconomic policy. 2. Traces the complete logic of the model, step-by-step, instead of trying to condense model into a two-dimensional diagram, such as IS-LM diagram. 3. Extends to real-world macroeconomic policy issues. 4. Same process applies to realistic models of actual economies, such as U.S. forecasting models, oil shocks, or world slowdown. Listing Of Variables in the Model 12 Endogenous Variables – GDP, C, I, EX, IM, NETEX, R, P, YDP, T, EXCH, P% (requires 12 equations in 12 unknowns) 7 Exogenous Variables – 3 Policy Variables: M, G, TAX% – 3 ROW Variables: P@ROW, R@ROW, GDP@ROW – 1 Other Variable: GDP@FULL Listing of 12 Equations in the Model 12 Endogenous Variables – One GDP Equation/Accounting Identity Accounting Identity – Three Consumption Related Equations Accounting Identity Accounting Identity Behavioral Equation – Two Interest Rate and Investment Equations Behavioral Equation Behavioral Equation – Four Exchange Rate, Export, Import and Net Export Equations Behavioral Equation Behavioral Equation Behavioral Equation Accounting Identity – Two Price Inflation Equations Behavioral Equation Accounting Identity Glossary of Variables Type Variable Meaning Units Endogenous C Consumption Billions of $ Endogenous EX Exports Billions of $ Endogenous EXCH Exchange Rate Index Exogenous G Government Purchases Billions of $ Endogenous GDP Gross Domestic Product Billions of $ Exogenous GDP@FULL GDP @ Full Employment Billions of $ Exogenous GDP@ROW GDP in Rest of the World Billions of $ Endogenous I Investment Billions of $ Endogenous IM Imports Billions of $ Exogenous M Money supply Billions of $ Endogenous NETEX Net Exports Billions of $ Endogenous P Price Level Index Endogenous P% Inflation Percent Exogenous P@ROW Price Level, Rest of the Index World Endogenous R Real Interest Rate Percent Exogenous R@ROW Real Interest Rate, Rest of Percent the World Endogenous T Tax Revenues Billions of $ Exogenous TAX% Tax Rate Fraction Endogenous YDP Disposable Income Billions of $ Additional Definitions The model variables are in real terms (except of course the price variable). We need three other variables in nominal terms to complete our understanding. These are like “derived” accounting identities. Econ 101 Rule Econ 101 Rule “Given the values of exogenous variables for a given economy, if the values of inflation (P%) = 0.00% & nominal exchange rate (EXCH) = 1.00, then the economy is in equilibrium or steady state in such a way that actual GDP is exactly equal to potential GDP”. ENDOGENOUS VARIABLES ACCOUNTING IDENTITIES Gross Domestic Product Tax Revenues Disposable Income Net Exports Price Level BEHAVIORAL EQUATIONS Consumption Expenditure Real Interest Rate Investment Real Exchange Rate Exports Imports Inflation Nominal Exchange Rate EXOGENOUS VARIABLES POLICY VARIABLES Money Government Purchases Tax Rate GDP T YDP NETEX P 2008 $ 7,000.00 $ 1,050.00 $ 5,950.00 $ (248.25) 1.000 C R I EXCH EX IM P% EXCH(N) $ 5,483.33 4.00 $ 999.99 1.000 $ 1,764.29 $ 2,012.53 0.000 1.000 M $ 3,500.00 G TAX% REST-OF-WORLD VARIABLES Price Level, ROW P@ROW Real Interest Rate, ROW R@ROW GDP@ROW GDP @ Rest of World OTHERS Price Level % (t-1) Price Level (t-1) Potential GDP $ 764.92 0.15 1.00 4.00 $ 7,000.00 P%(t-1) 0.00 P(t-1) 1.00 GDP@FULL $ 7,000.00 Equal Base Case The Base Case is the state of the economy where for the given values of exogenous variables, the ECON 101 rule applies and the values of endogenous variables solved in the first year remain constant for all subsequent years Base Case This means that GDP will be equal to its potential value for all the years in the base case. Name of Experiment: Table 1: BASE CASE History 2008 E NDOGENOUS VARIABLES ACCOUNTING IDENTITIES Gross Domestic Product (GDP) * *** 2009 Short Run 2010 2011 * ** * 2012 * ** * 2019 Long Run 2024 2029 * ** * 2034 New Sim Base Case Diff $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 $7,000.0 $0.0 New Sim Base Case Diff $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 OTHERS Potential GDP (GDP@FULL) Inflation will be equal to ZERO percent Name of Experiment: Table 1: BASE CASE History 2008 ENDOGENOUS VARIABLES ACCOUNTING IDENTITIES Inflation (P%) New Sim Base Case Diff **** 2009 Short Run 2010 2011 **** 2012 **** 2019 Long Run 2024 2029 **** 2034 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 And the exchange rate will be at one for all the years Name of Experiment: Table 1: BASE CASE History 2008 ENDOGENOUS VARIABLES ACCOUNTING IDENTITIES Real Exchange Rate (EXCH) New Sim Base Case Diff **** 2009 Short Run 2010 2011 **** 2012 **** 2019 Long Run 2024 2029 **** 2034 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 1.00 0.00 Cont… This also implies that values of all other endogenous variables will also be constant for the subsequent years. Why? Endogenous variables P and P% from today become the exogenous variables for subsequent years’ endogenous value calculations as seen from equations 11 and 12. Name of Experiment: Table 1: BASE CASE History 2008 E NDOGENOUS VARIABLES ACCOUNTING IDENTITIES Data Table 1 * *** 2009 Short Run 2010 2011 * ** * 2012 * ** * 2019 Long Run 2024 2029 * ** * 2034 Gross Domestic Product (GDP) New Sim Base Case Diff $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 Taxes (T) New Sim Base Case Diff $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 $1,050.0 $1,050.0 $0.0 Disposable Income (YDP) New Sim Base Case Diff $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 $5,950.0 $5,950.0 $0.0 Net Exports (NETEX) New Sim Base Case Diff ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 ($248.2) ($248.2) $0.0 P rice Level (P) New Sim Base Case Diff 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 Consumption E xpenditure ( C) New Sim Base Case Diff $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 $5,483.3 $5,483.3 $0.0 Real Interest Rate ( R) New Sim Base Case Diff 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 Investment (I) New Sim Base Case Diff $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 $1,000.0 $1,000.0 $0.0 Real Exchange Rate (EXCH) New Sim Base Case Diff 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 1.00 1.00 0.00 E xports (EX) New Sim Base Case Diff $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 $1,764.3 $1,764.3 $0.0 Imports (IM) New Sim Base Case Diff $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 $2,012.5 $2,012.5 $0.0 Inflation (P%) New Sim Base Case Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 BEHAVIORAL EQUATIONS Second half of the data Table 1 E XOGENOUS V ARIABLES P OLICY VARIABLES Money Supply (M) New Sim Base Case Diff $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 Government Purcha ses (G) New Sim Base Case Diff $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 $764.9 $764.9 $0.0 Tax Rate (TAX%) New Sim Base Case Diff 15% 15% 15% 15% 15% 15% 15% 15% 15% 15% 0% 15% 0% 15% 0% 15% 0% 15% 0% 15% 0% 15% 0% 15% 0% 15% 0% P rice Level, ROW New Sim Base Case Diff 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 1.0 1.0 0.0 Real Interest Rate, ROW New Sim Base Case Diff 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 New Sim Base Case Diff $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 New Sim Base Case Diff $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 $7,000.0 $7,000.0 $0.0 REST-OF-WORLD VARIABLES GDP @ Rest of World OTHERS P otential GDP (GDP@FULL) 4 Important Guidelines to Use the Model 1. Tools/Options/Calculations/Iterations=100 2. Use Graph Button to Generate New Graphs for the experiment performed 3. Use Print Button for Printing the Results 4. To Reset the Model, Press the Base Case Button, and run the model once using the Calculations Button 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 2012 Rate of growth of the money supply is increased from 0% to 5% in 2007. This is done for 4 years from 2009 to 2012, and then money supply growth drops to 0% in 2013 and thereafter. Money Supply $4,500 $4,000 $3,500 $2,500 $2,000 $1,500 $1,000 $500 Years Money Supply (Simulation) Money Supply (Base) 2034 2033 2032 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 $ Billions $3,000 • Money supply growth rate is a constant 5% for four years from 2009 – 2012 Money Supply Growth (in Percentage %) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 2034 Money Supply Growth (Simulation) 2033 Money Supply Growth (Base) 2032 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 Years GDP versus Potential GDP $7,150 $7,100 $ Billions $7,050 $7,000 $6,950 $6,900 $6,850 $6,800 Same as GDP Potential in Long Run $6,750 $6,700 2034 2033 2032 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 Years GDP (Simulation) GDP (Base) 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 (in Percentage %) • 4.0 3.0 2.0 1.0 0.0 2034 2033 2032 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 -1.0 -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! Real Interest Rate (In Percentage %) 4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 2033 Real Interest Rate (Base) 2031 Real Interest Rate (Simulation) 2029 2027 2025 2023 2021 2019 2017 2015 2013 2011 2009 2007 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 $920 2034 2033 2032 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 Years Investment (Simulation) Investment (Base) Comparison of Inflation and Nominal Interest Rates Nominal = Real + Inflation Rate Inflation vs. Nominal Interest Rate 12.0 10.0 (In Percentage %) 8.0 6.0 4.0 2.0 0.0 2034 2033 2032 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 -2.0 -4.0 Years Inflation Nominal Interest Rate Comparison of Real Interest Rate and Nominal Interest Rate Real Vs Nominal Interest Rate 12.0 (In Percentage %) 10.0 8.0 6.0 4.0 2.0 0.0 2034 2033 2032 2031 Nominal Interest Rate 2030 Real Interest Rate 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 Years •As R drops it pulls down the real exchange rate Real Exchange Rate 1.200 (In Percentage %) 1.000 0.800 0.600 0.400 0.200 0.000 Real Exchange Rate (Simulation) Real Exchange Rate (Base) 2033 2031 2029 2027 2025 2023 2021 2019 2017 2015 2013 2011 2009 2007 Years •Exports increase in the short-run due to a drop in the real exchange rate α9 < 0 Exports ($ Billions) Billions $1,790 4.6 $1,780 4.4 $1,770 4.2 $1,760 4.0 $1,750 3.8 $1,740 3.6 $1,730 3.4 $1,720 3.2 2034 2033 2032 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 Years Exports Real Interest Rate Real Interest Rate (in %) Exports Vs. Real Interest Rate $1,790 $1,780 ($ Billions) $1,770 $1,760 $1,750 $1,740 $1,730 $1,720 Years Exports (Simulation) Exports (Base) 2034 2033 2032 2031 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 Exports 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 Billions 2007 •Exports increase in the short-run due to a drop in the real exchange rate •Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased! α12 > 0 Imports Vs. Real Exchange Rate 1.2 Imports ($ Billions) $2,030 1.0 $2,020 0.8 $2,010 $2,000 0.6 $1,990 0.4 $1,980 0.2 $1,970 $1,960 0.0 2032 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 Years Imports Real Exchange Rate Real Exchange Rate (in %) $2,040 •Imports increase in the short-run due to a rise in GDP which overpowers the negative effect of a weak exchange rate on imports 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 2032 2033 2034 Imports $2,040 $2,030 $ Billions $2,020 $2,010 $2,000 $1,990 $1,980 $1,970 $1,960 Years Imports (Simulation) Imports (Base) •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!) Trade Deficit Vs. Real Exchange Rate $(230) 1.2 $(235) 1.0 $(240) 0.8 $(245) 0.6 $(250) 0.4 $(255) 0.2 Years $(260) 0.0 Trade Deficit Real Exchange Rate RealExchange Rate Trade Deficit 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 2032 2033 2034 Billions • 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 $7,150 $7,100 Unemployment Drops $ Billions $7,050 $7,000 $6,950 $6,900 $6,850 Unemployment Rises $6,800 $6,750 $6,700 2034 2033 2032 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 Years GDP (Simulation) GDP (Base) •Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant. Surplus / Deficit $310 $300 $ Billions $290 $280 $270 $260 $250 $240 2034 2033 2032 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 Years Surplus / Deficit (Simulation) Surplus / Deficit (Base) •Consumption rises as GDP has risen! Consumption $5,600 $5,550 $ Billions $5,500 $5,450 $5,400 $5,350 $5,300 $5,250 2034 2033 2032 Consumption (Base) 2031 Consumption (Simulation) 2030 2029 2028 2027 2026 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 Years Comparison of Government Surplus and Nominal Interest Rate $310 12.0 $300 10.0 Surplus $290 8.0 $280 6.0 $270 4.0 $260 $250 2.0 $240 0.0 2034 2033 2032 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 Years Surplus Nominal Interest Rate Nominal Interest Rate (in%) Surplus Vs. Nominal Interest Rate Cont… Comparison of Government Surplus and Real Interest Rate Surplus Vs. Real Interest Rate $310 4.0 4.0 Surplus $290 4.0 $280 4.0 $270 4.0 4.0 $260 4.0 $250 4.0 $240 4.0 2032 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 Years Surplus Real Interest Rate Real Interest Rate (in%) 4.0 $300 Name of Experiment: Money Supply Growth History 2008 ENDOGENOUS VARIABLES ACCOUNTING IDENTITIES **** 2009 Short Run 2010 2011 **** 2012 **** 2019 Long Run 2024 2029 **** 2034 Gross Domestic Product (GDP) New Sim Base Case Diff $7,000.0 $7,000.0 $0.0 $7,101.3 $7,000.0 $101.3 $7,114.6 $7,000.0 $114.6 $7,072.9 $7,000.0 $72.9 $7,017.9 $7,000.0 $17.9 $7,033.5 $7,000.0 $33.5 $6,994.3 $7,000.0 -$5.7 $7,000.5 $7,000.0 $0.5 $7,000.1 $7,000.0 $0.1 Taxes (T) New Sim Base Case Diff $1,050.0 $1,050.0 $0.0 $1,065.2 $1,050.0 $15.2 $1,067.2 $1,050.0 $17.2 $1,060.9 $1,050.0 $10.9 $1,052.7 $1,050.0 $2.7 $1,055.0 $1,050.0 $5.0 $1,049.2 $1,050.0 -$0.8 $1,050.1 $1,050.0 $0.1 $1,050.0 $1,050.0 $0.0 Disposable Income (YDP) New Sim Base Case Diff $5,950.0 $5,950.0 $0.0 $6,036.1 $5,950.0 $86.1 $6,047.3 $5,950.0 $97.3 $6,012.0 $5,950.0 $62.0 $5,965.2 $5,950.0 $15.2 $5,978.4 $5,950.0 $28.4 $5,945.2 $5,950.0 -$4.8 $5,950.4 $5,950.0 $0.4 $5,950.1 $5,950.0 $0.1 Net Exports (NETEX) New Sim Base Case Diff ($248.2) ($248.2) $0.0 ($254.0) ($248.2) -$5.7 ($254.7) ($248.2) -$6.5 ($252.3) ($248.2) -$4.0 ($249.2) ($248.2) -$1.0 ($250.1) ($248.2) -$1.8 ($247.9) ($248.2) $0.3 ($248.3) ($248.2) $0.0 ($248.3) ($248.2) $0.0 Price Level (P) New Sim Base Case Diff 1.00 1.00 0.00 1.02 1.00 0.02 1.07 1.00 0.07 1.14 1.00 0.14 1.21 1.00 0.21 1.20 1.00 0.20 1.22 1.00 0.22 1.22 1.00 0.22 1.22 1.00 0.22 Consumption Expenditure ( C) New Sim Base Case Diff $5,483.3 $5,483.3 $0.0 $5,562.7 $5,483.3 $79.3 $5,573.0 $5,483.3 $89.7 $5,540.4 $5,483.3 $57.1 $5,497.4 $5,483.3 $14.0 $5,509.5 $5,483.3 $26.2 $5,478.9 $5,483.3 -$4.4 $5,483.7 $5,483.3 $0.4 $5,483.4 $5,483.3 $0.1 Real Interest Rate ( R) New Sim Base Case Diff 4.0 4.0 0.0 3.7 4.0 -0.3 3.7 4.0 -0.3 3.8 4.0 -0.2 4.0 4.0 0.0 3.9 4.0 -0.1 4.0 4.0 0.0 4.0 4.0 0.0 4.0 4.0 0.0 Investment (I) New Sim Base Case Diff $1,000.0 $1,000.0 $0.0 $1,027.7 $1,000.0 $27.7 $1,031.4 $1,000.0 $31.4 $1,019.9 $1,000.0 $19.9 $1,004.8 $1,000.0 $4.9 $1,003.6 $1,000.0 $3.6 $998.5 $1,000.0 -$1.5 $1,000.1 $1,000.0 $0.1 $1,000.0 $1,000.0 $0.0 Real Exchange Rate (EXCH) New Sim Base Case Diff 1.00 1.00 0.00 0.97 1.00 -0.03 0.93 1.00 -0.07 0.88 1.00 -0.12 0.83 1.00 -0.17 0.83 1.00 -0.17 0.82 1.00 -0.18 0.82 1.00 -0.18 0.82 1.00 -0.18 Exports (EX) New Sim Base Case Diff $1,764.3 $1,764.3 $0.0 $1,773.3 $1,764.3 $9.1 $1,766.5 $1,764.3 $2.2 $1,748.4 $1,764.3 -$15.9 $1,745.0 $1,764.3 -$19.3 $1,768.5 $1,764.3 $4.2 $1,763.6 $1,764.3 -$0.7 $1,764.3 $1,764.3 $0.1 $1,764.3 $1,764.3 $0.0 Imports (IM) New Sim Base Case Diff $2,012.5 $2,012.5 $0.0 $2,030.8 $2,012.5 $18.2 $2,033.1 $2,012.5 $20.6 $2,025.6 $2,012.5 $13.1 $2,015.7 $2,012.5 $3.2 $2,018.5 $2,012.5 $6.0 $2,011.5 $2,012.5 -$1.0 $2,012.6 $2,012.5 $0.1 $2,012.5 $2,012.5 $0.0 Inflation (P%) New Sim Base Case Diff 0.0 0.0 0.0 2.2 0.0 2.2 4.6 0.0 4.6 6.2 0.0 6.2 6.6 0.0 6.6 0.3 0.0 0.3 -0.1 0.0 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 BEHAVIORAL EQUATIONS 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!