1 ka-fu wong school of economics and finance university of hong kong adjustment to shocks and the...
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Ka-fu WongSchool of Economics and
FinanceUniversity of Hong Kong
Adjustment to shocks and the role of government
policies
** Prepared for the Professional Development Seminar for Economics Teachers, October 28, 2009.
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Outline
AS-AD model revisited Self-adjustment mechanism
Time paths of output and price level Was Greenspan right in 1996
Long-run growth and inflation The role of the government The great depression and the recent crisis The passive role of Hong Kong
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Exercise #1
Imagine yourself the central banker of a big country (such as the United States). Your objective is to maintain inflation within a narrow range with the policy tool of an overnight interest rate (such as the Federal fund rate). You have been seeing the following data lately.
YearsGDP Growth
Unemployment Rate
Inflation Rate
1985-1995 2.80% 6.30% 3.5
1995-2000 4.10% 4.80% 2.5 Would you choose to raise the target interest rate?
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AS-AD model revisited Planned aggregate expenditure
PAE = C + I + G + NXC=a1+a2(Y-T)+a3r+a4W
I=b1+b2r
NX = d1+d2q
r = i -
q = ep*/p
Real interest rate
Real exchange rate
e = domestic currency per foreign currencyNominal exchange ratep*= price of foreign good in foreign currency
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Equilibrium output at a given price level
Y = PAE
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Determination of Short-Run Equilibrium Output
Output Y
Pla
nn
ed a
gg
reg
ate
exp
end
itu
re P
AE
960
Expenditure line PAE = 960 + 0.8Y
Slope = 0.8
45o
Y = PAE
4,800
Equilibrium Algebraically •At equilibrium: Y=PAE• PAE = 960 + 0.8Y• Y=960+0.8Y• 0.2Y = 960• Y = 960/0.2 = 4,800 in equilibrium
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Aggregate Demand
A relation between the equilibrium output and the price level.
Y = PAE (p1)
Y = PAE (p2)
Y = PAE (p3)
…
⇒ Y1
⇒ Y2
⇒ Y3
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⇒ real wealth ↑⇒ interest rates ↓⇒ exchange rate ↓
Price Level (P)
Quantity of output (Y)
0
AD
P1
P2
Y1 Y2
The Aggregate-Demand curve
⇒ consumption ↑⇒ consumption ↑, investment ↑ ⇒ net export ↑
P ↓
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In the short run,P ↓ ⇒ Y ↓ sticky wages,sticky prices, ormisperceptions.
Price Level (P)
Quantity of Output (Y)
0
P1
Y1
SRAS (Pe)
P2
Y2
The short-run aggregate-supply curve
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Output, Y, and the price level , P, adjust to the point at which the aggregate-supply, AS, and aggregate-demand, AD, curves intersect.
Price Level (P)
Quantity of Output (Y)
0
P*
Y*
AS
AD
Aggregate Demand and Aggregate Supply
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In the long run, Y depends on:labor,capital,natural resources, andtechnology.
… but not on P.
Thus, the LRAS curve is vertical at YN.
Price Level (P)
Quantity of Output (Y)
0
Natural rate of output
LRAS
P1
YN
P2
The Long-run Aggregate-supply curve
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Price Level (P)
Quantity of Output (Y)
0
Natural rate of output
SRAS
AD
A
LRAS
P*
YN
The Long-run equilibrium
In the long run, AD meets LRAS at point A.
Expected price level adjusts to equal the actual price level.
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0
SRAS1
AD
LRAS
P1
Y1Y2
A
Price Level (P)
Quantity of Output (Y)
Self-adjustment towards the long-run equilibrium
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Union wage contracts set wages for several years.
Contracts setting the price of raw materials and parts for manufacturing firms also cover several years.
These long-term contracts reflect the inflation expectations or price level expectation at the time they are signed.
Slow shifts in SRAS due to Long-term Wage and Price Contracts
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The Output Gap and Inflation
Relationship of outputto potential output Behavior of inflation
1. No output gap Inflation remains unchangedY = Y* (Price level remains unchanged)
2. Expansionary gap Inflation risesY > Y* (Price level rises)
3. Recessionary gap Inflation fallsY < Y* (Price level falls)
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0
SRAS1
SRAS3
AD
LRAS
P1
P2
Y1Y2
B
A
Price Level (P)
Quantity of Output (Y)
Self-adjustment of recessionary gap
SRAS2
Recessionary gap
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0
SRAS3
SRAS1
AD
LRAS
P1
P2
Y1 Y2
B
A
Price Level (P)
Quantity of Output (Y)
Self-adjustment of expansionary gap
SRAS2
Expansionary gap
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0
SRAS1
AD1
SRAS3
AD2
LRAS
P1
P2
P3
Y1Y2
A
C
B
Price Level (P)
Quantity of Output (Y)
A Contraction in aggregate demand
SRAS2
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Adjustment of output
Time
Y
0
Y1
Y2
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Adjustment of price level
Time
P
0
P1
P3
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0
SRAS2
SRAS1
AD1
LRAS
P2
P1
Y1Y2
C
B
Price Level (P)
Quantity of Output (Y)
Exercise #2Impact of an increase in oil prices
Sketch the possible time paths showing the impact of this oil shock if the government and the central bank do nothing to accommodate the shock.
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0
SRAS2
SRAS1
AD1
LRAS
P2
P1
Y1Y2
C
B
Price Level (P)
Quantity of Output (Y)
An increase in oil prices
SRAS1
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Adjustment of output
Time
Y
0
Y1
Y2
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Adjustment of price level
Time
P
0
P2
P1
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0
SRAS1
AD1
SRAS3
LRAS1
P1
P2
Y1 Y2
A
B
Price Level (P)
Quantity of Output (Y)
An increase in productivity (due to technological changes)
SRAS2
LRAS2
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Adjustment of output
Time
Y
0
Y1
Y2
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Adjustment of price level
Time
P
0
P1
P2
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Exercise #1
Imagine yourself the central banker of a big country (such as the United States). Your objective is to maintain inflation within a narrow range with the policy tool of an overnight interest rate (such as the Federal fund rate). You have been seeing the following data lately.
YearsGDP Growth
Unemployment Rate
Inflation Rate
1985-1995 2.80% 6.30% 3.5
1995-2000 4.10% 4.80% 2.5 Would you choose to raise the target interest rate?
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U.S. Macroeconomic Data, Annual Averages, 1985-2000
% Growth in Unemployment Inflation ProductivityYears real GDP rate (%) rate (%) growth (%)
1985-1995 2.8 6.3 3.5 1.4
1995-2000 4.1 4.8 2.5 2.5
Was Greenspan right in 1996?
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0
AD2000
AD1980
LRAS1980
P200
0
P1990
P198
0
Y1990Y1980
Price Level (P)
Quantity of Output (Y)
LRAS1990 LRAS2000
AD1990
Y2000
Long-run growth and inflation
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Government intervention
In the long run, we are all dead!
Short-run adjustments are painful!
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0
SRAS1
AD1
SRAS3
AD2
LRAS
P1
P2
P3
Y1Y2
A
C
B
Price Level (P)
Quantity of Output (Y)
A Contraction in aggregate demand
SRAS2
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Adjustment of output
Time
Y
0
Y1
Y2
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The usefulness of fiscal and monetary policy
A slow self-correcting mechanism Fiscal and monetary policy can help stabilize
the economy. A fast self-correcting mechanism
Fiscal and monetary policy are not effective and may destabilize the economy.
The speed of correction will depend on: The use of long-term contracts. The efficiency and flexibility of labor markets.
Fiscal and monetary policy are most useful when attempting to eliminate large output gaps.
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Fiscal policies
Government expenditure Taxation
Takes time to pass a legislation Takes time to implement
Supply-side policiesTaxation
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Monetary policy
Interest rate Discount rate Reserve requirement
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0
SRAS1
AD1AD2
LRAS
P1
P2
Y1Y2
A
B
Price Level (P)
Quantity of Output (Y)
A Contraction in aggregate demand
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Adjustment of output
Time
Y
0
Y1
Y2
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0
SRAS2
AD2
SRAS1
AD1
LRAS
P1
P2
P3
Y1Y2
A
C
B
Price Level (P)
Quantity of Output (Y)
An increase in oil priceswith accommodation policy
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Adjustment of output
Time
Y
0
Y1
Y2
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0
SRAS1
AD1
SRAS3
LRAS1
P1
P2
Y1 Y2
A
B
Price Level (P)
Quantity of Output (Y)
An increase in productivity (due to technological changes)
SRAS2
LRAS2
Do nothing!
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The Fed’s Role in Stabilizing Financial Markets:Banking Panics
Suppose: Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to
meet the depositors demand. The bank fails and further erodes depositor confidence
which triggers additional failures.
The Fed to the rescue: Instill confidenceDiscount lendingOpen Market Operations
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The banking panics of 1930 - 1933 and the money supply
One-third of U.S. banks closed Depositors withdrew their funds Banks raised the reserve-deposit ratio
(banks were not willing to lend, considering loans too risky.)
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Key U.S. MonetaryStatistics, 1929-1933
Currency Reserve-deposit Bank Moneyheld by public ratio reserves supply
December 1929 3.85 0.075 3.15 45.9
December 1930 3.79 0.082 3.31 44.1
December 1931 4.59 0.095 3.11 37.3
December 1932 4.82 0.109 3.18 34.0
December 1933 4.85 0.133 3.45 30.8
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The banking panics of 1930 - 1933 and the money supply
In response to the panics of 1929-1933, deposit insurance was established in 1934.
Deposit insurance gives depositors an incentive to keep their money in the banks.
Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank.
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Recent crisis:No response to expansionary monetary policy?
Liquidity trapThe demand for money becomes infinitely
elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates.
If the economy enters a liquidity trap area, monetary policy will be unable to stimulate the economy.
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Recent crisis:No response to expansionary monetary policy?
Credit rationing Banks maintain an interest rate lower than the market-
clearing level. Excess demand for loans allows banks to choose the
more profitable projects. When investment becomes more risky, banks are more
cautious.
Joseph E. Stiglitz and Andrew Weiss's 1981 paper explains why the bank (or any lending institution for that matter) may credit ration its borrower if 1) the bank was unable to perfectly distinguish the risky borrowers from the safe ones 2) the loan contracts were subject to limited liability (if projects returns were less than the debt obligation, the borrower bears no responsibility to pay out her pocket).Stiglitz, J. & Weiss, A. (1981). Credit Rationing in Markets with Imperfect Information, American Economic Review, vol. 71, pages 393-410.
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What can the Fed do if Fed funds rate is near zero
Fed can buy other assets such as treasury bonds or stocks (affect long interest rate)
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Policymaking: Art or Science?
Requirements for Perfect Macroeconomic Policy Accurate knowledge of current economic
conditions Knowledge of the future path of the economy
without policy The precise value of potential output Complete and immediate control of fiscal and
monetary policy Knowledge of how and when the economy will
respond to policy changes
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Policymaking: Art or Science?
Lags in the effect of macroeconomic policy: Inside Lag (of macroeconomic policy)
The delay between the date a policy change is needed and the date it is implemented
Outside Lag (of macroeconomic policy)The delay between the date a policy
change is implemented and the date by which most of its effects on the economy have occurred
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How to design macroeconomic policy?
“Cross the River by Groping the Stone Under Foot” or “Feeling for rocks while crossing a river”
“Feeling for rocks while crossing a river” connotes a gradual progress: When a step forward does not feel right, a step in another direction might be necessary.
Policymaking: Art or Science?
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The passive role of Hong Kong
The linked exchange rate does not allow independent monetary policyUncovered interest rate parity restricts Hong
Kong’s interest rate to be very close to that of the US.
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Impact of an expansionary monetary policy in the US
Low US interest rate
Low HK interest rate
AD increases
Y increases in the long runP increases in the long run
short
Asset and property bubbleswealth effect?
Investment and consumption
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0
SRAS1
AD1
SRAS3
AD3
LRAS
Y1 Y2
A
C
B
Price Level (P)
Quantity of Output (Y)
Changes in aggregate demand due to changes in the US monetary policies
SRAS2
AD2
Y3
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Adjustment of output
Time
Y
0
Y1
Y3
Y2
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Adjustment of inflation
Time
P
0
P1
P3
P2
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Role of Hong Kong government?
Monetary policy: By adopting the linked exchange rate system, we have given
up our autonomy of monetary policy. Fiscal policy:
We still have autonomy fiscal policy. It is tempting to use fiscal policy to accommodate the shocks.
But fiscal policy is slow to take effect. By the time we see the effect, the US monetary policy might have shifted in the opposite direction. If so, the active HK’s fiscal policy may destabilize the output.
Alternative: Make Hong Kong economy more flexible in adjusting to shocks.
Improve the matching of job-seekers and vacancies. Encourage shorter job contract? Reduce the use of the government fiscal policy to stabilize
the economy (government policies tend to be slow!)
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End