10/7/2015econ 7920/chatterjee. 10/7/2015econ 7920/chatterjee

04/21/23Econ 7920/Chatterjee

We cannot predict the future with any degree of certainty

But expectations about the future often determine the future course of an economy

“Managing” the public’s expectations is perhaps the most important objective of public policy


Modeling the formation of expectations:

◦ Adaptive Expectations (AE): People base their expectations of the future only on past observations

◦ Rational expectations (RE):People base their expectations on all available current information, including information about prospective future policies

◦ Critical differenceCritical difference: under RE, economic decisions change ONLY if there is “news” or new information about the future. Under AE, “news” has no impact on current decisions

Expected inflation plays a crucial role in determining current inflation and interest rates

A principal objective of monetary policy: ◦ to manage the public’s expectations of future

inflation

How can this be achieved?


For expected inflation to be low, the public must believebelieve that the Central Bank is committedcommitted to fighting inflation

The only way this can happen is if the Central Bank has credibilitycredibility with the private sector: it’s past actions confirm its commitment to keeping inflation low

Credibility is difficult to attain: often requires significant short-run sacrifices (high interest rates, unemployment and recessions)

One factor to consider: does Central Bank independence matter?


Can inflationary expectations be controlled by non-monetary measures?

A popular policy measure: impose wage and price controls

If the government mandates that it is illegal for prices and wages to increase above a pre-specified ceiling, wouldn’t that stabilize expectations of future inflation?

Wage and Price controls simply do not work. Why?


Extremely difficult to commit to and monitor such policies and punish violators

These policies inevitably create huge shortages and involve a misallocation of scarce resources becomes self-perpetuating


Inflation targeting:◦ Central Bank announces a target rate of inflation

(usually 2-3 percent)◦ It raises or lowers interest rates to keep inflation at the

target rate

Advantage: as long as there is credibility, inflationary spirals can be avoided

Disadvantage: if the economy faces a large supply-side shock (an oil price increase), maintaining the target can be difficult


Does “Say’s Law” always work?

Consider the following sequence:◦ For some reason, consumers suddenly expect bad times in the near

future cut back on spending◦ Firms face lower orders for goods and services cut back on

employment and investment lay off workers and keep machines idle

◦ The rising unemployment causes a reduction household incomes further cut-backs in spending further reduction in production of goods

◦ Leads to a downward spiral in economic activity severe recession (self-fulfilling prophecy)

“Paradox of Poverty in the Midst of Plenty” – Keynes (1936)

How can monetary and fiscal policy correct this “paradox”?


In a recession, the Central bank can implement an expansionary expansionary monetary policy◦ Increasing money supply and lowering interest rates

Households◦ Consumption more attractive than savings◦ “Durable” consumption (houses, cars, appliances)

cheaper Firms

◦ Cost of investment (financing new capital equipment, construction, etc) cheaper


Expansionary monetary policy may not be effective if◦ Expectations of future demand are severely

depressed

◦ The gap between actual output and potential output is small (can generate inflationary pressures)

◦ The economy is in a “liquidity trap”

◦ Prices are actually falling or expected to fall (deflationdeflation)


When nominal interest rates reach a critically low level (positive but close to zero): people might prefer holding money to assets (why?)

In such cases, injecting more money does not affect interest rates and thereby the incentives to spend and invest


Deflation: price level declines over time◦ Due to declining productivity and demand◦ Gap between actual and potential output

Monetary policy is ineffective in a deflation:◦ Let r = real rate of interest

i = nominal rate of interest = rate of inflation

Then,r = i -

With deflation, < 0 r > 0


Consider an example:◦ Suppose, due to an expansionary monetary policy, the nominal

interest rate is low, at i = 1%◦ But prices are falling at the rate of 5% = -5%◦ Then, the real rate of interest is:

r = i - = 1-(-5) = 6%

Therefore, the real cost of borrowing is 6% even though the nominal cost is only 1%

Facing a declining price level and a rising real interest rate, households and firms postpone spending

Monetary policy completely ineffective


1980s: Under pressure from the Ministry of Finance, the Bank of Japan kept interest rates low◦ Economy “awash” with liquidity◦ Created speculative bubbles in equities and real

estate◦ Economy started over-heating towards the end of

1980s◦ Inefficiencies in the corporate sector slowed

productivity◦ Financial liberalization of 1980s: more

competition among banks more risk-taking


Yasushi Mieno takes over as Governor of the Bank of Japan in 1989: promises to “cool” economy down◦ Interest rate rises from 2.5% in Dec 1989 to 6% in Aug 1990◦ Speculative bubble bursts in summer 1990: stock market

falls by more than 40% ◦ Firms and households significantly cut back on spending◦ Sharp economic slowdown begins in 1990:Land prices fell

quickly, mortgage defaults and bankruptcies increased

Throughout the 1990s, Japan experienced deflation and was stuck in a liquidity trap, in spite of monetary policy interventions


“Irresponsible Monetary Policy” was proposed as a solution by Paul Krugman of MIT (1998):

◦ Set an inflation target inflation target of 2-4%◦ Commit to the target and keep increasing money

supply in a sustained fashion◦ Eventually, public start expecting future inflation◦ Currency starts depreciating◦ Spending, investment, and demand for exports

restart the growth process…


Fiscal policy (government spending, taxation, and subsidies) can be an effective tool in ◦ a recession◦ when expectations of future demand are severely

depressed

Keynes (1936): through deficit spending, a government can influence expectations of the private sector:◦ Deficit spending: government spends more than it

receives in tax revenues (mainly financed through borrowing)

◦ Government spending creates new jobs multiplier multiplier effect effect on the economy


Basic idea: ◦ An initial amount of government spending creates new

incomes (through jobs created in the public sector)◦ A fraction of this new income is spent on goods and

services generates new income and spending, and so on…

◦ Similar to a “ripple” effect◦ The final increase in income and spending is much

larger than the initial increase in government spending “multiplier effect” economic expansion

What about the deficit?◦ The income generated increases tax revenues over time,

making the deficit sustainable


Suppose people spend a “b” fraction of their income (marginal propensity to consume)◦ Example: b = 0.75 people spend $0.75 of

every $1 of new income The government increases spending by $1 Total spending and income generated:


Spending Iterations New spending/income ($)

Round 1 (government) 1

Round 2 (private) b(1)=0.75

Round 3 (private) b(0.75)=0.56



And so on… …

Total increase in spending/income =1+0.75+0.56+0.42+…

....1 32 bbb

In general, the multiplier effect is given by:

In our example, b = 0.75. Then,

◦ Increase in income =

◦ A $1 increase in government spending increases total income by $4

◦ Also referred to as the “income multiplier”

A multiplier effect can also be generated by cutting taxes (the “tax multiplier”)


( consume to propensity Marginal1spending government in increase Initial

Income in Increase)b

425.01

75.011

If the economy’s capacity utilization rate (gap between potential and actual output) is well below 100%◦ When resources are idle (high unemployment and

shut-down factories) producers can increase production without raising prices

As capacity utilization nears 100%, deficit spending can overheat the economy and create inflationary pressures smaller multiplier effect


Factors that can reduce the size of the multiplier effect:◦ Government spending financed by higher taxes

◦ New income is fully spent on imports (does not affect GDP)

◦ New income is fully saved by households to provide for future expected tax increases (“Ricardian Equivalence”)

◦ “Crowding OutCrowding Out” of private investment by raising market interest rates

◦ Sometimes, the Central Bank may raise interest rates to offset any inflationary expectations (say, if capacity utilization is near 100%)


The U.S. government uses a forecasting model developed by Data Resources Inc. (DRI) to estimate the potential effects of fiscal policy

Estimates of Fiscal Policy Multipliers:


Assumption Government spending increase

Tax cut

No crowding out 1.93 1.19

Crowding out 0.60 0.26

Unemployment (right scale)

Real GNP(left scale)

120

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Asserts that the Great Depression was largely due to an exogenous fall in the demand for goods & services

Supporting evidence: ◦ output, consumption, and investment declined

steadily from 1929-1934◦ Government spending remained largely

unchanged during this period

Stock market crash exogenous fall in consumption ◦ Oct-Dec 1929: S&P 500 fell 17%◦ Oct 1929-Dec 1933: S&P 500 fell 71%

Drop in investment◦ “correction” after overbuilding in the 1920s◦ widespread bank failures made it harder to obtain

financing for investment (the FDIC did not exist then)

ContractionaryContractionary fiscal policy◦ Congress raised tax rates and cut spending

(deficits were considered “bad” for economy)

Asserts that the Depression was largely due to huge fall in the money supply

M1 fell 25% during 1929-33

The severity of the Depression was due to a huge deflation: the price level fell 25% during 1929-33

This deflation was probably caused by the fall in money supply

10/7/2015econ 7920/chatterjee. 10/7/2015econ 7920/chatterjee

Documents

formation of expectations

current inflation

future course

near future

adaptive expectations

inflation lowcredibility

target rate of inflation

available current information