slide 0 case study volcker’s monetary tightening late 1970s: > 10% oct 1979: fed chairman...

CASE STUDY CASE STUDY

Volcker’s Monetary TighteningVolcker’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 How do you think this policy change would affect interest rates? would affect interest rates?

How do you think this policy change How do you think this policy change would affect interest rates? would affect interest rates?

Volcker’s Monetary Tightening, Volcker’s Monetary Tightening, cont.cont.

i < 0i > 0

1/1983: i = 8.2%8/1979: i = 10.4%4/1980: i = 15.8%

flexiblesticky

Quantity Theory, Fisher Effect

(Classical)

Liquidity Preference(Keynesian)

prediction

actual outcome

The effects of a monetary tightening on nominal interest rates

prices

model

long runshort run

EXERCISE:EXERCISE: Analyze shocks with the IS-LM modelAnalyze shocks with the IS-LM modelUse 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.

What is the Fed’s policy instrument?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 The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value,

and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve

as needed to attain its target rate. as needed to attain its target rate.

The Fed The Fed targetstargets the Federal Funds rate: the Federal Funds rate: it announces a target value, it announces a target value,

and uses monetary policy to shift the LM and uses monetary policy to shift the LM curve curve

as needed to attain its target rate. as needed to attain its target rate.

What is the Fed’s policy instrument?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.

Interaction between Interaction between monetary & fiscal policymonetary & 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.

The Fed’s response to The Fed’s response to GG > 0 > 0

Suppose Congress increases G.

Possible Fed responses:1. hold M constant2. hold r constant3. hold Y constant

In each case, the effects of the G are different:

If Congress raises G, the IS curve shifts right

IS1

Response 1: hold Response 1: hold MM constant constant

Y

rLM1

r1

Y1

IS2

Y2

r2If Fed holds M constant, then LM curve doesn’t shift.

Results:2 1Y Y Y

2 1r r r


IS1

Response 2: hold Response 2: hold rr constant constant

Y

rLM1

r1

Y1

IS2

Y2

r2To keep r constant, Fed increases M to shift LM curve right.

3 1Y Y Y

0r

LM2

Y3

Results:


IS1

Response 3: hold Response 3: hold YY constant constant

Y

rLM1

r1

IS2

Y2

r2To keep Y constant, Fed reduces M to shift LM curve left.

0Y

3 1r r r

LM2

Results:

Y1

r3

CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The U.S. economic slowdown of 2001

~What happened~

1. Real GDP growth rate1994-2000: 3.9% (average

annual)2001: 1.2%

2. Unemployment rateDec 2000: 4.0%

Dec 2001: 5.8%

CASE STUDYCASE STUDY The U.S. economic slowdown of 2001The 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.

The Great DepressionThe Great Depression

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ions

of 1

958 d

olla

rs

0

5

10

15

20

25

30

perc

ent o

f labor

forc

e

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

bill

ions

of 1

958 d

olla

rs

0

5

10

15

20

25

30

perc

ent o

f labor

forc

e

Unemployment (right scale)

Real GNP(left scale)

The Spending Hypothesis: The Spending Hypothesis: Shocks to the IS CurveShocks 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

The Spending Hypothesis: The Spending Hypothesis: Reasons for the IS shiftReasons 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

The Money Hypothesis: The Money Hypothesis: A Shock to the LM CurveA 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.

The Money Hypothesis Again: The Money Hypothesis Again: The Effects of Falling PricesThe 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?


The stabilizing effects of deflation:

P (M/P ) LM shifts right Y

Pigou effect:

P (M/P )

consumers’ wealth

C

IS shifts right

Y


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


The destabilizing effects of expected deflation:

e

r for each value of i I because I = I (r ) planned expenditure & agg.

demand income & output

Why another Depression is unlikelyWhy 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.

Percentageof GDP

40

35

30

25

20

15

10

5

0Canada France Germany Italy Japan U.K. U.S.Imports Exports

Imports and Exports Imports and Exports as a percentage of output: 2000as a percentage of output: 2000

Three experimentsThree experiments

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

1. 1. Fiscal policy at homeFiscal policy at home

r

S, I

I (r )

1S

I 1

An increase in G or decrease in T reduces saving. 1

*r

NX1

2S

NX2

Results:

0I

0NX S

NX and the Government Budget DeficitNX and the Government Budget Deficit

Budget deficit(right scale)

Net exports(left scale)

2. 2. Fiscal policy abroadFiscal policy abroad

r

S, I

I (r )

1SExpansionary fiscal policy abroad raises the world interest rate.

1*r

NX1

NX2

Results: 0I

0NX I

2*r

1( )*I r2( )*I r

3. 3. An increase in investment demandAn increase in investment demand

r

S, I

I (r )1

EXERCISE:Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow.

NX1

*r

I 1

S

3. 3. An increase in investment demandAn increase in investment demand

r

S, I

I (r )1

ANSWERS:I > 0,S = 0,net capital outflows and net exports fall by the amount I

NX2

NX1

*r

I 1 I 2

S

I (r )2

U.S. Net Exports and the U.S. Net Exports and the Real Exchange Rate, Real Exchange Rate, 1975-20021975-2002

-5

-4

-3

-2

-1

0

1

2

1975 1980 1985 1990 1995 2000

Per

cen

t o

f G

DP

0

20

40

60

80

100

120

140

1998

:2 =

100

Net exports (left scale) Real exchange rate (right scale)

Four experimentsFour experiments

1. Fiscal policy at home

2. Fiscal policy abroad

3. An increase in investment demand

4. Trade policy to restrict imports

1. 1. Fiscal policy at homeFiscal policy at homeA 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

NX

NX(ε

)

1 ( *)S I r

ε 1

NX 1NX 2

2 ( *)S I r

ε 2

2. 2. Fiscal policy abroadFiscal policy abroad

An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market…

…causing the real exchange rate to fall and NX to rise.

ε

NX

NX(ε

)

1 1( *)S I r

NX 1

ε 1

21 ( )*S I r

ε 2

NX 2

3. 3. An increase in investment An increase in investment demanddemand

An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market…

ε

NX

NX(ε

)…causing the real exchange rate to rise and NX to fall.

ε 1

1 1S I

NX 1

21S I

NX 2

ε 2

4. 4. Trade policy to restrict importsTrade policy to restrict imports

ε

NX

NX (ε )1

S I

NX1

ε 1

NX (ε )2

At any given value of ε, an import quota IM NXdemand for

dollars shifts right

Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed.

ε 2

4. 4. Trade policy to restrict importsTrade policy to restrict imports

ε

NX

NX (ε )1

S I

NX1

ε 1

NX (ε )2

Results:

ε > 0 (demand increase)

NX = 0(supply fixed)

IM < 0 (policy)

EX < 0(rise in ε )

ε 2

Inflation and nominal exchange ratesInflation and nominal exchange rates

Percentage changein nominalexchange rate

10 9 8 7 6 5 4 3 2 1

0 -1 -2 -3 -4

Inflation differential

Depreciationrelative to U.S. dollar

Appreciationrelative to U.S. dollar

-1-2-3 10 2 3 4 5 6 87

France

Canada

SwedenAustralia

UK

Ireland

Spain

South Africa

Italy

New Zealand

NetherlandsGermany

Japan

Belgium

Switzerland

no change

no change

no change

no change

129.4

-2.0

19.4

6.3

17.4

3.9

115.1

-0.3

19.9

1.1

19.6

2.2

closed economy

small open economy

actual change

ε

NX

I

r

S

G – T

1980s

1970s

Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index.

CASE STUDYCASE STUDYThe Reagan Deficits revisitedThe Reagan Deficits revisited

slide 0 case study volcker’s monetary tightening late 1970s: > 10% oct 1979: fed chairman...

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