Lecture 6: Macromodel Exercises

1. Lecture 6: Macromodel Exercises Dr. Rajeev Dhawan Director Given to the EMBA 8400 Class South Class Room #600 February 3, 2007

2. Policy Experiments With The Integrated Macro Model • Policy Experimentsare 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: • 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). • A Fiscal-Stimulus Policy Experiment: Simulated response to an increase in real government spending by $50 billion increments without any change in taxes. • A Neutral-Budget Policy Experiment: Simulated response to two coordinated fiscal policy changes: • 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.

3. 1A: Monetary-Stimulus (Inflation) Experiment Money Growth Stops in 2010 • Rate of growth of the money supply is increased from 0% to 5% in 2007. • This is done for 4 years from 2007 to 2010, and then money supply growth drops to 0% in 2011 and thereafter.

4. Money supply growth rate is a constant 5% for four years from 2007 – 2010

5. GDP versus Potential Same as GDP Potential in Long Run

6. 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.

7. Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

8. The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M!

9. 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

10. Comparison of Inflation and Nominal Interest Rates Nominal = Real + Inflation Rate

11. Comparison of Real Interest Rate and Nominal Interest Rate

12. As R drops it pulls down the real exchange rate

13. Exports increase in the short-run due to a drop in the real exchange rate α9 < 0 Billions

14. Exports increase in the short-run due to a drop in the real exchange rate Billions

15. Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased! α12 > 0

16. Imports increase in the short-run due to a rise in GDP which • overpowers the negative effect of a weak exchange rate on imports

17. 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!) Billions

18. 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 Unemployment Drops Unemployment Rises

19. Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.

20. Consumption rises as GDP has risen!

21. Comparison of Government Surplus and Nominal Interest Rate

22. Cont… Comparison of Government Surplus and Real Interest Rate

24. 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 net-effect 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.

25. 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!!

26. Summary of Reactions • Inflation follows the money growth path, lagging behind at first but then over-shooting 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!

27. 1B: Monetary-Stimulus (Inflation) Experiment When Money Growth Stops Slowly by 2014 • Rate of growth of the money supply is increased from 0% to 5% in 2007, and then kept at 5% until 2010, and then decreased slowly to 0% by 2014 (stays at 0% afterwards)

29. Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

30. The real interest rate becomes cyclic. At first it drops which helps investment and then when it rises it hurts investment.

32. Real GDP shoots above the base case values, 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 Unemployment Drops Unemployment Rises

33. 1C: Monetary-Stimulus (Inflation) Experiment When Money Growth Never Stops! • Rate of growth of the money supply is increased from 0% to 5%. • This is done forever (till the end of simulation period in 2032!)

34. Money Supply Growth Rate is a constant 5% forever starting in year 2007

35. Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

37. Comparison of Real and Nominal Interest Rates

38. Real GDP shoots above the base case values, 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 the potential GDP

39. Lessons From the Three Monetary (Inflation) Experiments 1c 1b 1a

40. Inflation Response Depends on How Long Monetary Stimulus Lasts 1c 1b 1a

41. Interest Rate Overshooting Depends on How QUICKLY Monetary Growth Returns to Normal 1b 1c 1a

42. Depth of the Recession Depends Upon How Quickly the Monetary Stimulus is Withdrawn! 1b 1c 1a

43. 2a. Fiscal-Stimulus Policy Experiment

44. 2a. Fiscal-Stimulus Policy Experiment • In this experiment real government spending is increased in steps of $100 billion higher from 2007 to 2010, and then spending stays elevated at that level forever. • NO INCREASE IN TAX RATE: A deficit-financed war provides the historical context for large increases in government spending.

45. Government Spending and Tax Rate

46. Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state Unemployment Drops Unemployment Rises

47. Inflation follows the a cyclic path. Why? Because GDP has risen. So initially it shoots up and then drops, but eventually settles to the steady state values

48. The booming economy raises the demand for money and forces the real interest rate higher.

49. Rise in interest rate hurts investment

50. Real Exchange Rate