Understanding Short and Long-Run Equilibrium in Economics

1. TOPIC 7 The Model at Work (Reference Slides – I may or may not talk about all of this depending on time and how the conversation in class evolves) Note: In terms of the details of the models for changing G, consumer confidence, oil prices, and TFP – it is better to use the supplemental notes.

2. To Sum Up: What is an Equilibrium? • SHORT RUN EQUILIBRIUM:AD = SRAS and IS = LM • The Labor Market need not be in equilibrium • We need not be at the potential level of GDP Y* • If Y<Y* we are in a recession, if Y>Y* the economy could be overheating • LONG RUN EQUILIBRIUM:AD = SRAS = Y* and IS = LM = Y* and Nd = Ns = N* • By definition, the labor market will clear • By definition, we will move to Y* • . • Reference: Supplemental Notes 9, 10

3. Road Map • Recessions may be driven by: • demand shocks(e.g. current recession) P and Y co-move positively • supply shocks (e.g. oil shocks) P and Y move in opposite directions • How to get out of a recession? • 1. Self-Correcting Mechanism • 2. Monetary Policy • 3. Fiscal Policy • Brief History of the Fed policy: from output targeting to Taylor Rule • http://www.federalreserve.gov/Pubs/feds/2007/200718/200718pap.pdf • Should the Fed react to asset price bubbles?

4. Part A: Self-Correcting Mechanism vs. Fed Policy in Getting Economy Back to Y*

5. Self-Correcting Mechanism • What would happen in the long-run after a negative shock that resulted in N < N* if there was no policy? • A Self-Correcting Mechanism will bring the economy back to the potential Y* • How? Workers would like to work more than they are currently (cyclical unemployment exists), so firms at some point will decrease nominal wages, so that the labor market goes back to equilibrium! (This is key to self-correcting mechanism). • As nominal wages decrease, it is cheaper to produce and the SRAS will shift to the right. • As wages decrease, prices decrease, the real value of money supply increase and the LM shifts to the right. • As M/P increases, the equilibrium interest rate has to decrease, causing I to increase (returning Y back to Y*).

6. Goals of the Fed • The Fed wants to set r so that • output/unemployment target: Y = Y* or U = U* • inflation target:  =  * (2% inflation). • The Fed wants to raise r when • Y > Y*, U < U*, N > N* •  >  * • The Fed wants to lower r when the opposite conditions hold.

7. Fed Policy versus Self-correcting Mechanism • The Fed may decide to conduct an expansionary monetary policy (increase M) to fight the recession • Benefit: Prevent deflationary pressures ; speed up recovery • COMPARISON: • Real variables go back to the same long run equilibrium (both Fed or self-correcting mechanism) • BUTprices and nominal wagesbehave differently under the two ways of returning to Y*. Under the self-correcting mechanism, there is a risk of deflation! The Fed can fight that. • Fed can increase thespeed of adjustment…

8. Part B: Examples 4 and 5 From Class – A Fall in Consumer Confidence

9. Example 4 (from class): Loss in Consumer Confidence • Consider a loss in consumer confidence as in 1991 (and in the current recession!) • Change in expectations about the future can have dramatic effects even if not founded! • What does a loss of consumer confidence affect? • Potentially no effect on labor demand: IfA hasn’t really changed (only perceived change). • Consumption changes and the AD and IS curves shift • Some effect on labor supply (income effect): If believe PVLR decreased • Assumptions we will make for the following example: • No income effect on labor supply (labor supply does not move) • No actual change in A (from the perspective of firms). • Consumers are standard PIH, no liquidity constrained, and non-Ricardian

10. Consumer Confidence: 1978M1 – 2019M9 Fall in consumer confidence

11. Example 4: Graphical Representation – Decline in Consumer Confidence (C(.)) • Assume we start at Y* P SRAS(W0) P0 AD(C0) Y Y*0 r LM(P0) IS(C0) Y Y*0

12. Example 4: Decline in Consumer Confidence (C(.)) • Loss of Consumers’ Confidence (short run) P SRAS(W0) 0 P0 x P1 AD(C0,M0) C AD(C1,M0) Y Y*0 Y1 LM(M0,P0) r LM(M0,P1) 0 x 1 IS(C0) IS(C1) Y Y1 Y*0

13. Example 4:Use Self Correcting Mechanism to Get Back to Y* • Loss of Consumers’ Confidence (self-correcting mechanism back to) P SRAS(W0) SRAS(W1): W1 < W0 0 P0 x P1 1 2 AD(C0,M0) P2 AD(C1,M0) Y Y*0= Y*2 Y1 LM(M0,P0) r LM(M0,P1) 0 LM(M0,P2) x 1 IS(C0) 2 IS(C1) Y Y1 Y*0 = Y*2

14. Example 5 (decline in consumer confidence): Use Monetary Policy To Get Back to Y* • Loss of Consumers’ Confidence (in short run – same as before) P SRAS(W0) 0 P0 x P1 AD(C0,M0) 1 AD(C1,M0) Y Y*0 Y1 LM(M0,P0) r LM(M0,P1) 0 x 1 IS(C0) IS(C1) Y Y1 Y*0

15. Example 5 (decline in consumer confidence):Use Monetary Policy To Get Back to Y* • Loss of Consumers’ Confidence (have Fed get us back to Y* by increasing M) P SRAS(W0) 0 P0=P2 x P1 AD(C0,M0) = AD(C1,M1) 1 AD(C1,M0) Y Y*0= Y*2 Y1 LM(M0,P0) r LM(M0,P1) 0 LM(M1,P0) x 1 IS(C0) 2 IS(C1) Y Y1 Y*0 = Y*2

16. Part C: Supply vs. Demand Shocks

17. Analyzing Demand and Supply Shocks • DEMAND SHOCK: unemployment and prices move in opposite directions if there are no policies! • Example: loss in consumer confidence (negative), increase in M (positive) • SUPPLY SHOCK: unemployment and prices to move in the same direction if there are no policies! • Example: oil shocks (negative) or increase in productivity (positive) • A negative supply shock is bad in that in reduces output, increases unemployment and results in higher inflation. • STAGFLATION: increase in inflation + increase in unemployment

18. Reviewing The Data • From our first lecture: • Some falls in GDP were associated with no increase in prices. • Some falls in GDP were associated with large increase in prices. • Do our theories reconcile these facts? • YES! Demand shocks explain (1) • YES! Supply shocks explain (2) • Study Note: You should really understand the difference between demand shocks (things that primarily affect AD) and supply shocks (things that primarily affect AS) on the economy - their implications are much different!

19. Reinterpreting the Business Cycle Data 1970-2017 • 1970 recession: Inflation increasing at start of recession! • Supply shock: oil price + productivity + misguided Fed policy • 1981 recession: Dramatic decrease in inflation at start of recession • Demand shock: Volker (Fed starts to worry about inflation!) • 1990 recession: Little increase in inflation/but low level of inflation • Demand shock: fall in consumer confidence • Rapid growth in mid 1990s: No inflation • Positive Supply shock: IT revolution • 2001 recession: No inflation • Demand shock: firms overconfidence: inventory adjustment • 2008 recession: Inflation first up and then down. Supply: oil shock • Demand: credit crunch, confidence loss, drop in wealth

20. Part D: A History of U.S. Inflation – The Importance of Inflation Expectations (most important part of this lecture)

21. A Look at U.S. Inflation: 1970M1 – 2019M9

22. The Fed in the ’70s: accommodating inflation • After the negative supply shocks in the mid/late ’70s, the Fed adopted a policy mainly based on fighting the recession by increasing M • With aggregate supply shocks, the Fed cannot simultaneously keep Y close to Y* and P close to P0. Need to make a choice. • The Fed chose to keep Y close to Y* (minimize unemployment). To do so, it had to increase M (shifting out the AD curve to return the economy to Y*). • The expansionary monetary policy “accommodated” inflationary pressures by putting additional upward pressure on P. • Key: In doing so, Fed policy in the 1970s shifted inflation expectations. Workers and firms received a signal that the Fed will accommodate inflationary pressures. So, they increased their inflation expectations. • Through wage setting process, inflationary expectations became self-fulfilling (as long as the Fed continued to accommodate).

23. Volker and the Start of Inflation Targeting • Late ’70s: inflation was out of control also because of accommodative Fed policies. • Friedman: the Fed has to control inflation! Reset, expected inflation rates. • Volker becomes Fed chair in 1979. Main goal was to fight inflation. • Sharp decline in money supply (M) to reduce inflation and change individuals’ perception of Fed policy (not try to stabilize output at the expense of inflation!) • o Cut inflation from double digits to 4% • o Created a massive recession in the process (Volker Recession) • Volker Recession: massive decline in M caused a short deep recession (shifting AD and IS dramatically to the left such that inflation expectations fell).

24. Part E: The Phillips Curve

25. On unemployment and inflation… • In the short run, the SRAS tells us that if output is high, or unemployment low, typically prices are high! • If Y<Y*, or u>u*, output stabilization policies tend to generate inflation… • If Y=Y*, or u=u*, but P high, inflation control policies generate a recession… • Phillips curve = relationship between inflation and unemployment: one-to-one relationship with the AS! • Phillips discovered a negative correlation between unemployment rate and inflation rate across time in the 1950s (Phillips curve); • Old Keynesians in the 1960s: there is a stable, exploitable trade-off between the rate inflation and unemployment. Maybe can permanently lower unemployment at the cost of permanently higher inflation!

26. Friedman: evidence killed it! • Milton Friedman in 1968: the long run Phillips Curve is vertical at u*. • This is because the LRAS is vertical at Y*! • Vindicating evidence: the Phillips Curve broke down after 1970, as the Fed was trying to push Y above Y* • Over time in the U.S., higher money growth just lead to more inflation and no higher real GDP • Across countries, higher money growth just leads to more inflation and no higher real GDP. • If anything, in the long run, real GDP appears to be hindered by high levels of inflation!

27. To sum up … • In the SHORT RUN there is a tradeoff between the unemployment rate and inflation rate changes: • Inflation tends to fall in years following U > U*. • The cost of a permanently lower inflation rate is a • temporarily higher unemployment rate. • Inflation tends to rise in years following U < U*. • The cost of temporarily lowering the unemployment rate • is a permanently higher inflation rate. • In the LONG RUN the unemployment rate is fixed at u* and any monetary policy will have only effects on the inflation rate

28. Part F: Fed Policy – Rules vs. Discretion

29. Rules vs. Discretion • Should a central bank have a specific policy rule? • Rules may be explicit and mandated by law • Money should grow at 4% per year (Friedman preferred rule). • Rules may be implicit and known by all economic agents • The Fed will target the inflation rate at 2-4% per year and natural unemployment rate. • The Fed uses a discretionary rule. The members of the bank vote on a monetary policy at each meeting. Policy is not dictated by some explicit rule.

30. Benefits of Rules • If the Central Bank is committed to keep inflation under control… • Inflation temptation is powerless! • Creates a more stable economic situation: individuals and firms can anticipate the central bank actions. No surprises! • Discretion may help the Central Bank to be more flexible … • BUT allows the Bank to think too much - the economy is so complex that Fed policy can have delayed impact and is usually initiated too late! • Central Bank actions can often be ‘destabilizing’ (Freidman, Lucas: both prefer simple rules)

31. The Taylor Rule • John Taylor of Stanford University said that the Fed’s behavior under Greenspan (1987-2006) and Bernanke (today) is well-described by: • Taylor Rule: i = r* + πe+ aπ*(πe - π*) + ay*(Y - Y*)/Y* • with aπ + ay=1. In particular Taylor assumes aπ = ay=.5. • i = the nominal federal funds rate • r* = the real fed funds rate target (this is the r consistent with Y=Y*) • πe = expected inflation • π* = target inflation • Y = real GDP • Y* = potential real GDP • (Y-Y*)/Y* is the output gap or GDP gap. A positive output gap means overheating and potentially rising inflation (labor markets will demand higher wages). • Taylor used r* = 2% and π* = 2%. The Taylor Rule explains about 2/3 of quarterly variation in the fed funds rate since 1987.

32. Notes on the Taylor Rule • This does NOT mean that Bernanke uses this ‘rule’, it is just that Fed behavior looks very similar to this rule. • Furthermore, Fed tends to smoothinterest rates relative to the Taylor Rule: • i = .6*(last quarter’s actual i) + .4*(Taylor Rule i) • Studies have found that other G7 Central Banks (e.g., the Bundesbank) have also followed versions of a smoothed Taylor Rule • Read the speeches by Bernanke or Greenspan to see the Fed’s take on such subject (on my teaching site) • The Fed has become quicker to act to gain credibility…in this recession, the Fed has acted preemptively!

33. Hawks and Doves • How does the Fed balance price stability ( =  *) and full employment (U = U*) when they conflict? (when  >  * and U > U* at the same time) • Hawks put more weight on  * (and have lower values for it): • U.K., Canada, New Zealand. • Bundesbank before; European Central Bank now! • Doves put more weight on staying near U* (and have higher  *) • Greenspan and Bernanke tend to put the same “weight” on each • Current Recession: unusual shock to y for almost any weight, i goes to 0! (Liquidity Trap),

34. Part G: Fed Policy in Practice

35. Other Limitations of Policy (Monetary and Fiscal) • Some caveats about Monetary and Fiscal Policy: • NOT AN EXACT SCIENCE – • o How much stimulus is necessary to move the economy to Y* • o Where is Y*? • o Policy Creates uncertainty as economic agents try to anticipate Fed/Government rules • o Long and variable lags! • Some argue avoid using no stabilization policy (just a simple Quantity Theory representation) or suggest using very simple rules. • Some research says that every sustained period of large inflation is due to the Fed!

36. Fed Timing • Recession BeginsFirst Fed nominalrate cut • December 1969 11 months later • November 1973 13 months later • July 1981 4 months later • July 1990 5 months later • December 2007 4 months earlier!

37. Did the Fed do something wrong during the 2000s? • During the expansion after 2001, the economy did not seem to overheat, output was around potential Y* and inflation was stable • However, at the same time, housing prices were rising steadily …. • Greenspan did not do anything, according to the Taylor Rule: i should not change if output and inflation are around target. • Should the Fed have reacted to the housing bubble? Should the Taylor rule include asset prices (S)? • i = r* + πe+ aπ*(πe - π*) + ay*(Y - Y*)/Y* + aS*(S - S*) • Bernanke and Gertler answer: NO!

38. Housing Bubble • Bernanke and Gertler argument: • the Fed should care about asset prices only if they have macro effects • if the housing bubble had macro effects you should see output or inflation react (standard demand shock) • BUT then standard Taylor rule would suffice • However, it seems that the housing bubble had macro impact when it burst! • It could be that asset price bubbles are problematic because agents tend to leverage too much and then a crisis can occur if the bubble bursts • Is monetary policy the right tool to control a bubble? Can you even do it?

39. Part H: Liquidity Traps

40. When Does Policy Not Work? • Vertical IS Curve: What if firms don’t respond to interest rate changes (they think future economic conditions are going to be bad or interest rates will be lower in the future or the banking system has problems making loans)? • o Monetary Policy Becomes Dampened. • Central bank becomes can become powerless because nominal rates are already so low! (Deflationary periods). • Keynesian “Liquidity Trap”

41. A Look At Liquidity Traps • Example: Krugman’s “Babysitting the Economy” (See: #2 from Reading List) • Liquidity Traps: (1) Nominal Interest Rates Are Bounded At Zero • (2) People believe that there will be deflation in the future. • (3) Real Interest Rates are Large and Positive. • Fed Would like to cut rates (to stimulate Y (shift out AD) which will put upward pressure on prices), but nominal rates cannot go below zero! • The Fed is helpless. How do they stimulate when they cannot cut rates? • This describes the situation in Japan during the late 1990s. Japan had experienced deflation AND nominal rates are close to zero. • Similar to economic conditions globally during the Great Recession.

42. Demand Side Effects of Deflation • Deflation can make borrowers - either consumers or firms, worse off. • As we saw early in the course, unexpected inflation makes borrowers better off. They expected to pay a certain real rate and when inflation is higher and the nominal rate is fixed, the real rate they pay is lower (in terms of lost purchasing power). • Key Insight: If the economy experiences unexpected deflation, the opposite happens-- borrowers are paying more in terms of lost real purchasing power when there is unexpected deflation. • o Borrowers, both consumers and firms, will essentially be poorer. (Even though, there is another side of the market - somebody’s got to lend to them, this could still have large effects on consumption and investment). • o This demand side effect of deflation is called ‘debt overhang’ or ‘debt deflation’. <<Note, even the government is paying higher than expected real rates on their debt>>. • Even if the deflation is expected, large transfers can occur from borrowers to lenders because nominal interest rates are bounded by zero (shuts down lending channels).