Ka-fu Wong School of Economics and Finance University of Hong Kong

1. 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.

2. 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

3. 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. • Would you choose to raise the target interest rate?

4. AS-AD model revisitedPlanned aggregate expenditure PAE = C + I + G + NX C=a1+a2(Y-T)+a3r+a4W I=b1+b2r NX = d1+d2q Real interest rate r = i - p Real exchange rate q = ep*/p Nominal exchange rate e = domestic currency per foreign currency p*= price of foreign good in foreign currency

5. Equilibrium output at a given price level Y = PAE

6. Y = PAE Expenditure line PAE = 960 + 0.8Y Slope = 0.8 • 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 960 45o 4,800 Determination of Short-Run Equilibrium Output Planned aggregate expenditure PAE Output Y

7. Aggregate Demand • A relation between the equilibrium output and the price level. Y = PAE (p1) ⇒ Y1 Y = PAE (p2) ⇒ Y2 Y = PAE (p3) ⇒ Y3 …

8. The Aggregate-Demand curve P ↓ Price Level (P) ⇒ real wealth ↑ ⇒ interest rates ↓ ⇒ exchange rate ↓ ⇒ consumption ↑ ⇒ consumption ↑, investment ↑ ⇒ net export ↑ P1 P2 AD 0 Y1 Y2 Quantity of output (Y)

9. The short-run aggregate-supply curve Price Level (P) In the short run, P ↓ ⇒ Y ↓ • sticky wages, • sticky prices, or • misperceptions. SRAS (Pe) P1 P2 0 Quantity of Output (Y) Y2 Y1

10. Aggregate Demand and Aggregate Supply Price Level (P) Output, Y, and the price level , P, adjust to the point at which the aggregate-supply, AS, and aggregate-demand, AD, curves intersect. AS P* AD 0 Y* Quantity of Output (Y)

11. The Long-run Aggregate-supply curve Price Level (P) LRAS In the long run, Y depends on: • labor, • capital, • natural resources, and • technology. … but not on P. Thus, the LRAS curve is vertical at YN. P1 P2 0 YN Quantity of Output (Y) Natural rate of output

12. The Long-run equilibrium Price Level (P) LRAS SRAS In the long run, AD meets LRAS at point A. A P* Expected price level adjusts to equal the actual price level. AD 0 YN Quantity of Output (Y) Natural rate of output

13. Self-adjustment towards the long-run equilibrium Price Level (P) LRAS SRAS1 A P1 AD 0 Y2 Y1 Quantity of Output (Y)

14. Slow shifts in SRAS due to Long-term Wage and Price Contracts • 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.

15. The Output Gap and Inflation Relationship of output to potential output Behavior of inflation 1. No output gap Inflation remains unchanged Y = Y* (Price level remains unchanged) 2. Expansionary gap Inflation rises Y > Y* (Price level rises) 3.Recessionary gap Inflation falls Y < Y* (Price level falls)

16. Self-adjustment of recessionary gap Price Level (P) LRAS SRAS1 SRAS2 SRAS3 A P1 B P2 AD 0 Y2 Y1 Quantity of Output (Y) Recessionary gap

17. Self-adjustment of expansionary gap Price Level (P) LRAS SRAS3 SRAS2 SRAS1 B P2 A P1 AD 0 Y1 Y2 Quantity of Output (Y) Expansionary gap

18. A Contraction in aggregate demand Price Level (P) LRAS SRAS1 SRAS2 SRAS3 A P1 B P2 C P3 AD1 AD2 0 Y2 Y1 Quantity of Output (Y)

19. Adjustment of output Y Y1 Y2 Time 0

20. Adjustment of price level P P1 P3 Time 0

21. Exercise #2Impact of an increase in oil prices Price Level (P) LRAS SRAS2 SRAS1 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. B P2 C P1 AD1 0 Y2 Y1 Quantity of Output (Y)

22. An increase in oil prices Price Level (P) LRAS SRAS2 SRAS1 SRAS1 B P2 C P1 AD1 0 Y2 Y1 Quantity of Output (Y)

23. Adjustment of output Y Y1 Y2 Time 0

24. Adjustment of price level P P2 P1 Time 0

25. An increase in productivity (due to technological changes) Price Level (P) LRAS1 LRAS2 SRAS1 SRAS2 SRAS3 A P1 P2 B AD1 0 Y1 Y2 Quantity of Output (Y)

26. Adjustment of output Y Y2 Y1 Time 0

27. Adjustment of price level P P1 P2 Time 0

28. 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. • Would you choose to raise the target interest rate?

29. U.S. Macroeconomic Data, Annual Averages, 1985-2000 Was Greenspan right in 1996? % Growth in Unemployment Inflation Productivity Years 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

30. Long-run growth and inflation Price Level (P) LRAS1980 LRAS1990 LRAS2000 P2000 P1990 P1980 AD2000 AD1990 AD1980 Quantity of Output (Y) 0 Y1980 Y1990 Y2000

31. Government intervention Short-run adjustments are painful! In the long run, we are all dead!

32. A Contraction in aggregate demand Price Level (P) LRAS SRAS1 SRAS2 SRAS3 A P1 B P2 C P3 AD1 AD2 0 Y2 Y1 Quantity of Output (Y)

33. Adjustment of output Y Y1 Y2 Time 0

34. 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.

35. Fiscal policies • Government expenditure • Taxation • Takes time to pass a legislation • Takes time to implement • Supply-side policies • Taxation

36. Monetary policy • Interest rate • Discount rate • Reserve requirement

37. A Contraction in aggregate demand Price Level (P) LRAS SRAS1 A P1 B P2 AD1 AD2 0 Y2 Y1 Quantity of Output (Y)

38. Adjustment of output Y Y1 Y2 Time 0

39. An increase in oil priceswith accommodation policy Price Level (P) LRAS SRAS2 SRAS1 A P1 B P2 C P3 AD2 AD1 0 Y2 Y1 Quantity of Output (Y)

40. Adjustment of output Y Y1 Y2 Time 0

41. An increase in productivity (due to technological changes) Price Level (P) LRAS1 LRAS2 SRAS1 SRAS2 SRAS3 A P1 Do nothing! P2 B AD1 0 Y1 Y2 Quantity of Output (Y)

42. 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 confidence • Discount lending • Open Market Operations

43. 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.)

44. Key U.S. MonetaryStatistics, 1929-1933 Currency Reserve-deposit Bank Money held 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

45. 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.

46. Recent crisis:No response to expansionary monetary policy? • Liquidity trap • The 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.

47. 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.

48. 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)

49. 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

50. 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