Macroeconomic Models: Impact of Fiscal and Monetary Shocks on the Economy

1. EC 827 Macroeconomic Models III

2. Macroeconomic Models Conditional Forecasting

3. Sources of Exogenous Shocks to Macroeconomy • Fiscal Shocks - changes in government purchases (G) or net taxes (T) • Monetary Shocks - Changes in the Nominal Money Stock or its growth rate • Supply Shocks - changes in the level of “natural output”

4. Macro Model - Basic Graphs r LM IS = Commodity Mkt Equilibrium LM = Asset Market Equilibrium SP = Short-Run Phillips Curve LP = Long-Run Phillips Curve YN = “natural output” IS Y LP p SP Y YN

5. Macroeconomy - Initial Conditions • Assume: • Initial inflation rate = 0.0 • Initial Real Output = Natural Output • Initially no unexpected inflation (actual and expected inflation are equal) • Nominal Money Stock is held constant at some value M0. • Alternative initial conditions are possible (e.g. positive inflation and expected inflation); but these parameters keep difficulties to a minimum.

6. Unanticipated Fiscal Stimulus I 1. IS curve shift up (or right) as a result of increase in G or decrease in T. 2. Economy moves along fixed SP curve if action is not anticipated. 3. Output increases, but p must also increase. 4. p >0 means P increases and M/P falls inducing shift in LM r LM IS IS’ Y LP p SP Y YN

7. Unanticipated Fiscal Stimulus II 1. Positive inflation generates higher price level. 2. Higher Price level with fixed Nominal Money Supply reduces supply of Real Balances 3. LM curve Shifts up 4. Real interest rate increases; real output falls, inflation is lower, but still higher than initial value (0.0) r LM LM’ IS’ Y LP p SP Y YN

8. Unanticipated Fiscal Stimulus III 1. Left with a situation where inflation turned out to be different than agents forecast it to be (YN < Y). 2. State of the economy can’t remain here indefinitely unless we assume that agents never correct their forecast errors! r LM’ IS’ Y LP p SP Y YN

9. Unanticipated Fiscal Stimulus IV Three Potential Outcomes: 1. The LM curve continues to adjust back towards the initial level of income. Why? People would have to be continually re-adjusting to the shock 2. The IS curve shifts left again, e.g. if there has been a temporary government program which has now ended 3. The fiscal shock generated some positive effect on YN, e.g. education spending.

10. Anticipated Fiscal Stimulus I • What happens to the economy if the fiscal stimulus is announced in advance of the action. • Depends on whether agents think that the announcement is credible. Talk is cheap; if not believed then it is the same as making no announcement. • If announcement is credible, then effect on economy depends on how agents forecast.

11. Anticipated Fiscal Stimulus II • If agents make forecasts based only on history of economy, then the prospective fiscal change is not something they consider in constructing their forecasts. • Their expectations of future inflation do not depend on information about future fiscal policy. • any changes in inflation resulting from the preannounced policy are unexpected changes • economy reacts as to the unanticipated stimulus • If so: at time of the stimulus, inflation expectations adjust, SP curve shifts.

12. Anticipated Fiscal Stimulus -Perfect Foresight LM’ 1. At the announcement, the SP shifts upwards, then the policy shifts the IS out. 2. People forecast higher inflation, which rapidly shifts the LM curve left, until output returns to natural levels. 3. The inflation rate will remain high until the policy is reversed. r LM IS Y SP’ LP p SP

13. Fiscal Stimulus • What is the initial effect of a fiscal shock in an environment where agents make perfect forecasts of inflation, or the ultimate effect in a world where agents make forecasting errors but eventually will correct them? • on real output? • on the price level? • on inflation? • on real interest rates? • on nominal interest rates?

14. Deficits and Inflation • What is the impact of the deficit created by the fiscal stimulus (anticipated or unanticipated) on: • interest rates? • sustained inflation? • the price level?

15. Unanticipated Money Supply Stimulus 1.LM curve shifts down as nominal money supply is increased. 2. Economy moves along fixed SP curve if action is not anticipated 3. Output increases, but p must also increase 4. p > 0 means P increases and M/P is somewhat reduced which induces an offsetting shift in LM r LM LM’ IS Y LP p SP Y YN

16. Unanticipated Monetary Stimulus II r 1. Left with a situation where inflation turned out to be different than agents forecast it to be (YN < Y). 2. State of the economy can’t remain here indefinitely unless we assume that agents never correct their forecast errors! 3. Will the policy be cancelled? Will inflation cut the LM back? Will YN increase? LM’ IS’ Y p LP SP Y YN

17. Anticipated Monetary Stimulus I • Issues here are the same as in fiscal policy: • is the pre-announced policy taken seriously, so that agents react to the information? • how do agents make forecasts of inflation (form inflation expectations) • if agents make forecast conditional on future values of exogenous (including fiscal and monetary policy variables, how accurate are their forecasts and are they free to act?

18. Anticipated Monetary Stimulus II • Any revision of inflation forecast based on policy announcement means that SP curve will shift when policy is implemented. • Perfect forecast of the inflation effects of the announcement means that SP intersects LP at the new actual inflation rate and Y = YN • IS-LM intersection will have to occur at. Y=YN for all markets to be in equilibrium.

19. Anticipated Monetary Stimulus III 1. Since Y must = YN, new IS-LM intersection must occur at Y=YN. 2. Increase in P that results from a perfect forecast of inflation will shift the LM back to its original position (since IS is not shifted by monetary stimulus). 3. real rate unchanged 4. ex-post nominal rate higher. r LM LM’ IS Y SP’ LP p SP

20. Anticipated Monetary Stimulus IV • Does this end the story of the response to a monetary stimulus when conditional forecasts of inflation are accurate? • Depends on the nature of the monetary shock • changes in the level of the nominal money stock. • changes in the growth rate of the nominal money stock.

21. Anticipated Monetary Stimulus V • Change in the level of Money Stock • agents who make perfect inflation forecasts will realize that no future changes in price level are required to maintain IS/LM intersection at YN • such agents will forecast zero inflation for future periods.

22. Anticipated Increase in Level of Nominal Money Stock • Ultimate Effects in Expectational Equilibrium: • real interest rate (r) is unchanged • p = pe = 0 again • Y = YN again • implies that demand for real balances is unchanged • Conclusion: P must change proportional to the change in M!

23. Anticipated Increase in Growth Rate of Nominal Money Stock • Permanent change in the growth rate of the nominal money stock. • Agents who make perfect conditional forecasts of inflation based on this path for exogenous variable will see that continuous inflation is required to keep real balances unchanged so that LM curve will continue to intersect IS at YN. • SP curve will remain permanently higher. • Inflation expectations will be validated.

24. Sustained Inflation • Sustained inflation is always a monetary phenomenon! • other sources of shocks to the economy can change the price level (transitory inflation) but a continuing inflation requires continuous growth in the nominal money stock. • p must be equal to M growth to keep IS/LM intersection at Y = YN in expectational equilibrium

25. Anticipated Shocks and Forecasting Techniques • Initial reaction of economy to anticipated shocks depends critically upon theory of how expectations are formed • Competing theories • Adaptive or backward looking expectations - inflation expectations (forecasts) are conditioned only on history of economy • Rational or forward looking expectations - inflation expectations (forecasts) are conditioned on future paths of exogenous variables