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Understanding the Macroeconomy Chapter 3 Expectations

Understanding the Macroeconomy Chapter 3 Expectations. Why are Expectations Important?. We cannot predict the future with any degree of certainty But expectations about the future often determine the future course of an economy

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Understanding the Macroeconomy Chapter 3 Expectations

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  1. Understanding the MacroeconomyChapter 3Expectations Econ 7920/Chatterjee

  2. Econ 7920/Chatterjee

  3. Why are Expectations Important? • We cannot predict the future with any degree of certainty • But expectations about the future often determine the future course of an economy • “Managing” the public’s expectations is perhaps the most important objective of public policy Econ 7920/Chatterjee

  4. Econ 7920/Chatterjee

  5. How are Expectations Formed? Modeling the formation of expectations: • Adaptive Expectations (AE): People base their expectations of the future only on past observations • Rational expectations (RE):People base their expectations on all available current information, including information about prospective futurepolicies • Critical difference: under RE, economic decisions change ONLY if there is “news” or new information about the future. Under AE, “news” has no impact on current decisions

  6. Expectations and Inflation • Expected inflation plays a crucial role in determining current inflation and interest rates • A principal objective of monetary policy: • to manage the public’s expectations of future inflation • How can this be achieved? Econ 7920/Chatterjee

  7. Monetary Policy and Expected Inflation • For expected inflation to be low, the public must believe that the Central Bank is committed to fighting inflation • The only way this can happen is if the Central Bank has credibility with the private sector: it’s past actions confirm its commitment to keeping inflation low • Credibility is difficult to attain: often requires significant short-run sacrifices (high interest rates, unemployment and recessions) • One factor to consider: does Central Bank independence matter? Econ 7920/Chatterjee

  8. Credibility and Autonomy in Monetary Policy Econ 7920/Chatterjee

  9. Wage and Price Controls • Can inflationary expectations be controlled by non-monetary measures? • A popular policy measure: impose wage and price controls • If the government mandates that it is illegal for prices and wages to increase above a pre-specified ceiling, wouldn’t that stabilize expectations of future inflation? • Wage and Price controls simply do not work. Why? Econ 7920/Chatterjee

  10. Problems with Wage and Price Controls • Extremely difficult to commit to and monitor such policies and punish violators • These policies inevitably create huge shortages and involve a misallocation of scarce resources  becomes self-perpetuating Econ 7920/Chatterjee

  11. Inflation Targeting • Inflation targeting: • Central Bank announces a target rate of inflation (usually 2-3 percent) • It raises or lowers interest rates to keep inflation at the target rate • Advantage: as long as there is credibility, inflationary spirals can be avoided • Disadvantage: if the economy faces a large supply-side shock (an oil price increase), maintaining the target can be difficult Econ 7920/Chatterjee

  12. Expectations and Output Econ 7920/Chatterjee

  13. “Supply Creates its Own Demand”-J.B. Say (19th century French Economist) • Does “Say’s Law” always work? • Consider the following sequence: • For some reason, consumers suddenly expect bad times in the near future  cut back on spending • Firms face lower orders for goods and services  cut back on employment and investment  lay off workers and keep machines idle • The rising unemployment causes a reduction household incomes  further cut-backs in spending  further reduction in production of goods • Leads to a downward spiral in economic activity  severe recession (self-fulfilling prophecy) • “Paradox of Poverty in the Midst of Plenty” – Keynes (1936) • How can monetary and fiscal policy correct this “paradox”? Econ 7920/Chatterjee

  14. Using Monetary Policy to Stabilize Output • In a recession, the Central bank can implement an expansionary monetary policy • Increasing money supply and lowering interest rates • Households • Consumption more attractive than savings • “Durable” consumption (houses, cars, appliances) cheaper • Firms • Cost of investment (financing new capital equipment, construction, etc) cheaper Econ 7920/Chatterjee

  15. Monetary Policy: Potential Pitfalls • Expansionary monetary policy may not be effective if • Expectations of future demand are severely depressed • The gap between actual output and potential output is small (can generate inflationary pressures) • The economy is in a “liquidity trap” • Prices are actually falling or expected to fall (deflation) Econ 7920/Chatterjee

  16. A Liquidity Trap • When nominal interest rates reach a critically low level (positive but close to zero): people might prefer holding money to assets (why?) • In such cases, injecting more money does not affect interest rates and thereby the incentives to spend and invest Econ 7920/Chatterjee

  17. Deflation • Deflation: price level declines over time • Due to declining productivity and demand • Gap between actual and potential output • Monetary policy is ineffective in a deflation: • Let r = real rate of interest i = nominal rate of interest  = rate of inflation Then, r = i -  With deflation,  < 0  r > 0 Econ 7920/Chatterjee

  18. Consider an example: • Suppose, due to an expansionary monetary policy, the nominal interest rate is low, at i= 1% • But prices are falling at the rate of 5%   = -5% • Then, the real rate of interest is: r = i -  = 1-(-5) = 6% • Therefore, the real cost of borrowing is 6% even though the nominal cost is only 1% • Facing a declining price level and a rising real interest rate, households and firms postpone spending • Monetary policy completely ineffective Econ 7920/Chatterjee

  19. Japan in the 1990’s • 1980s: Under pressure from the Ministry of Finance, the Bank of Japan kept interest rates low • Economy “awash” with liquidity • Created speculative bubbles in equities and real estate • Economy started over-heating towards the end of 1980s • Inefficiencies in the corporate sector slowed productivity • Financial liberalization of 1980s: more competition among banks  more risk-taking Econ 7920/Chatterjee

  20. Japan in the 1990s • Yasushi Mieno takes over as Governor of the Bank of Japan in 1989: promises to “cool” economy down • Interest rate rises from 2.5% in Dec 1989 to 6% in Aug 1990 • Speculative bubble bursts in summer 1990: stock market falls by more than 40% • Firms and households significantly cut back on spending • Sharp economic slowdown begins in 1990:Land prices fell quickly, mortgage defaults and bankruptcies increased • Throughout the 1990s, Japan experienced deflation and was stuck in a liquidity trap, in spite of monetary policy interventions Econ 7920/Chatterjee

  21. Econ 7920/Chatterjee

  22. Getting out of a Liquidity Trap and Deflationary Spiral • “Irresponsible Monetary Policy” was proposed as a solution by Paul Krugman of MIT (1998): • Set an inflation target of 2-4% • Commit to the target and keep increasing money supply in a sustained fashion • Eventually, public start expecting future inflation • Currency starts depreciating • Spending, investment, and demand for exports restart the growth process… Econ 7920/Chatterjee

  23. Fiscal Policy and Output • Fiscal policy (government spending, taxation, and subsidies) can be an effective tool in • a recession • when expectations of future demand are severely depressed • Keynes (1936): through deficit spending, a government can influence expectations of the private sector: • Deficit spending: government spends more than it receives in tax revenues (mainly financed through borrowing) • Government spending creates new jobs  multiplier effect on the economy Econ 7920/Chatterjee

  24. The Government Spending Multiplier • Basic idea: • An initial amount of government spending creates new incomes (through jobs created in the public sector) • A fraction of this new income is spent on goods and services  generates new income and spending, and so on… • Similar to a “ripple” effect • The final increase in income and spending is much larger than the initial increase in government spending  “multiplier effect”  economic expansion • What about the deficit? • The income generated increases tax revenues over time, making the deficit sustainable Econ 7920/Chatterjee

  25. The Multiplier Effect: An Example • Suppose people spend a “b” fraction of their income (marginal propensity to consume) • Example: b = 0.75  people spend $0.75 of every $1 of new income • The government increases spending by $1 • Total spending and income generated: Econ 7920/Chatterjee

  26. The Multiplier Effect • In general, the multiplier effect is given by: • In our example, b = 0.75. Then, • Increase in income = • A $1 increase in government spending increases total income by $4 • Also referred to as the “income multiplier” • A multiplier effect can also be generated by cutting taxes (the “tax multiplier”) Econ 7920/Chatterjee

  27. When does Deficit Spending Work? • If the economy’s capacity utilization rate (gap between potential and actual output) is well below 100% • When resources are idle (high unemployment and shut-down factories)  producers can increase production without raising prices • As capacity utilization nears 100%, deficit spending can overheat the economy and create inflationary pressures  smaller multiplier effect Econ 7920/Chatterjee

  28. “Leakages” from the Multiplier • Factors that can reduce the size of the multiplier effect: • Government spending financed by higher taxes • New income is fully spent on imports (does not affect GDP) • New income is fully saved by households to provide for future expected tax increases (“Ricardian Equivalence”) • “Crowding Out” of private investment by raising market interest rates • Sometimes, the Central Bank may raise interest rates to offset any inflationary expectations (say, if capacity utilization is near 100%) Econ 7920/Chatterjee

  29. Military Spending and Interest Rates in the United Kingdom1730-1920 Econ 7920/Chatterjee

  30. How Large is the Multiplier? • The U.S. government uses a forecasting model developed by Data Resources Inc. (DRI) to estimate the potential effects of fiscal policy • Estimates of Fiscal Policy Multipliers: Econ 7920/Chatterjee

  31. Unemployment (right scale) Real GNP(left scale) The Great Depression 240 30 220 25 200 20 billions of 1958 dollars 180 15 percent of labor force 160 10 140 5 120 0 1929 1931 1933 1935 1937 1939

  32. Econ 7920/Chatterjee

  33. Econ 7920/Chatterjee

  34. THE SPENDING HYPOTHESIS • Asserts that the Great Depression was largely due to an exogenous fall in the demand for goods & services • Supporting evidence: • output, consumption, and investment declined steadily from 1929-1934 • Government spending remained largely unchanged during this period

  35. THE SPENDING HYPOTHESIS: • Stock market crash  exogenous fall in consumption • Oct-Dec 1929: S&P 500 fell 17% • Oct 1929-Dec 1933: S&P 500 fell 71% • Drop in investment • “correction” after overbuilding in the 1920s • widespread bank failures made it harder to obtain financing for investment (the FDIC did not exist then) • Contractionary fiscal policy • Congress raised tax rates and cut spending (deficits were considered “bad” for economy)

  36. THE MONEY HYPOTHESIS • Asserts that the Depression was largely due to huge fall in the money supply • M1 fell 25% during 1929-33 • The severity of the Depression was due to a huge deflation: the price level fell 25% during 1929-33 • This deflation was probably caused by the fall in money supply

  37. Econ 7920/Chatterjee

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