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Macroeconomics

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Title: Macroeconomics


1
Modern Macroeconomic Practice
Gavin Cameron University of Oxford
OUBEP 2006
2
the theory of short-run fluctuations
Keynesian Cross
IS Curve
IS-LM-BP
AD curve
AS-AD model
Money Market
LM Curve
NAIRU
AS curve
BP Curve
FX Market
Productivity
3
a modern framework
IS Curve
Monetary Reaction (MR)
IS-MR-PC model
Phillips Curve (PC)
4
the Phillips Curve
  • In 1958, A.W. Phillips of the LSE found relation
    an empirical relationship between unemployment
    and inflation in the UK the Phillips curve.
  • Original interpretation
  • There is a permanent trade-off between inflation
    and unemployment.
  • Problem
  • After sustained inflation, the empirical
    relationship broke down.
  • New interpretation
  • There is a trade-off between unemployment and
    unexpected inflation
  • outputequilibrium output b(unexpected
    inflation)
  • Therefore output deviates from its equilibrium
    level by the extent to which inflation deviates
    from its expected level.
  • But in the long-run, there is no such trade-off.

5
what affects the IS curve?
  • Aggregate expenditure comprises five components
  • consumption
  • investment
  • primary government spending (i.e. net of
    transfers)
  • net exports (i.e. exports minus imports)
  • inventories (i.e. changes in stocks held by
    businesses)
  • The level of income (both current and expected)
    is a major determinant of consumption, government
    spending and net exports.
  • The real exchange rate is a major influence on
    net exports.
  • The interest rate is also an influence on
    consumption and investment (with the latter being
    also dependent upon output expectations and
    animal spirits).

6
shocks to the economy
  • Why might the economy get shocked away from
    equilibrium?
  • IS-curve shocks
  • an investment boom
  • a pre-election government spending spree
  • a sudden rise in the real exchange rate
  • a consumer boom abroad
  • a boom in the housing market
  • an unexpected cut in interest rates
  • a slump in share prices.
  • Phillips curve shocks
  • a sudden rise in oil prices
  • the invention and diffusion of a new technology
  • labour market changes.

7
an IS curve shock
inflation
interest rates
LRPC
LRAS
C
C
D
B
SRPC (pep2)
D
B
A
A
IS2
SRPC (pep1)
IS1
Y
Y
Y
Y
  • An investment boom shifts the AD curve outwards.
    At first, expectations lag behind events, so
    output and inflation rise (unexpected
    inflation) to point B. The monetary response
    leads to higher interest rates for long enough to
    crowd-out excess spending (point C) and then
    return inflation to its original level (point D).

8
monetary policy reaction
  • The monetary authority will seek to offset a
    demand shock by raising interest rates.
  • In order to reduce inflation, unemployment must
    rise above its equilibrium!

inflation
LRPC
C
D
B
A
SRPC (pep1)
Y
Y
9
monetary policy reaction II
  • Some monetary authorities will be more averse to
    inflation, some more averse to unemployment.
  • An inflation-averse authority will seek to bring
    down inflation quickly by moving to E.
  • The slope of the SRPC also matters if it is
    steep then disinflation is relatively quick.
  • It will be steeper when there is less inflation
    inertia and less real wage rigidity.

inflation
LRPC
SRPC (pep2)
B
C
D
SRPC (pep1)
E
A
Y
Y
10
a policy problem data revisions!
Revisions to level of UK market sector output
between May and June 2005
Source Inflation Report, August 2005
11
monetary policy
  • Having regard to human nature and our
    institutions, it can only be a foolish person who
    would prefer a flexible wage policy to a flexible
    money policy, unless he can point to advantages
    from the former that are not obtainable from the
    latter J.M.Keynes, 1936.
  • Monetary policy can be implemented through either
    changes in the money supply or interest rate, or
    through direct controls on lending.
  • Changes in the interest rate will affect the
    interest-sensitive components of aggregate
    demand. The exact size and timing of these
    effects will differ from country to country.
  • If economy is at equilibrium output, interest
    rate cuts will lead to an inflationary boom,
    which eventually will lead only to higher prices.
  • If economy is below equilibrium output, interest
    rate cuts will tend to raise output (as well as
    prices) and shift the economy back towards
    equilibrium.
  • Typical lag effect on output one year, inflation
    two years.

12
the limits to monetary policy
  • But there are problems with the use of monetary
    policy
  • Measurement of output where are we? where are
    we going? how fast? will we know when we get
    there?
  • Lags in the monetary policy process
    implementation (recognition administrative
    lags) and operational
  • What kind of monetary policy? Interest rates,
    open-market operations, quantitative controls,
    credit controls.
  • The liquidity trap credit channel will policy
    actually affect the interest rates and lending
    policies faced by agents?

13
Taylor rules and inflation targeting
  • After the inflationary difficulties of the 1970s
    and 1980s, many countries moved towards having
    independent central banks and the use of
    inflation targets.
  • This form of constrained discretion seems to
    work because it takes control of monetary policy
    out of the hands of politicians!
  • In practice, most monetary authorities operate
    something called a Taylor rule. That is, they
    raise the real interest rate (the nominal rate
    minus expected inflation) whenever inflation is
    above target or when capacity constraints appear
    in the economy (since these may predict future
    inflation).
  • We can think of a monetary policy reaction
    function, where
  • r inflation target equilibrium real r
  • a(output equilibrium output) b (inflation
    inflation target)
  • The coefficient a measures how averse the
    monetary authority is to output deviations and b
    measures how averse it is to inflation
    deviations.

14
UK inflation performance
Source Carlin and Soskice (2006)
15
fiscal policy
  • If the Treasury were to fill old bottles with
    bank notes, bury them at suitable depths in
    disused coal mines which are then filled up with
    town rubbish, and leave them to private
    enterprise to dig them up again, there need be
    no more unemployment. It would, indeed, be more
    sensible to build houses and the like, but if
    there are political and practical difficulties in
    the way of this, the above would be better than
    nothing J.M. Keynes, 1936.
  • Changes in the governments fiscal stance (that
    is, the difference between government spending
    and taxation) will change the level of aggregate
    demand.
  • If economy is at equilibrium output, increases in
    spending (or tax cuts) will lead to an
    inflationary boom, which eventually will lead
    only to higher prices.
  • If economy is below equilibrium output, increases
    in spending (or tax cuts) will tend to raise
    output (as well as prices) and shift the economy
    back to equilibrium.

16
the limits to fiscal policy
  • But there are problems with the use of fiscal
    policy
  • Measurement of output where are we? where are
    we going? how fast? will we know when we get
    there?
  • Lags in the fiscal policy process implementation
    (recognition administrative lags) and
    operational
  • What kind of fiscal policy? Spending (on what?)
    or tax cuts (for whom?)
  • Will spending crowd-out other spending, either
    directly or indirectly (through interest rates,
    inflation, or the exchange rate)?
  • Will consumers pierce the veil? Will they
    attempt to offset the actions of the government
    (Ricardian Equivalence)?

17
fiscal rules
  • Even now that most monetary policy is conducted
    by independent monetary authorities, there is
    still the problem that politicians may pursue
    fiscal policies that are incompatible with stable
    inflation.
  • Consequently, some countries have adopted fiscal
    rules. The two most famous are
  • The Stability and Growth Pact (revised!)
    countries should aim to run no more than a 1
    deficit over the business cycle cannot borrow
    more than 3 of GDP (cf. France and Germany!) in
    any one year government debt should be kept
    below 60 of GDP.
  • Gordon Browns Golden Rule over the business
    cycle borrowing should equal net government
    investment government debt should be kept below
    40 of GDP.
  • A fiscal rule that states that debt must be kept
    below a level of X of GDP implies that the
    average deficit over the cycle must be
    approximately equal to the average growth rate of
    GDP times the target level of X. For Britain,
    with an average growth rate of 2 and a target of
    40, the average deficit must be kept around 0.8.

18
debt sustainability
  • B(t)B(t-1)D(t)
  • ?(t) ?(t-1)Y(t-1)/Y(t)? (t) where ? B/Y and
    ?D/Y
  • Y(t-1)/Y(t)1-?/(1 ?) where ? is growth rate of
    Kalman-filtered GDP
  • Therefore when ?(t) ?(t-1), we set them both
    equal to ? and find
  • ? -(1- ?/(1 ?)) ?? (t) or
  • (1-(1- ?/(1 ?)) ? ? (t) which simplifies to
  • (? /(1 ?)) ? ? (t) or
  • ?(1/(?/(1 ?))) ?(t) is the equilibrium
  • since (?/(1 ?)) ? we can say
  • ?. ? ? (t)

19
how does monetary policy work?
Source Carlin Soskice, p12
20
transmission mechanisms
Market rates
Domestic demand
Domestic inflationary pressure
Total demand
Asset prices
Official rate
Net external demand
Inflation
Expectations confidence
Import prices
Exchange rate
21
higher interest rates do not always tighten
financial conditions
Source Goldman Sachs
22
Euro area responses to a 1 rise in ECB repo rate
for two years
Real GDP
Consumer prices
Year 1
Year 2
Year 3
Year 1
Year 2
Year 3
ECB -0.34 -0.71
-0.71 -0.15 -0.30
-0.38
NCB -0.22 -0.38
-0.31 -0.09 -0.21
-0.31
NIGEM -0.34 -0.47
-0.37 -0.06 -0.10
-0.19
Note The table shows responses of real GDP and
consumer prices to a two-year increase of 100
basis points in the policy-controlled interest
rates of the euro area. Figures are expressed in
per cent from baseline. Simulations are performed
using the ECBs area-wide model, the national
central banks macroeconometric models and the
multi-country model of the NIESR
Source ECB Monthly Bulletin, October 2002, p45
23
the Keynes view
  • But this long run is a misleading guide to
    current affairs. In the long run we are all dead.
    Economists set themselves too easy, too useless a
    task if in tempestuous seasons they can only tell
    us that when the storm is long past the ocean is
    flat again. J.M. Keynes, 1936.

24
recent developments
  • Euroland growth has been slow since 2000
  • US recovery from recession in 2000-1 has been
    good, although employment has not recovered as
    much as output
  • The UK has grown steadily
  • Japan may be picking up China and India continue
    to grow rapidly.
  • World monetary policy has been extraordinarily
    relaxed since 2000, with interest rates of around
    0 in Japan, 1 in the USA and 2 in Euroland.
  • But short-term interest rates are now rising
    around the world.

25
recent performance
Source CESifo (2006).
26
recent loose monetary policy
Source CESifo (2006).
27
even on a real basis
Source CESifo (2006).
28
breaking the rules?
Source CESifo (2006).
29
rising debt
Source CESifo (2006).
30
bond yields low despite rule-breaking!
Source CESifo (2006).
31
inflationary pressure
Source BIS Annual Report (2006)
32
contango!
Source BIS Annual Report (2006)
33
rising yield expectations
Source BIS Annual Report (2006)
34
excess liquidity?
Source BIS Annual Report (2006)
35
focus on the USA
Source BIS Annual Report (2006)
36
focus on Japan
Source BIS Annual Report (2006)
37
focus on Japan
Source BIS Annual Report (2006)
38
Junker vs Trichet
Source BIS Annual Report (2006)
39
global imbalances
Source CESifo (2006)
40
global prospects
  • While the US continues to run such large twin
    deficits, there is the possibility of a
    disorderly correction to global imbalances. Not
    clear how different Bernanke will be to Greenspan
    yet.
  • In the absence of such a correction, continued
    broad growth with some inflationary pressure is
    likely.
  • Corporate profits have been very strong in the
    USA and wage growth has been weak not much more
    scope for profits to outperform revenues.
  • In Europe, on the other hand, corporate profits
    may rise faster than revenues as the economy
    picks up assuming no more oil price rises.
  • Very hard to predict changes in China. Likely to
    be modest upward movement of renminbi and modest
    decline in share of investment in GDP (46 in
    2005!). Current policy hugely distorts price
    mechanism credit too cheap, exchange rate too
    low, labour market distortions.
  • The need for reform in Chinese banking system and
    credit allocation and to deal with inflation and
    excess capital investment must be balanced
    against risk of sudden adjustment.

41
prospects for the world macroeconomy
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