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.

Years GDP Growth Unemployment Rate Inflation Rate
1985-1995 2.80 6.30 3.5
1995-2000 4.10 4.80 2.5

• Would you choose to raise the target interest
  rate?

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AS-AD model revisited Planned aggregate
expenditure
PAE C I G NX
Ca1a2(Y-T)a3ra4W
Ib1b2r
NX d1d2q
r i - p
Real interest rate
q ep/p
Real exchange rate
e domestic currency per foreign currency
Nominal exchange rate
p price of foreign good in foreign currency
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Equilibrium output at a given price level
Y PAE
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Determination of Short-Run Equilibrium Output
Planned aggregate expenditure PAE
Output Y
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Aggregate Demand

• A relation between the equilibrium output and the
  price level.

Y PAE (p1)
?
Y1
Y PAE (p2)
?
Y2
Y PAE (p3)
?
Y3

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The Aggregate-Demand curve
P ?
Price Level (P)

• ? real wealth ?
• ? interest rates ?
• ? exchange rate ?

? consumption ? ? consumption ?, investment ? ?
net export ?
P1
P2
AD
Quantity of output (Y)
0
Y1
Y2
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The short-run aggregate-supply curve
Price Level (P)
SRAS (Pe)
P1

• In the short run,
• P ? ? Y ?
• sticky wages,
• sticky prices, or
• misperceptions.

P2
Quantity of Output (Y)
0
Y1
Y2
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Aggregate Demand and Aggregate Supply
Price Level (P)
AS

• Output, Y, and the price level , P, adjust to the
  point at which the aggregate-supply, AS, and
  aggregate-demand, AD, curves intersect.

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

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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 gt Y (Price
level rises) 3. Recessionary gap Inflation
falls Y lt Y (Price level falls)
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Self-adjustment of recessionary gap
Price Level (P)
LRAS
SRAS1
SRAS2
SRAS3
A
P1
B
P2
AD
0
Y1
Y2
Quantity of Output (Y)
Recessionary gap
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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
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A Contraction in aggregate demand
Price Level (P)
LRAS
SRAS1
SRAS2
SRAS3
A
P1
B
P2
C
P3
AD1
AD2
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y1
Y2
Time
0
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Adjustment of price level
P
P1
P3
Time
0
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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
Y1
Y2
Quantity of Output (Y)
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An increase in oil prices
Price Level (P)
LRAS
SRAS2
SRAS1
SRAS1
B
P2
C
P1
AD1
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y1
Y2
Time
0
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Adjustment of price level
P
P2
P1
Time
0
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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)
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Adjustment of output
Y
Y2
Y1
Time
0
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Adjustment of price level
P
P1
P2
Time
0
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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.

Years GDP Growth Unemployment Rate Inflation Rate
1985-1995 2.80 6.30 3.5
1995-2000 4.10 4.80 2.5

• Would you choose to raise the target interest
  rate?

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U.S. Macroeconomic Data, Annual Averages,
1985-2000
Was Greenspan right in 1996?
Growth in Unemployment Inflation Productivity Y
ears 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
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Long-run growth and inflation
Price Level (P)
LRAS1980
LRAS1990
LRAS2000
P2000
P1990
P1980
AD2000
AD1990
AD1980
Quantity of Output (Y)
0
Y1990
Y1980
Y2000
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Government intervention
Short-run adjustments are painful!
In the long run, we are all dead!
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A Contraction in aggregate demand
Price Level (P)
LRAS
SRAS1
SRAS2
SRAS3
A
P1
B
P2
C
P3
AD1
AD2
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y1
Y2
Time
0
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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.

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Fiscal policies

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

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Monetary policy

• Interest rate
• Discount rate
• Reserve requirement

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A Contraction in aggregate demand
Price Level (P)
LRAS
SRAS1
A
P1
B
P2
AD1
AD2
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y1
Y2
Time
0
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An increase in oil priceswith accommodation
policy
Price Level (P)
LRAS
SRAS2
SRAS1
A
P1
B
P2
C
P3
AD2
AD1
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y1
Y2
Time
0
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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)
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The Feds Role in Stabilizing Financial
MarketsBanking 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

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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.)

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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
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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.

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Recent crisisNo 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.

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Recent crisisNo 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.
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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)

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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

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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

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Policymaking Art or Science?

• How to design macroeconomic policy?
• Cross the River by Groping the Stone Under Foot
  or Feeling for rocks while crossing a river
• Feeling for rocks while crossing a river
  connotes a gradual progress When a step forward
  does not feel right, a step in another direction
  might be necessary.

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The passive role of Hong Kong

• The linked exchange rate does not allow
  independent monetary policy
• Uncovered interest rate parity restricts Hong
  Kongs interest rate to be very close to that of
  the US.

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Impact of an expansionary monetary policy in the
US
Low US interest rate
Low HK interest rate
Asset and property bubbles wealth effect?
Investment and consumption
AD increases
Y increases in the long run P increases in the
long run
short
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Changes in aggregate demand due to changes in the
US monetary policies
SRAS2
Price Level (P)
LRAS
SRAS1
SRAS3
B
A
C
AD2
AD1
AD3
Y3
0
Y1
Y2
Quantity of Output (Y)
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Adjustment of output
Y
Y2
Y1
Y3
Time
0
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Adjustment of inflation
P
P2
P1
P3
Time
0
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Role of Hong Kong government?

• Monetary policy
• By adopting the linked exchange rate system, we
  have given up our autonomy of monetary policy.
• Fiscal policy
• We still have autonomy fiscal policy. It is
  tempting to use fiscal policy to accommodate the
  shocks.
• But fiscal policy is slow to take effect. By
  the time we see the effect, the US monetary
  policy might have shifted in the opposite
  direction. If so, the active HKs fiscal policy
  may destabilize the output.
• Alternative
• Make Hong Kong economy more flexible in adjusting
  to shocks.
• Improve the matching of job-seekers and
  vacancies.
• Encourage shorter job contract?
• Reduce the use of the government fiscal policy to
  stabilize the economy (government policies tend
  to be slow!)

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End