slide 0 CASE STUDY Volcker’s Monetary Tightening  Late 1970s:  > 10%  Oct 1979: Fed Chairman Paul Volcker announced that monetary policy would aim to reduce inflation.  Aug 1979-April 1980: Fed reduces M/P 8.0%  Jan 1983:  = 3.7% How do you think this policy change would affect interest rates?

slide 1 Volcker’s Monetary Tightening, cont.  i < 0  i > 0 1/1983: i = 8.2% 8/1979: i = 10.4% 4/1980: i = 15.8% flexiblesticky Quantity Theory, Fisher Effect (Classical) Liquidity Preference (Keynesian) prediction actual outcome The effects of a monetary tightening on nominal interest rates prices model long runshort run

slide 2 EXERCISE: Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. A boom in the stock market makes consumers wealthier. 2. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r. b. determine what happens to C, I, and the unemployment rate.

slide 3 What is the Fed’s policy instrument? What the newspaper says: “the Fed lowered interest rates by one-half point today” What actually happened: The Fed conducted expansionary monetary policy to shift the LM curve to the right until the interest rate fell 0.5 points. The Fed targets the Federal Funds rate: it announces a target value, and uses monetary policy to shift the LM curve as needed to attain its target rate.

slide 4 What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply? 1)They are easier to measure than the money supply 2)The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.

slide 5 Interaction between monetary & fiscal policy  Model: monetary & fiscal policy variables (M, G and T ) are exogenous  Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.  Such interaction may alter the impact of the original policy change.

slide 6 The Fed’s response to  G > 0  Suppose Congress increases G.  Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant  In each case, the effects of the  G are different:

slide 7 If Congress raises G, the IS curve shifts right IS 1 Response 1: hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

slide 8 If Congress raises G, the IS curve shifts right IS 1 Response 2: hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results:

slide 9 If Congress raises G, the IS curve shifts right IS 1 Response 3: hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3

slide 10 CASE STUDY The U.S. economic slowdown of 2001 ~What happened~ 1. Real GDP growth rate : 3.9% (average annual) 2001: 1.2% 2. Unemployment rate Dec 2000: 4.0% Dec 2001: 5.8%

slide 11 CASE STUDY The U.S. economic slowdown of 2001 ~Shocks that contributed to the slowdown~ 1. Falling stock prices From Aug 2000 to Aug 2001:-25% Week after 9/11: -12% 2. The terrorist attacks on 9/11 increased uncertainty fall in consumer & business confidence Both shocks reduced spending and shifted the IS curve left.

slide 12 The Great Depression Unemployment (right scale) Real GNP (left scale)

slide 13 The Spending Hypothesis: Shocks to the IS Curve  asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve  evidence: output and interest rates both fell, which is what a leftward IS shift would cause

slide 14 The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash  exogenous  C  Oct-Dec 1929: S&P 500 fell 17%  Oct 1929-Dec 1933: S&P 500 fell 71% 2. Drop in investment  “correction” after overbuilding in the 1920s  widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy  in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending

slide 15 The Money Hypothesis: A Shock to the LM Curve  asserts that the Depression was largely due to huge fall in the money supply  evidence: M1 fell 25% during But, two problems with this hypothesis: 1. P fell even more, so M/P actually rose slightly during nominal interest rates fell, which is the opposite of what would result from a leftward LM shift.

slide 16 The Money Hypothesis Again: The Effects of Falling Prices  asserts that the severity of the Depression was due to a huge deflation: P fell 25% during  This deflation was probably caused by the fall in M, so perhaps money played an important role after all.  In what ways does a deflation affect the economy?

slide 17 The Money Hypothesis Again: The Effects of Falling Prices The stabilizing effects of deflation:   P   (M/P )  LM shifts right   Y  Pigou effect:  P   (M/P )  consumers’ wealth   C C  IS shifts right  Y Y

slide 18 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls

slide 19 The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of expected deflation:  e  r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output 

slide 20 Why another Depression is unlikely  Policymakers (or their advisors) now know much more about macroeconomics:  The Fed knows better than to let M fall so much, especially during a contraction.  Fiscal policymakers know better than to raise taxes or cut spending during a contraction.  Federal deposit insurance makes widespread bank failures very unlikely.  Automatic stabilizers make fiscal policy expansionary during an economic downturn.

slide 21 Percentage of GDP CanadaFranceGermanyItalyJapanU.K.U.S. ImportsExports Imports and Exports as a percentage of output: 2000

slide 22 Three experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand

slide Fiscal policy at home r S, I I (r )I (r ) I 1I 1 An increase in G or decrease in T reduces saving. NX 1 NX 2 Results:

slide 24 NX and the Government Budget Deficit Budget deficit (right scale) Net exports (left scale)

slide Fiscal policy abroad r S, I I (r )I (r ) Expansionary fiscal policy abroad raises the world interest rate. NX 1 NX 2 Results:

slide An increase in investment demand r S, I I (r )1I (r )1 EXERCISE: Use the model to determine the impact of an increase in investment demand on NX, S, I, and net capital outflow. NX 1 I 1I 1 S

slide An increase in investment demand r S, I I (r )1I (r )1 ANSWERS:  I > 0,  S = 0, net capital outflows and net exports fall by the amount  I NX 2 NX 1 I 1I 1 I 2I 2 S I (r )2I (r )2

slide 28 U.S. Net Exports and the Real Exchange Rate,

slide 29 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports

slide Fiscal policy at home A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in the foreign exchange market… …causing the real exchange rate to rise and NX to fall. ε NX NX(ε ) ε 1ε 1 NX 1 NX 2 ε 2ε 2

slide Fiscal policy abroad An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the foreign exchange market… …causing the real exchange rate to fall and NX to rise. ε NX NX(ε ) NX 1 ε 1ε 1 ε 2ε 2 NX 2

slide An increase in investment demand An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange market… ε NX NX(ε ) …causing the real exchange rate to rise and NX to fall. ε 1ε 1 NX 1 NX 2 ε 2ε 2

slide Trade policy to restrict imports ε NX NX (ε ) 1 NX 1 ε 1ε 1 NX (ε ) 2 At any given value of ε, an import quota  IM  NX  demand for dollars shifts right Trade policy doesn’t affect S or I, so capital flows and the supply of dollars remains fixed. ε 2ε 2

slide Trade policy to restrict imports ε NX NX (ε ) 1 NX 1 ε 1ε 1 NX (ε ) 2 Results:  ε  > 0 (demand increase)  NX = 0 (supply fixed)  IM < 0 (policy)  EX < 0 (rise in ε ) ε 2ε 2

slide 35 Inflation and nominal exchange rates Percentage change in nominal exchange rate Inflation differential Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar France Canada Sweden Australia UK Ireland Spain South Africa Italy New Zealand Netherlands Germany Japan Belgium Switzerland

slide 36 no change               closed economy small open economy actual change ε NX I r S G – T 1980s1970s Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index. CASE STUDY The Reagan Deficits revisited