1 The full dynamic short-run model and macroeconomic controversies

2 Paper topic Last problem is short paper (1000 words + tables, figures) Topic will be to discuss economics of U.S. federal debt and/or deficit Due December 9 Get approval from TF or me for topic Broad latitude on particular topic, but narrow it down. Examples (verbally, but will be in posted assignment) Good style Acceptable references (not Internet junk) Don’t wait until last moment.

3 The Dynamic Model A nice new addition to Mankiw. Combines - IS - LM (changed to reflect central bank targeting a la Taylor) - Phillips curve Closed economy Short-run of business cycles Keynesian rather than classical

4 Monetary policy rule Taylor rule: i t = π t + r* + θ π (π t - π*) +θ Y (Y t - Y* ) Rationale: a rule that incorporates both real and inflation targets But, also one that has good stability properties Derived from minimizing loss function such as L = λ π (π t - π*) 2 + λ Y (lnY t - lnY* ) 2

5 Econometric estimate (for info purposes) FYFF = federal funds rate PIPCECORE4Q = rate of core inflation, consumption deflator, 4 quarter LHUR = unemployment rate NAIRU = natural rate of unemployment (-1) = lagged one quarter

6 Fed funds =π *(π – 2) – 1.811*(u – natural rate) π = 4 quarter PCE core inflation Why is rate below target today!?!

7 Algebra of Dynamic AS-AD analysis Key equations: 1. Demand for goods and services: Y t = Y* - α (r t –r*) + μG + ε t 2. Cost of capital: r t = i t – π e t + σ t 3. Phillips curve: π t = π e t + φ(Y t - Y* ) + v t 4. Inflation expectations: π e t = π t-1 5. Monetary policy: i t = π t + r* + θ π (π t - π*) +θ Y (Y t - Y* ) Notes: Equation (1) is just our IS-LM solution Phillips curve substitutes output by Okun’s Law We add premium to capture long v. short rates and financial crises ( σ t ) Mankiw uses slightly different version of (4) Mankiw doesn’t consider risk premium, so ignore for now Added r* to Taylor rule from last lecture (forgot it).

8 Note on interest rates r = real interest rate relevant for business decisions = nominal long-run risky rate – expected inflation Nominal long-run risky rate = nominal long-run risk-free rate + risk premium Nominal long-run risk-free (say Treasury bond rate) = f(expected short rates) + term premium

9 Solve for AS and AD AD: Y t -Y* = -[ α /(1+ α θ Y )] [(1+ θ π )π t + σ t - π t-1 +…] + [ 1/(1+ α θ Y )](μG + ε t ) AS: π t = π t-1 + φ(Y t - Y* ) + v t NOTE: AD is like IS-LM equilibrium except is substitutes the Fed response for a fixed money supply AS is Phillips curve with substitution for expected inflation Note that we have moved up one derivative in prices from introductory AS-AD because Phillips curve related to inflation.

10 π Y = real output (GDP) AD(π*, G, ε t, σ t ) Yt*Yt* AS(π t-1, Y*, v t ) The graphics of dynamic AS-AD πt*πt*

11 Inflationary shock π Y = real output (GDP) AD AS AS’ Y t ** π t **

12 Financial shock or cut in G π Y = real output (GDP) AD AS Y t ** π t ** AD’

13 Example by simulation model This will be available on course web page. You might download and do some experiments to see how it works. New kind of economics: computerized modeling.

14 Screen shot

15 Parameters

16 Numerical simulation in base run

17 Graph of base case Forecast

18 Some policy approaches What should the Fed do today? Has run out of conventional bullets. Unconventional tool today is “quantitative easing 2” (QE2) FOMC statement on Wednesday: “To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. …. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.” Impact: -Remember, r = i – π + Expected future i + risk and term premiums -Point of QE2 is to lower term premium -Estimates are in the range of 50 basis points maximum

19 Quantitative easing (lowers r by 50 basis points) Forecast (base + QE2)

20 What about raising inflation target? Some have argued that Fed should raise target. Would keep i at zero for longer period.

21 Impact of higher inflation premium* Forecast (base + raise inflation target to 3 percent) * Works by lowering the expected future short rates through Taylor rule and then building that into current long rates by expectations theory.

22 Balance the budget One of the perennial concerns is budget deficits. Deficit Commission: “President Obama created the bipartisan National Commission on Fiscal Responsibility and Reform to address our nation's fiscal challenges. The Commission is charged with identifying policies to improve the fiscal situation in the medium term and to achieve fiscal sustainability over the long run. Specifically, the Commission shall propose recommendations designed to balance the budget, excluding interest payments on the debt, by ” ( about/) about/ Republican platform on balanced budget amendement: “Republicans … favor adoption of the Balanced Budget Amendment to require a balanced federal budget except in time of war.” What would be the effect of attempting to balance the budget over the next 3 years? (For simplicity, I use the full-employment budget.)

23 Balanced federal budget by 2015 Forecast (base + balanced budget)

24 Summary This now finishes our treatment of closed-economy business cycles. Key elements are - IS elements in I, C, fiscal policy, and trade - Financial markets and monetary policy - Inflation dynamics We now move on to long-run growth theory next week.