1. Lecture 6: Macromodel Exercises Given to the EMBA 8400 Class South Class Room #600 February 3, 2007 Dr. Rajeev Dhawan Director

2. Policy Experiments With The Integrated Macro Model  Policy Experiments are comparisons of simulated time paths of all endogenous variables to changes in the values of some of the exogenous variables representing macroeconomic policy, such as government spending, taxes, or money supply. Three policy experiments are discussed in this Guide: 1.A Monetary-Stimulus (Inflation) Policy Experiment: Simulated response to an increase in the growth of money supply from zero to a chosen rate of inflation (1 to 20 percent range). 2.A Fiscal-Stimulus Policy Experiment: Simulated response to an increase in real government spending by $50 billion increments without any change in taxes. 3.A Neutral-Budget Policy Experiment: Simulated response to two coordinated fiscal policy changes: a.An increase in real government spending, (the same as in the second experiment). b. An increase in tax rates high enough to “crowd out” an exactly offsetting amount of consumption.

3.  Rate of growth of the money supply is increased from 0% to 5% in 2006.  This is done for 4 years from 2006 to 2009, and then money supply growth drops to 0% in 2010 and thereafter. 1A: Monetary-Stimulus (Inflation) Experiment Money Growth Stops in 2010

4. Money supply growth rate is a constant 5% for four years from 2006 – 2009

5. GDP versus Potential Same as GDP Potential in Long Run

6. Q & A Q: Why does GDP values fluctuate around the potential? A: Interest Rate becomes cyclic which makes Investment cyclical Q: So? A: Interest rate is cyclical because inflation rate in the model at first is smaller than or lags the money supply growth rate, and then later overshoots it. The important thing to note is that if the inflation rate is equal to the money growth rate, then there will be no dynamics! Q: Why does Inflation lag the money growth rate initially? A: By construction, based upon historical evidence, there is a lag or slowness in people’s adjustment of their inflation expectations. However, this adjustment is complete i.e. expectations are equal to actual inflation rate in the long run, which is equal to the growth rate of money supply. Inflation is always a monetary phenomenon.

7. Inflation follows the money growth path, lagging behind at first but then over- shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

8. The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M!

9. Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value

10. Comparison of Inflation and Nominal Interest Rates Nominal = Real + Inflation Rate

11. Comparison of Real Interest Rate and Nominal Interest Rate

12. As R drops it pulls down the real exchange rate

13. Billions Exports increase in the short-run due to a drop in the real exchange rate α 9 < 0

14. Billions Exports increase in the short-run due to a drop in the real exchange rate

15. Billions Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased! α 12 > 0

16. Billions Imports increase in the short-run due to a rise in GDP which overpowers the negative effect of a weak exchange rate on imports

17. Billions Trade deficit increases in the short-run because the increase in real exports is less than the increase in real imports (based upon values of alphas!)

18. Real GDP shoots above the base case value, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value Unemployment Drops Unemployment Rises

19. Billions Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.

20. Billions Consumption rises as GDP has risen!

21. Billions Comparison of Government Surplus and Nominal Interest Rate

22. Billions Cont… Comparison of Government Surplus and Real Interest Rate

23. (Growth stops in 2009)

24. A Somewhat “Sequential” Working of the Model (Monetary Policy)  As Money Supply goes up (M↑), Inflation goes up (P↑), but not as much which implies that Real Interest Rate falls (R↓) which stimulates the Investment (I↑).  Also as Real Interest Rate falls (R↓), the Real Exchange Rate falls (EXCH↓) which boost Exports (EX↑) but hurts Imports (IM↓)  Rise in Investment and Exports by GDPO identity means GDP increases (GDP↑). Consumption also rises (C↑) as GDP rises.  However a rise in GDP also stimulates Imports and the net- effect is that Imports rise overall (IM↑).  Trade Deficit (NETEX↑) increases because the rise in Imports is greater than the rise in Exports.  Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.

25. In the Long Run… Inflation rate is exactly equal to the money growth rate. This means there is no change in the value of real interest rate which in turn implies no change in the other variables of the model, and hence no change in GDP!!

26.  Inflation follows the money growth path, lagging behind at first but then over- shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run  The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M! Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value  As R drops it pulls down the real exchange rate  Exports increase in the short-run due to a drop in the real exchange rate  Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased!  Trade deficit increases in the short-run because the increase in real exports is less than the increase in real imports (based upon values of alphas!)  Real GDP shoots above the base case value, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value.  Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.  Consumption rises as GDP has risen! Summary of Reactions

27. 1B: Monetary-Stimulus (Inflation) Experiment When Money Growth Stops Slowly by 2013 Rate of growth of the money supply is increased from 0% to 5% in 2006, and then kept at 5% until 2009, and then decreased slowly to 0% by 2013 (stays at 0% afterwards)

29. Inflation follows the money growth path, lagging behind at first but then over- shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

30. The real interest rate becomes cyclic. At first it drops which helps investment and then when it rises it hurts investment.

32. Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP Unemployment Drops Unemployment Rises

33. 1C: Monetary-Stimulus (Inflation) Experiment When Money Growth Never Stops! Rate of growth of the money supply is increased from 0% to 5%. This is done forever (till the end of simulation period in 2030!)

34. Money Supply Growth Rate is a constant 5% forever starting in year 2005

35. Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

37. Comparison of Real and Nominal Interest Rates

38. Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to the potential GDP

39. Lessons From the Three Monetary (Inflation) Experiments 1a 1c 1b

40. Inflation Response Depends on How Long Monetary Stimulus Lasts 1b 1a 1c

41. Interest Rate Overshooting Depends on How QUICKLY Monetary Growth Returns to Normal 1a 1b 1c

42. Depth of the Recession Depends Upon How Quickly the Monetary Stimulus is Withdrawn! 1b 1c 1a

43. 2a. Fiscal-Stimulus Policy Experiment

44.  In this experiment real government spending is increased in steps of $100 billion higher from 2006 to 2009, and then spending stays elevated at that level forever.  NO INCREASE IN TAX RATE: A deficit-financed war provides the historical context for large increases in government spending.

45. Government Spending and Tax Rate

46. Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state GDP Unemployment Drops Unemployment Rises

47. Inflation follows the a cyclic path. Why? Because GDP has risen. So initially it shoots up and then drops, but eventually settles to the steady state values

48.  The booming economy raises the demand for money and forces the real interest rate higher.

49. Rise in interest rate hurts investment

50. Real Exchange Rate

51.  Higher real interest rates also raise the exchange rate relative to the domestic price level and the rest- of-the-world price level. That is, the real exchange rate rises. This lowers real exports.

52.  The imports rise as exchange rate rises.

53.  Higher imports and lower exports cause net exports (trade deficit) to drop. Billions(in %)

54.  Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values

55. Comparison of Government Spending and Consumption

56.  Even though the tax rate is constant, higher GDP levels result in increased tax revenues

57. Government Deficit/Surplus and the Real Interest Rate

58.  As Government Spending goes up (G↑), GDP goes up (GDP↑) which causes price level to go up too (P↑).  Real Interest Rate rises (R↑) which depresses Investment (I↓).  Also as Real Interest Rate rises the Real Exchange Rate rises (EXCH↑) which hurts Exports (EX↓) but boosts Imports (IM↑) causing the Trade Deficit to rise (NETEX ↑).  As GDP goes up the tax collections rise but not by as much as the increase in government spending causing the Government deficit to increases. A Somewhat “Sequential” Working of the Model (Fiscal Policy)

59.  In this experiment real government spending is increased in steps of $100 billion higher from 2006 to 2009, and then spending stays elevated at that level forever.  Inflation follows the a cyclic path. Initially shoots and then drops, but eventually settles to the steady state values  Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state  The booming economy raises the demand for money and forces the real interest rate higher.  Higher real interest rates also raise the exchange rate relative to the domestic price level and the rest-of-the-world price level. That is, the real exchange rate rises. This lowers real exports and raises real Imports, causing net exports (trade deficit) to drop for both the reasons.  Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values  Even though the tax rate is constant, higher GDP levels result in increased tax revenues Summary of Reactions

60. Data Table 2 (a): Govt. Spending

62. 2b: When…Govt. Spending is Reduced to its Original Spending Value by 2013 Government Spending increases for four years and then gradually reduced back to the original spending by 2013

63. Government Spending increases for four years and then gradually reduced back to the original spending in 2012 whereas the tax rats remain constant

64. Because the government spending is reduced and brought back to the original level in 2012, the real interest rates are forced to come back to the original as the stimulus is taken away.

65. Inflation Behavior

66. As inflation wears off and the real interest rate returns to normal implies that the nominal interest rate will drop

67. Comparison of Government Spending and Consumption

68. Higher government spending adds directly to real GDP from the national accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillation toward the long run steady state

69. 3. Neutral-Budget Policy Experiment –In this experiment real government spending is increased by the same one-step increase imposed in the fiscal-stimulus experiment. –Instead of running a deficit, the government raises the tax rate high enough to crowd out the exact amount of increase in government spending by reducing consumption. Billions(in %)

70. Billions

71. Higher taxes via higher tax rate leads to drop in consumption

72. Government Spending vs. Consumption

73. No Change in Interest Rate!

74. Billions Increased G and Decreased C => Constant GDP

76. Second half of the data Neutral Experiment Table

77. 4: Stop and Go Experiment