the economy in the long run - sgh warsaw school of …mbrzez/makro_ii/economy in the long...

The economy in the long run

M.Brzoza-Brzezina:

Macroeconomics II – Long run

2

Outline

The difference between the short and long run

1. Money, prices and output

2. Exchange rates

3. The labor market

4. Interest rates

This lecture follows (partly) chapter 6 of the textbook.

1. Money, prices and output

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Neutrality of money

Imagine an exogeneous doubling of the

money supply (helicopter drop)

People go and shop

In the short run output may increase

But why should it change in the long

run?

Does productivity change? No!

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Neutrality of money

Neutrality of money assumes that:

- Real categories do not change when

money supply changes

- Nominal categories change

proportionally

Empirical evidence shows that it holds

in the long run

Bullard (1999) reviews empirical papers:

most confirm long-run neutrality of

money

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Empirical evidence on money in

the long run (1)

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Empirical evidence on money in

the long run (2) King and Watson (1997) estimate a

VAR model

And define long run impact of money on

output

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Empirical evidence (3)

King and Watson apply various

identification schemes that result in

multiplicity of solutions

But all are statistically undistiguishable

from zero

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Some simple arithmetics

Assume money demand function of the

form (so called Cambridge equation):

𝑀𝐷 = 𝑘𝑃𝑌

We will derive it later from first principles

In equilibrium 𝑀𝐷 = 𝑀𝑆 = 𝑀 so:

𝑀 = 𝑘𝑃𝑌 M.Brzoza-Brzezina:


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Inflation and money in the long

run

Assume k constant and differentiate

𝜋 =Δ𝑀

𝑀−

Δ𝑌

𝑌

In the long run inflation differs from the

growth rate of money

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© Oxford University

Press, 2012. All rights

reserved.

Nominal money

supply (%)

Inflation rate (%)

0 -3

3 0

8 5

50 47

103 100

Table 6.1

Inflation and Money Growth in the Long Run:

A Rule of Thumb*

*Assuming real money demand grows at 3% per

annum.

When is the run long?

Keynes (1923): … long run is a

misleading guide to current affairs. In

the long run we are all dead.

Nice, but does not bring us far

We can be more precise

The long run (in the monetary context is

when nominal quantities adjust to the

new money supply.

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Sources of nominal stickiness

Sticky wages:

- Wage contracts (cost of renegotiations)

- DNWR

Sticky prices:

- Menu costs

- Customer relationship

- Rational inattention

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Empirical evidence on nominal

stickiness

Median duration of contract

Wages:

- Euro area: 15 months (Druant et al. 2009)

Prices

- Euro area: 11 months (Dhyne et al. 2009)

- US: 4 months (Bils & Klenow 2004)

- Poland: 7 months (Macias & Makarski

2013) M.Brzoza-Brzezina:


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Potential output

Concept related to neutrality – potential

output

Output that the economy would produce if

prices were perfectly elastic

Also – output that is consistent with stable

inflation

Grows at approx. 2% in advanced

economies

But finding its current level is more tricky

Note however: there are many definitions

of potential output M.Brzoza-Brzezina:


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Superneutrality

Supereutrality of money assumes that:

- Real categories do not change when

growth rate of money supply changes

- Nominal categories change

proportionally

Empirical evidence shows that it does

not hold in the long run

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Why does superneutrality not

hold?

High inflation hurts efficiency and

economic growth:

- Relative prices may change strongly for

random reasons

- People spend too much time and effort

for tracking prices (updating

information)

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Empirical evidence on

superneutrality (King

& Watson 1997)

Long-run effect of

money growth on

output is either zero or

negative

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Exchange rate

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Nominal exchange rate

Let S be the nominal exchange rate

Two conventions: European (units of

domestic currency for unit of foreign

currency) or British (units of foreign

currency for unit of domestic currency)

In Poland we use the European

!!! The textbook (and lecture) applies

the British

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Apreciation and depreciation

Apreciation – S increases (decreases in

European system)

Depreciation – S decreases (increases

in European system)

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Real exchange rate

Define the real exchange rate:

𝜎 = 𝑆𝑃

𝑃∗

This is a popular measure of

competitiveness

Shows whether home country is more

(𝜎 > 1) or less expensive than foreign

country (𝜎 < 1)

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Exchange rates in the long run

Long run neutrality suggests that real

exchange rate should be unaffected by

inflation

Differentiate: Δ𝜎

𝜎=

Δ𝑆

𝑆+ 𝜋 − 𝜋∗

If real rate is unaffected by inflation: Δ𝑆

𝑆= 𝜋∗ − 𝜋

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© Oxford University

Press, 2012. All rights

reserved. Source: IMF International Financial Statistics

Fig. 6.1 (b)

Inflation and Exchange Rate Depreciation, 1975-2006

Relative purchasing power parity

Assumption Δ𝜎

𝜎= 0 is called relative

purchasing power parity

It means that price levels change

proportionally at home and abroad

It usually holds in the (not so long) run

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Why?

Assume one country has higher inflation

Assume initially nominal exchange rate

does not change

The country becomes less competitive

Demand for foreign currency exceeds

its supply

The price (nominal exchange rate) must

adjust M.Brzoza-Brzezina:


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Absolute purchasing power parity

Stronger assumption: price levels are

equal

𝑆𝑃 = 𝑃∗

so that:

𝜎 = 1

This is much stronger and finds mixed

empirical support

Some countries are more/ less expensive

for many years

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Absolute PPP in practice

For some countries it works

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For other countries not. Why?

Tarifs

Taxes

Transportation costs

Etc

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Equilibrium exchange rates

As with output many concepts of long-

run exchange rates exists and are

calculated

Examples:

- PPP

- FEER

- BEER

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3. The labor market in the long

run

Equilibrium unemployment rates

Employment trends in the long run

Economic activity in the long run

Histeresis and long-term unemployment

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Equilibrium unemployment rates

As many variables unemployment has a

cyclical and permanent component

The permanent (equilibrium) one is the

sum of frictional and structural

unemployment

Structural unemployment results from

the inability of the real wage to clear the

market in the long run M.Brzoza-Brzezina:


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Special long run concept -

NAIRU

The unemployment rate that is

consistent with stable inflation

It is the flipside of potential output

Again: several concepts of equilibrium

unemployment rates

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M.Brzoza-Brzezina:

Macroeconomics II –

Long run

Estimates of Equilibrium

Unemployment Rates

Table 5.10

34

Unemployment in the EU and US

After the 1970s shocks unemploment

rates diverged sharply

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Why?

Not clear. Some suspects:

1. More generous unemployment

protection schemes in the EU

2. Higher wage growth in the EU

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Employment trends in the long

run

In the long run as income increases

people often tend to work less

Note that our derived labor supply curve is

short-medium term

Total Hours Worked and Real

Wages

Table 5.1

Source: see text, p. 111

1870 1913 1938 1973 1992 2000 2007 2009

Annual hours worked per Person

France 2945 2588 1848 2027 1695 1591 1556 1558

Germany 2941 2584 2316 1870 1566 1473 1430 1390

UK 2984 2624 2267 2016 1874 1712 1673 1646

USA 2964 2605 2062 1797 1716 1739 1709 1681

Sweden 2945 2588 2204 1564 1565 1642 1618 1602

Real Wage (index: 1870=100)

France 100 205 335 1048 1505 1614 1714 1727

Germany 100 185 285 944 1226 1320 1309 1306

UK 100 157 256 439 605 691 770 767

USA 100 189 325 595 696 791 860 871

Sweden 100 270 521 1228 1523 1874 2132 2085

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Economic activity in the long run

Not only unemployment rates differ

between countries

So do economic activity rates

This is even more important

Depends on labor market

characteristics but also traditions

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Histeresis and long-term

unemployment

Strong link between cyclical and long-

term unemploment

Loss of skills during unemployment

makes people „unemployable”

This is called labor market histeresis

http://data.worldbank.org/indicator/SL.UE

M.LTRM.ZS/countries?display=map

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http://data.worldbank.org/indicator/SL.UEM.LTRM.ZS/countries?display=map

http://data.worldbank.org/indicator/SL.UEM.LTRM.ZS/countries?display=map

4. Interest rates

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Nominal and real interest rate

The real interest rate is the nominal rate

corrected for expected inflation

𝑟 = 𝑖 − 𝜋𝑒

Again, long run neutrality suggests that

the real rate is unaffected by inflation in

the long run M.Brzoza-Brzezina:


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Equilibrium concept

Again, we have an equilibrium concept

Real interest rate consistent with stable

inflation

Called natural rate of interest

Important concept for central banks

2-3% in advanced economies (e.g.

Laubach & Williams 2001)

More in emerging markets (e.g. 4-6 in

Poland 1998-2003, Brzoza-Brzezina 2006)

NRI is time varying!

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Estimate of the NRI (Laubach &

Williams)

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Takeaways

Economists talk of „long run” as of the period when effects of

shocks die out

This can be months for small shocks, but years for large shocks

Several related long-run eqiulibrium concepts:

– Potential output

– Natural rate of unemployment

– Natural rate of interest

– Equilibrium exchange rate

They define levels to which the economy converges in the long

run

Definitions of neutrality (superneutrality) of money: changes of

money stock (growth rate) do not affect real variables

Money is neutral in the long run (but not superneutral)

Money is neither neutral nor superneutral in the short run

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Extra Check how the FEER is calculated

(Williamson 1994). Find its estimates for

Poland (Rubaszek)

Collect data on the nominal rates and

inflation in many countries and make a

scatterplot of their changes in the long

run. Are they correlated? What does it

tell us about real rates?

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