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UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS Spring 2018
Professor David Romer
LECTURE 8
REVIEW OF OPEN-ECONOMY IS-MP AND THE AD-IA FRAMEWORK FEBRUARY 12, 2018
I. OVERVIEW II. OPEN-ECONOMY IS-MP WITH FLEXIBLE EXCHANGE RATES A. Preliminaries B. Another piece of planned expenditures: net exports (NX) 1. What determines NX? 2. Key relationship between NX and net capital outflows (CF) 3. What determines CF? C. How does including international factors change IS-MP? D. Example: An expansionary change in the monetary policy rule III. AGGREGATE DEMAND (AD) A. Working toward a model of inflation and output determination B. Deriving the AD curve from the IS-MP framework C. What shifts the AD curve? IV. INFLATION ADJUSTMENT (IA) A. Behavior of inflation B. IA curve C. Short-run equilibrium D. Transition to long-run equilibrium V. APPLICATION: RECENT CHANGES IN U.S. FISCAL POLICY A. Background: Recent fiscal developments B. Effect in IS-MP framework C. Effect in the AD-IA framework D. Return to long-run equilibrium E. Where do we end up? F. Discussion
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LECTURE 8 Review of Open Economy IS-MP and
the AD-IA Framework
February 12, 2018
Economics 134 David Romer Spring 2018
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Announcements
• An answer sheet to Problem Set 1 has been posted on the course website. You should study it carefully.
• The start of lecture on Wednesday will be set aside for you to fill out an “Early Feedback” form.
• I would like each of you to set a goal of speaking in lecture at least once this semester.
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LECTURE 7 Monetary Factors in the
Great Depression (concluded)
Economics 134 David Romer Spring 2018
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0. EXPECTED INFLATION IN THE IS-LM MODEL (REVISITED)
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Real versus Nominal Interest Rates
i ≡ r + πe
• i is the nominal rate
• r is the real rate
• πe is expected inflation
r ≡ i - πe
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How Expected Inflation Affects the IS-LM Diagram
• As we have discussed, we can use the money market diagram to find the nominal interest rate that causes money demand and money supply to be equal for a given Y.
• r ≡ i - πe.
• So, the real interest rate that causes money demand and money supply to be equal for a given Y is the nominal rate that we find using the money market diagram minus expected inflation.
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Expected Inflation in IS-LM
Y
r LM0
IS0
r0
Y0
LM (in terms of i and Y)
πe
We subtract off πe from each point on the LM curve in terms of i and Y to get the LM curve in terms of r and Y.
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Fall in Expected Inflation in IS-LM
Y
r LM0 (π0𝑒)
IS0
r0
Y0
LM1 (π1𝑒)
π1𝑒 < π0𝑒
LM curve shifts up by the fall in πe.
π0𝑒 - π1𝑒
Y1
r1
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Effect of a Fall in Expected Inflation in IS-LM
• A fall in πe shifts the LM curve (in terms of r and Y) up.
• The LM curve shifts up by the fall in πe (π0𝑒 – π1𝑒).
• r rises and Y falls.
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What happens to i when there is a fall in expected inflation?
• i ≡ r + πe
• r rises, which tends to increase i.
• πe falls, which tends to decrease i.
• r rises by less than πe falls, so i falls.
• A fall in expected inflation (to expected deflation) can help explain why real rates rose and nominal rates fell in the early 1930s.
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The Impact of a Fall in Expected Inflation on i
Y
r LM0 (π0𝑒)
IS0
r0
Y0
LM1 (π1𝑒)
π1𝑒 < π0𝑒
The rise in r (the distance from r0 to r1) is less than the fall in πe (the distance from LM0 to LM1).
π0𝑒 - π1𝑒
Y1
r1 r0 - r1
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There was a large fall in expected inflation in 1930 and 1931.
Source: Stephen Cecchetti, American Economic Review, March 1992.
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Narrative Evidence from Business Week
• Expected deflation after mid-1930.
• Monetary developments and Fed policy were a key source of expectations of deflation.
• “Our idle gold hoard piles up without increasing the means of payment by credit expansion because of paralysis of banking policy, thus prolonging price deflation” (4/29/31, cover).
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00. OCTOBER 1931
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October 1931
• One of Friedman and Schwartz’s crucial episodes.
• Britain went off the gold standard in September 1931.
• Federal Reserve raised the discount rate 200 basis points to stem gold outflow.
• Pretty clearly another contractionary monetary shock.
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Source: Friedman and Schwartz, A Monetary History of the United States, 1963
Discount Rate
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Effect of the rise in the discount rate (and fall in high-powered money) in October 1931
Y
r LM0
IS0
r0
LM1
r1
Y1 Y0
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LECTURE 8 Review of Open Economy IS-MP and
the AD-IA Framework
Economics 134 David Romer Spring 2018
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I. OVERVIEW OF WHERE WE ARE HEADED
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IS-LM Useful for the Great Depression
• Key story of the Depression is a collapse in aggregate demand.
• IS-LM useful for understanding the sources of the decline in demand.
• International factors present, but not essential.
• Likewise, inflation adjustment present, but swamped by the collapse in demand.
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Need a Richer Model for the Postwar Era
• Useful to incorporate international trade and flexible exchange rates.
• Need a framework that includes inflation adjustment.
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II. OPEN-ECONOMY IS-MP WITH FLEXIBLE EXCHANGE RATES
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Preliminaries
• Working with IS-MP because we are focusing on the postwar period.
• Fed has been conducting policy in terms of the interest rate for most of this period, so MP is appropriate.
• Only doing the case of flexible exchange rates.
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Real Exchange Rate (ε) • Number of units of foreign goods we can obtain by
buying 1 less unit of domestic goods.
• For ε between the dollar and some foreign currency, a rise in ε is a real appreciation of the dollar.
• Note: We can write ε as eP/P*, where e is the number of units of foreign currency we can get with 1 unit of domestic currency (so e is the nominal exchange rate), P is the price of domestic goods in terms of domestic currency, and P* is the price of foreign goods in terms of foreign currency. However, we will generally work directly with ε.)
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Planned Expenditures
• E = C(Y-T) + I(r) + G + NX
• NX (Net Exports) is Exports - Imports
• Proximate determinant of net exports is the real exchange rate: NX = NX(ε)
• Relationship is negative: A rise in ε lowers NX.
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Key Relationship between NX and CF
• Quantity of dollars supplied in foreign currency market must equal the quantity demanded
• Supply of Dollars: Imports (M) + Capital Outflows (CO)
• Demand for Dollars: Exports (X) + Capital Inflows (CI)
• M + CO = X + CI
• CO – CI = X – M
• Net Capital Outflow (CF) = Net Exports (NX)
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What Determines CF?
• The real interest rate in U.S.
• CF = CF(r)
• Relationship is negative.
• A higher r in U.S. reduces CF.
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A Helpful Substitution
• E = C(Y-T) + I(r) + G + NX(ε)
• Since CF(r) = NX(ε), we can write instead:
E= C(Y-T) + I(r) + G + CF(r)
• Now two pieces of planned expenditures depend negatively on r.
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A Rise in the Interest Rate in the Closed Economy Keynesian Cross
Y
E E = Y
E = C(Y–T) + I(r0) + G
Y0
r1>r0
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A Rise in the Interest Rate in the Open Economy Keynesian Cross
Y
E E = Y
E = C(Y–T) + I(r0) + G + CF(r0)
Y0
r1>r0
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Closed-Economy vs. Open-Economy IS
Y
r MP
ISClosed
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Expansionary Change in MP Rule in an Open Economy
Y0 Y
r MP0
ISClosed
r0
ISOpen
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What happens to the real exchange rate in response to the shift in MP?
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III. AGGREGATE DEMAND
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Where we are headed: AD-IA
Y
π
IA
AD
π0
Y0
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Impact of Inflation in IS-MP
• No impact on IS curve
• MP curve shows Fed’s policy rule for the real interest rate.
• r = r(Y, π), where π is inflation.
• Since we draw r = r(Y), a change in π shifts the MP curve.
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π is a shift variable for the MP Curve in (Y,r) space π1 > π0
Y
r MP0 (π0)
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Derivation of the Aggregate Demand (AD) Curve
π0
Y0 Y
π Y
r
IS0
MP0 (π0)
Y0
•
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What Shifts the AD Curve?
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IV. INFLATION ADJUSTMENT
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Key Assumptions about Inflation Behavior
• At a point in time, inflation is given.
• When Y > Y, inflation gradually rises.
• When Y < Y, inflation gradually falls.
• When Y = Y, inflation is constant.
• Note: Y is normal or potential output – the level of output that prevails when prices are fully flexible.
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Inflation fell less in the Great Recession and the (subsequent period of continued high unemployment) than in previous recessions.
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Two Important Points
• Inflation does not respond immediately to deviations of output from potential.
• We are talking about inflation, not prices. Output below potential causes the rate of inflation to fall from one positive number to a smaller positive number.
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Inflation Adjustment Curve (IA)
Y
π
π0 IA
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Short-Run Equilibrium
Y
π
IA0
AD0
π0
Y0
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AD/IA Intersect below Y
Y
π
IA0
AD0
π0
Y0 Y
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AD/IA Intersect above Y
Y
π
IA0
AD0
π0
Y0 Y
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AD/IA Intersect at Y
Y
π
IA0
AD0
π0
Y0 Y
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Long-Run Equilibrium r
Y
π Y
r
rLR
Y
MP
IS
IA
AD
πLR
Y
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V. APPLICATION: RECENT CHANGES IN U.S. FISCAL POLICY
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Recent U.S. Fiscal Developments
• Since last June, the projected deficit for fiscal year 2019 has risen from $700 billion (3% of GDP) to $1.2 trillion (6% of GDP).
• The change is entirely the result of changes in policy, not in the health of the economy: roughly $300 billion from the tax bill, and roughly $200 billion from the budget agreement.
• Most observers think that output is currently very close to potential (𝑌 ≈ 𝑌�).
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A Decrease in T and an Increase in G
Y
π Y
r
IA0 π0
Y
IS0
AD0
MP0
r0
Y
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Impact of a Decrease in T and an Increase in G
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What Happens to the Real Exchange Rate (ε)?
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What Other Disadvantages Might There Be to the Fiscal Developments?
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What Advantages Might There Be to the Fiscal Developments?