The Limits of Demand Management 5.4 Policy responses to shocks - - PowerPoint PPT Presentation

The Limits of Demand Management

 So far:

 Dynamic AS-AD model  Central bank only follows its predetermined Taylor Rule (except in case

• f shift in monetary policy)

 Government is not intervening to reduce the initial shock.

 Today:

 What can a government do to influence the growth performance

• f the economy?

 Aggregate demand policies: Fiscal policy and Monetary policy (CB)  Macroeconomic stabilization (Chapter 17)

 Supply-side policies / structural reforms (not treated in detail in this course)

• What should it do?

Macroeconomic Policy

5.4 Policy responses to shocks

Outline

1.

The effects of policy interventions in theory

1.

Supply shock

2.

Demand shock

2.

Neoclassicals vs. Keynesians

3.

Macroeconomic policy and business cycles

1.

Impulse Propagation Mechanism

2.

Policy lags

Literature Chapter 16:

• 16.1 + 16.2 (16.2.3 was already covered together with Chapter 6)
• 16.3.1 + 16.3.2
• 16.4.1 + 16.4.4
• Not necessary: 16.3.3, 16.4.2, 16.4.3

Introduction

 What can policy makers do in case of a negative demand or

supply shock?

 Fiscal policy  Monetary policy

 Expansionary versus contractionary

 Reminder: fiscal policy under flexible exchange rates is NOT or only little

effective in a small & open economy, under fixed exchange rates it is monetary policy that is ineffective. Both are effective in an economy without free international capital flows or in a big & open economy with flexible exchange rate (EU or US).

 Different consequences in case of  Supply shock  Demand shock

 Consequence depend also on how expectations are formed and speed

• f adjustment

Supply shock & demand policies

• 1. Policy responses to shocks

LAD AS´ LAS AS AD Inflation B

Stagflation: both unemployment and inflation increase. We study three possible measures to bring the economy quickly back to the LAS curve.

Output gap A

Adverse supply shock

 If s >0  Shift in the AS curve:

s aYgap     ~

1.1 Policy responses to shocks – supply shock

Supply shock & demand policies – Option 1

 Suppose we try to fight resulting unemployment with

expansionary demand policies... AD´ AS´ LAS LAD AD Inflation B C

We successfully fight unemployment, but at a cost

• f increased inflation in the

long-run. New eq: at C (LAD curve would need to shift up).

Output gap A

1.1 Policy responses to shocks – supply shock

 ... or we try to fight the inflationary impact of the adverse

supply shock through a contractionary policy. LAD AD´´ AS´ LAS AD AS Inflation B D

We successfully fight π but at a cost of increased unemployment (via point D) until we return to the long-run eq. at A.

Output gap A

Supply shock & demand policies – Option 2

1.1 Policy responses to shocks – supply shock

 Third option: Central bank announces credibly that

inflation will be at its target level.

 Aim: stop the underlying inflation from increasing to allow a

swift return to the initial AS curve and initial equilibrium.

 Role of expectations: importance of forward looking

component of underlying inflation

 Foward looking component: inflation target set by the CB (in the LR

inflation is determined by money supply!)

 If a country suffers from high inflation: high inflation expectations

drive actual inflation further up

 If the CB can now make a credible statement that it will not increase

money supply, inflation expectations are low nominal wages & prices set low  actual inflation decreases.

Supply shock & demand policies – Option 3

1.1 Policy responses to shocks – supply shock

 Third option: Central bank announces credibly that inflation

will be at its target level. LAD AS´ LAS AD AS Inflation B

If people expect inflation to be at its target level, AS curve shifts back to its

• riginal position.

We return directly to the long-run equilibrium at A.

Output gap A

Supply shock & demand policies – Option 3

1.1 Policy responses to shocks – supply shock

AD´ LAS AD AS Inflation A B Output gap

Adverse demand shock

 An adverse demand shock brings the economy from point

A to point B…

1.2 Policy responses to shocks – demand shock

AD´ LAS AD AS Inflation A B Output gap

Adverse demand shock

 AD policy change to offset demand shock

 To go back to point A: Expansionary fiscal or expansionary

monetary policy

1.2 Policy responses to shocks – demand shock We return directly to the long-run equilibrium at A. No fear for high inflation (above target level)

Neoclassicals vs Keynesians

 What is the role of demand management policies in

practice?

 In theory this works. But are they actually successful?

 Mixed results

 The debate: Keynesians  Neoclassicals

• Do we need to adjust?
• What is the speed of adjustment?
• 2. Neoclassicals versus Keynesians

John Maynard Keynes 1883-1946 Milton Friedman 1912-2006

Rational expectations & adjustments

 The speed of price adjustment depends on the expectations

formation mechanism

 If expectations are backward looking, depending only on the

past, the adjustment takes a long time (see next slide)

But backward looking expectations are not “consistent”, i.e.

they imply that people make systematic errors.

• In the case of rational expectations, expectations are

“consistent” i.e. people do not make systematic errors,

• The agents “know” the model, and the speed of adjustment can

be very high.

• 2. Neoclassicals versus Keynesians

LAD

Inflation

AD LAS

A C Output gap

t

 ~

n t n t   

 ~

t



Recall: shift of the AS curve

B

1

~





t t

 

ASt ASt+1 ASt+n

t gap t t

s aY     ~

Adaptive expectations: Underlying π = previous year’s observed inflation  slow shift of Ast via Ast+1 to ASt+n Rational expectations: Underlying π = long run inflation  direct shift from ASt to Ast+n

• 2. Neoclassicals versus Keynesians

Shift of the AS-curve

Why does the short run AS-curve shift?

Year t: ASt

 in A: inflation in year t < underlying (expected) inflation  (compare with inflation in C, the intersection AS –LAS)  Underlying inflation falls  Based on the new underlying inflation, firms and unions negotiate the

(expected) real wage which should bring the economy to Un  nominal wages

 Short-run AS-curve shifts downwards (to the right)

Year t+1: ASt+1

 Inflation lower than expected real wages higher than expected  Ut+1 > Un , but Ut+1 < Ut since inflation closer to expected inflation than

in t  real wages in t+1 < real wages in t

 Labor cheaper than in t firms are willing to employ more workers and

produce more

• 2. Neoclassicals versus Keynesians

Key elements of Keynesian theory

 Keynesians: Prices are sticky

 Adjustment of prices and wages takes time

 nominal rigidities, long term contracts

 Backward-looking component dominates

 wage indexation

 Consequence: short run AS curve shifts only slowly

• We are not always on the LAS curve.
• We have free capacities that can be used
• In case of recession, we should intervene to get back to LAS

quickly

“In the long-run we are all dead”

• 2. Neoclassicals versus Keynesians

Inflation

 In the case of a negative demand shock…

AS

AD LAS A C AS

AS ...what if the underlying inflation only adjusts very slowly? Output gap

The Keynesian case

Starting point: left

• f the LAS curve

B

• 2. Neoclassicals versus Keynesians

Inflation AS AD B LAS A  AD AD Output gap

The Keynesian case

 Government

intervention is desirable…

 (fiscal policy under fixed

exchange rates, monetary policy under flexible exchange rates, both in closed or big and open economy)

 …rather than wait

for underlying inflation to adjust enough to get back to the trend. C

Favorable demand policy brings economy quickly back to LAS. Gain: earlier back to trend GDP.

• 2. Neoclassicals versus Keynesians

Key elements of the Neoclassics

 Neoclassics: Prices are flexible

 Fast adjustment of prices and wages  Foward-looking component dominates

 Consequences: short run AS curve shifts quickly back to

the equilibrium on the LAS (anticipations adjust quickly)

• We will never be far away from the equilibrium
• No free capacities (unemployment at its natural level)
• No room for demand management policies
• 2. Neoclassicals versus Keynesians

Output gap Inflation AS

 Expansionary policy stimulates the economy, BUT…

 (fiscal policy under fixed exchange rates, monetary policy under flexible

exchange rates, both in closed or big and open economy)

AD A LAS  AD AD Short-run: output gain B

The neoclassical case – no shock

Starting point: ON the LAS curve

• 2. Neoclassicals versus Keynesians

The neoclassical case – no shock

 ...underlying inflation reacts to the impact of the policy.

Inflation AS AD A LAS  AD B C AS AS

Long-run: no

• utput gain, but

higher inflation

Output gap

• 2. Neoclassicals versus Keynesians

Inflation AS AD A LAS D AS AS  AD AD Output gap

The neoclassical case – adverse shock

 If underlying π adjusts

quickly, actual π drops quickly.

 That means: people

understand the relationship between actual and underlying inflation.

 Adaptation of

expectations if negative demand shock (or lower inflation target) is believed to be long-term (rational expectations).

As soon as expectations are correct: we are on the LAS curve!

• 2. Neoclassicals versus Keynesians

Summary

 Keynesians

 Sticky prices lead to a dominating backward-looking component

 slow adjustment

 We can be for a long time off the LAS curve

• Demand policies help to get back on track

 Neoclassics

 Foward-looking component dominates  fast adjustment  We should always come back quickly to the LAS curve  We will never be far away from the equilibrium

• No room for demand policies
• 2. Neoclassicals versus Keynesians

How to explain business cycles

• 1. Deterministic view of business cycles

 Today’s situation depends mechanically on the economic

history



Problems of the deterministic model:

• Generates regular business cycles, reproducing themselves
• 2. Stochastic view of business cycles

 Economy is hit regularly by random shocks → the economic

system leads to the propagation of the shock → over time: back to equilibrium → new shock…

Economic System

Cycles Random Shocks

• 3. Business cycles and Macroeconomic policies

Impulse-Propagation Mechanism

Impulse-propagtion mechanism

 We use the AS-AD framework  Central idea:

 Economy is hit by a shock

 Supply shock or demand shock

 Response of the economy to a shock takes time  There are lags in the shift of AD and AS

 AD shifts slowly: it takes time for a policy to take an effect in the real

economy

 AS shifts slowly: underlying inflation adjusts only gradually

• 3. Business cycles and Macroeconomic policies

AS-AD: positive demand shock



AD

AS

A

 

A

Output gap Output gap

• 3. Business cycles and Macroeconomic policies

AD  AD

Increase in the government spending increases output and inflation

AS

A A B

 

Output gap Output gap

B



• 3. Business cycles and Macroeconomic policies

Underlying inflation adjusts and AS shifts upwards

 AD

AS  AS

A A B

 

Figure 16.06

Output gap Output gap

• 3. Business cycles and Macroeconomic policies

Lagged policy effects lead to further shift of AD (see also Keynesian

multiplier)

 AD

 AS

A A B

C

 

 AD

Figure 16.06

Output gap Output gap

B

C

• 3. Business cycles and Macroeconomic policies

Further upward shift in underlying inflation and AS

 AD

 AS

A A B

C

D

 

 AS

Figure 16.06

Output gap Output gap

B

C

D

• 3. Business cycles and Macroeconomic policies

AS´´  AS´´´

 AD

 AS

A A B

C

D B

C

D

  

Output gap Output gap

AS´´´ AD´´´

E E

If expansionary policy is reversed: a shift of AD´´  AD´´´...

• 3. Business cycles and Macroeconomic policies

• Adverse supply shocks:
• 1973-74 First oil price

shock

• 1979-81 Second oil price

shock

• Demand shocks:
• 1990 Reunification (+)
• 1992 Bundesbank applies

more restrictive monetary policy (-)

Source: Dustmann, Glitz and Vogel, 2010, “Employment, wages, and the economic cycle: Differences between immigrants and natives,” European Economic Review, 54 (1)

Explaining short run fluctuations

• 3. Business cycles and Macroeconomic policies

1994 1993

0.0 1.0 2.0 3.0 4.0 5.0

• 2%
• 1%

0% 1% 2% 3%

Output (deviations from trend) Inflation (%)

Example: Counterclockwise loop observed in West Germany after reunification

1992 1991 1990

Figure 16.11

• 3. Business cycles and Macroeconomic policies

Riding out an adverse supply shock without an AD response

Output gap Inflation

A AD AS B AS´ AS A A

• 3. Business cycles and Macroeconomic policies

5 10 15 20 25

• 3% -2% -1% 0% 1% 2% 3% 4% 5%

Output (deviations from trend) Inflation (%)

United Kingdom. Oil price shock 1973-74.

1976 1975 1974 1973 1977

• 3. Business cycles and Macroeconomic policies

Uncertainty and policy lags

• Can the government effectively conduct policy?

 Economic policy is characterized by a series of `lags’

 Recognition lag  Decision lag  Implementation lag  Effectiveness lag

  it is possible that a policy that was meant to be

countercyclical actually reinforces the cycle.

3.2 Business cycles and Macroeconomic policies – policy lags

B amplified cycle A smoother cycle

Lags and demand management policy

Time Output

Business cycle 3.2 Business cycles and Macroeconomic policies – policy lags

Friedman critique

 Friedman:

 Ill-timed policy intervention might worsen the cycle  Sometimes it is better to do nothing!

 Possible actions for policy makers:  Automatic stabilizers

 Policies that stimulate or depress the economy when necessary

without any deliberate policy change  Watch the so-called ‘leading indicators’

 New orders, index of stock prices

(if firms have many new orders, sign for growth) 3.2 Business cycles and Macroeconomic policies – policy lags

Conclusion

Conclusion  Despite the many drawbacks, demand management policies

have been proven successful in many occasions:

 In particular effective when large exogenous shocks hit the

economy

 09/11

 Current financial crisis: AD shifted left

 Fed and ECB: increase in money supply  AD shifts right  US government: decrease in taxes  AD shifts right

 European governments: small open economies, fiscal policy

ineffective (Ch. 11)

• What will happen next?

 Swift return to trend? Inflation?