UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS - - PDF document

UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS Spring 2018 Professor David Romer LECTURE 10 THE ZERO LOWER BOUND IN THE IS-MP-IA FRAMEWORK FEBRUARY 21, 2018

• I. INTRODUCTION
• II. THE IS-MP-IA MODEL EXTENDED
• A. Assumptions
• 1. The nominal interest rate can’t be negative
• 2. Expected inflation depends on actual inflation
• 3. Discussion
• B. The AD Curve
• 1. Where we are headed
• 2. The IS-MP diagram
• 3. Deriving the AD curve
• C. A Little Bit about the Case of Money Targeting
• III. EXAMPLES
• A. A Large, Long-Lasting Fall in Planned Expenditure
• 1. The initial situation
• 2. The shock
• 3. Aside: Why doesn’t the AD curve shift left by the same amount at

each inflation rate?

• 4. The dynamics of the economy
• 5. What happens when there is a rebound in planned expenditure
• 6. How seriously should we take this?
• B. The Case of “Anchored” Expectations
• 1. Overview
• 2. A model of anchored expectations
• 3. The effects of a large, long-lasting fall in planned expenditure
• 4. A concern: how long can this last?

LECTURE 10 The Zero Lower Bound in the IS-MP- IA Framework

February 21, 2018

Economics 134 David Romer Spring 2018

Announcements

• Problem Set 2 is being distributed.
• It is due at the beginning of lecture a

week from today (Feb. 28).

• Optional problem set work session:

Monday, Feb. 26, 6:45–8:15, in 597 Evans Hall.

• A packet of “sample exam questions” is also

being distributed.

Announcements (cont.)

• For next time, you do not need to read the

paper by Temin and Wigmore.

• My upcoming office hours:
• This week: Usual time: Thursday (2/22),

4–5:30.

• Next week and the week after: Monday

(2/26 and 3/5), 3:30–5:00.

LECTURE 9 The Conduct of Postwar Monetary Policy (concluded)

Economics 134 David Romer Spring 2018

Bad Idea: Inflation Responds Little to Slack

Y π IA0 AD π0 Y Y0

IA will shift down only very slowly in response to Y < Y.

IA1 π1

Y π AD0 π0 Y ,Y1 Y0

No reason to have Y < Y . Result: Inflation doesn’t fall.

AD1

What Policies Are Likely to Be Followed If Policymakers Believe Inflation Responds Little to Slack?

IA0

Y π AD1 π0

No reason to have Y < Y

• believed. Result: Inflation rises.

Y actual Y believed

What If Policymakers Believe Inflation Responds Little to Slack and Have an Overly Optimistic Estimate of Y ?

IA0 IA1 π1

Y r MP1

Fed shifts MP down to get Y = Y believed.

Y actual Y believed

If It Is Monetary Policymakers Who Have These Ideas, What Will Be Going on in IS-MP?

IS0 MP0

How Were Ideas Reflected in Monetary Policy Choices in the Early and Late 1970s?

• No reason to for contractionary policy

because they thought it wouldn’t curb inflation.

• Unrealistic estimates of the natural rate led to

expansionary policy.

• Fed officials pushed for other policies to

control inflation, such as price controls.

• 5

5 10 15 20 Jan-34 Jan-37 Jan-40 Jan-43 Jan-46 Jan-49 Jan-52 Jan-55 Jan-58 Jan-61 Jan-64 Jan-67 Jan-70 Jan-73 Jan-76 Jan-79 Jan-82 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00 Jan-03 Percent

Figure 2 Inflation Rate

Eccles Martin Burns Volcker Greenspan

What Does Romer and Romer’s Analysis Suggest about a Question We Discussed Early in the Course?

• Why did the rise of stabilization policy not

cause the economy to quickly become much more stable?

• Romer and Romer’s analysis provides support

for the “the tools were used badly” hypothesis.

The Unemployment Rate after “Romer & Romer Dates”

• 5

5 10 15 20

Jan-47 May-49 Sep-51 Jan-54 May-56 Sep-58 Jan-61 May-63 Sep-65 Jan-68 May-70 Sep-72 Jan-75 May-77 Sep-79 Jan-82 May-84 Sep-86 Jan-89 May-91 Sep-93 Jan-96 May-98 Sep-00 Jan-03 May-05 Sep-07 Jan-10

Percent

The CPI Inflation Rate after “Romer & Romer Dates”

Interpreting Regression Results – Example: Taylor’s Estimates of the Pre-Volcker Monetary Policy Rule

Note: Numbers in parentheses are t-statistics (coefficient estimate divided by the standard error).

Interpreting Regression Results – Example (cont.)

• For the 1960–1979 sample, Taylor finds a

coefficient on inflation = 0.813, with t-statistic = 12.9.

• Since the t-statistic is >> 2, we can reject the

hypothesis that the coefficient is 0.

• But what is the 2-standard error confidence

interval? Can we reject the hypothesis that the coefficient is 1?

Interpreting Regression Results – Example (cont.)

• Coefficient on inflation = 0.813, t-statistic = 12.9.
• t-statistic ≡ coefficient/standard error, so standard error =

coefficient/t-statistic.

• So: standard error = 0.813/12.9 = 0.063.
• The two-standard error confidence interval is from 2

standard errors below point estimate to 2 standard errors above.

• So: 2-standard error confidence interval = (0.687,0.939).
• 1 is outside this confidence interval, so we can reject (“at

the 5% level”) the hypothesis that the coefficient is 1.

LECTURE 10 The Zero Lower Bound in the IS-MP- IA Framework

Economics 134 David Romer Spring 2018

• I. INTRODUCTION

• II. THE IS-MP-IA MODEL EXTENDED

Key Assumptions: 1 The nominal interest rate cannot be negative

• The central bank would like to set r = r(Y,π).
• Since the real interest rate, r, equals i – πe,

this means that r cannot be less than 0 – πe.

• Thus:

     − ≥ + =

• therwise

π π π) , Y ( r if ) π , Y ( r r

e e

Key Assumptions: 2

• Expected inflation is an increasing function
• f actual inflation.
• That is, πe = πe(π), where πe(π) is an

increasing function.

One Comment Before We Proceed

• We will continue to use the usual IS-MP-IA

model (that is, the model without the zero lower bound) in cases where it is appropriate.

Where We Are Headed: The Aggregate Demand Curve Accounting for the Zero Lower Bound Y π AD

The IS and MP Curves Accounting for the Zero Lower Bound: Step 1 Y r r(Y,π)

0 – πe(π)

IS

The IS and MP Curves Accounting for the Zero Lower Bound: Step 2 Y r MP

0 – πe(π)

IS

Y π Y r Deriving the AD Curve 0 – πe(π0) MP(π0) IS0 π0 Y0

Y π Y r Deriving the AD Curve 0 – πe(π0) MP(π0) IS0 π0 MP(π1) π1 0 – πe(π1) MP(π2) 0 – πe(π2) π2 Y0 Y1 Y2 π0 > π1 > π2

Y π Y r Deriving the AD Curve (continued) IS0 0 – πe(π2) π2 Y2 MP(π2)

Y π Y r Deriving the AD Curve (continued) IS0 MP(π3) π2 Y2 π2 > π3 MP(π2) Y3 π3 0 – πe(π2) 0 – πe(π3)

Deriving the Aggregate Demand Curve: Conclusion Y π AD

A Little Bit about the Case of Money Targeting

• Continue to assume that expected inflation is

lower when actual inflation is lower.

• Suppose that at some inflation rate, π0, the

nominal interest rate is zero. Thus the real interest rate is 0 – πe(π0).

• Now consider lower inflation, π1 (so π0 > π1).
• The lowest possible real interest rate is 0 –

πe(π1), which is higher than the real interest rate at π0, 0 – πe(π0). Thus, r must be higher.

• That is, it is still true that when the economy is

at the zero lower bound, lower inflation raises r.

• III. EXAMPLES

Y π Y r IS1 MP(π0) π0, π1 IS0 IA0, IA1 Y0 (= Y) Y1 Y1 Y0 (= Y) AD0 AD1 Example: A Large, Long-Lasting Fall in Planned Expenditure 0 – πe(π0)

Y π AD if r = r(Y,π) AD if r = 0 – πe(π)

Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate?

Y r IS0 IS1 Y1 Y0 Y r IS0

0 – πe(π)

IS1 Y1 Y0

r = r(Y,π)

Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (continued) A given shift of the IS curve causes a bigger fall in Y (at a given π) if r = 0 – πe(π) than if r = r(Y,π).

Y π AD if r = r(Y,π) AD if r = 0 – πe(π)

Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (continued)

Y π AD0 AD1

Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (concluded)

Y π Y r IS1 MP(π1) 0 – πe(π1)

π1

IA1 Y2 AD1 MP(π2) Y1 IA2

π2

Y A Large, Long-Lasting Fall in Planned Expenditure (cont.) 0 – πe(π2)

Note: Because inflation does not respond immediately to shocks, π1 = π0 (and so IA1 is the same as IA0).

Y π Y r IS1 Y2 AD1 MP(π2) 0 – πe( π2) IA2

π2

Y The Effects of a Large Rebound in Planned Expenditure IS3 Y4 AD3

How Seriously Should We Take This?

The main message, which we should take very seriously: When the economy is at the zero lower bound, a key force keeping the economy stable is inoperative.

Inflation fell less in the Great Recession and the (subsequent period

• f continued high unemployment) than in previous recessions.

Example 2: Anchored Expectations

Two influences on inflation:

• As usual, below-normal output acts to make

firms raise price and wages by less than before. This works to push inflation down.

• Firms’ expectations of inflation act to move

inflation toward π*. When actual inflation is below π*, this works to push inflation up.

A Model of Anchored Expectations

Y π Y r Revisiting a Large, Long-Lasting Fall in Planned Expenditure MP(π*) 0 – πe(π*) π* IS0 IA0 Y0 (= Y) Y0 (= Y) AD0

Y π Y r IS1 MP(π*)

π*

IA1 AD1 Y1 Y A Large, Long-Lasting Fall in Planned Expenditure (cont.) 0 – πe(π*)

With anchored expectations, inflation can stabilize at a level below π* where the upward pull from π* and the downward pull from Y – Y < 0 balance.

A Large, Long-Lasting Fall in Planned Expenditure (concluded) _