1 Ka-fu Wong School of Economics and Finance University of Hong Kong Adjustment to shocks and the...

1

Ka-fu WongSchool of Economics and

FinanceUniversity of Hong Kong

Adjustment to shocks and the role of government

policies

** Prepared for the Professional Development Seminar for Economics Teachers, October 28, 2009.

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Outline

AS-AD model revisited Self-adjustment mechanism

Time paths of output and price level Was Greenspan right in 1996

Long-run growth and inflation The role of the government The great depression and the recent crisis The passive role of Hong Kong

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Exercise #1

Imagine yourself the central banker of a big country (such as the United States). Your objective is to maintain inflation within a narrow range with the policy tool of an overnight interest rate (such as the Federal fund rate). You have been seeing the following data lately.

YearsGDP Growth

Unemployment Rate

Inflation Rate

1985-1995 2.80% 6.30% 3.5

1995-2000 4.10% 4.80% 2.5 Would you choose to raise the target interest rate?

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AS-AD model revisited Planned aggregate expenditure

PAE = C + I + G + NXC=a1+a2(Y-T)+a3r+a4W

I=b1+b2r

NX = d1+d2q

r = i -

q = ep*/p

Real interest rate

Real exchange rate

e = domestic currency per foreign currencyNominal exchange ratep*= price of foreign good in foreign currency

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Equilibrium output at a given price level

Y = PAE

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Determination of Short-Run Equilibrium Output

Output Y

Pla

nn

ed a

gg

reg

ate

exp

end

itu

re P

AE

960

Expenditure line PAE = 960 + 0.8Y

Slope = 0.8

45o

Y = PAE

4,800

Equilibrium Algebraically •At equilibrium: Y=PAE• PAE = 960 + 0.8Y• Y=960+0.8Y• 0.2Y = 960• Y = 960/0.2 = 4,800 in equilibrium

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Aggregate Demand

A relation between the equilibrium output and the price level.

Y = PAE (p1)

Y = PAE (p2)

Y = PAE (p3)

…

⇒ Y1

⇒ Y2

⇒ Y3

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⇒ real wealth ↑⇒ interest rates ↓⇒ exchange rate ↓

Price Level (P)

Quantity of output (Y)

0

AD

P1

P2

Y1 Y2

The Aggregate-Demand curve

⇒ consumption ↑⇒ consumption ↑, investment ↑ ⇒ net export ↑

P ↓

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In the short run,P ↓ ⇒ Y ↓ sticky wages,sticky prices, ormisperceptions.

Price Level (P)

Quantity of Output (Y)

0

P1

Y1

SRAS (Pe)

P2

Y2

The short-run aggregate-supply curve

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Output, Y, and the price level , P, adjust to the point at which the aggregate-supply, AS, and aggregate-demand, AD, curves intersect.

Price Level (P)


0

P*

Y*

AS

AD

Aggregate Demand and Aggregate Supply

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In the long run, Y depends on:labor,capital,natural resources, andtechnology.

… but not on P.

Thus, the LRAS curve is vertical at YN.

Price Level (P)


0

Natural rate of output

LRAS

P1

YN

P2

The Long-run Aggregate-supply curve

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Price Level (P)


0

Natural rate of output

SRAS

AD

A

LRAS

P*

YN

The Long-run equilibrium

In the long run, AD meets LRAS at point A.

Expected price level adjusts to equal the actual price level.

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0

SRAS1

AD

LRAS

P1

Y1Y2

A

Price Level (P)


Self-adjustment towards the long-run equilibrium

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Union wage contracts set wages for several years.

Contracts setting the price of raw materials and parts for manufacturing firms also cover several years.

These long-term contracts reflect the inflation expectations or price level expectation at the time they are signed.

Slow shifts in SRAS due to Long-term Wage and Price Contracts

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The Output Gap and Inflation

Relationship of outputto potential output Behavior of inflation

1. No output gap Inflation remains unchangedY = Y* (Price level remains unchanged)

2. Expansionary gap Inflation risesY > Y* (Price level rises)

3. Recessionary gap Inflation fallsY < Y* (Price level falls)

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0

SRAS1

SRAS3

AD

LRAS

P1

P2

Y1Y2

B

A

Price Level (P)


Self-adjustment of recessionary gap

SRAS2

Recessionary gap

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0

SRAS3

SRAS1

AD

LRAS

P1

P2

Y1 Y2

B

A

Price Level (P)


Self-adjustment of expansionary gap

SRAS2

Expansionary gap

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0

SRAS1

AD1

SRAS3

AD2

LRAS

P1

P2

P3

Y1Y2

A

C

B

Price Level (P)


A Contraction in aggregate demand

SRAS2

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Adjustment of output

Time

Y

0

Y1

Y2

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Adjustment of price level

Time

P

0

P1

P3

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0

SRAS2

SRAS1

AD1

LRAS

P2

P1

Y1Y2

C

B

Price Level (P)


Exercise #2Impact of an increase in oil prices

Sketch the possible time paths showing the impact of this oil shock if the government and the central bank do nothing to accommodate the shock.

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0

SRAS2

SRAS1

AD1

LRAS

P2

P1

Y1Y2

C

B

Price Level (P)


An increase in oil prices

SRAS1

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Time

Y

0

Y1

Y2

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Time

P

0

P2

P1

25

0

SRAS1

AD1

SRAS3

LRAS1

P1

P2

Y1 Y2

A

B

Price Level (P)


An increase in productivity (due to technological changes)

SRAS2

LRAS2

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Time

Y

0

Y1

Y2

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Time

P

0

P1

P2

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Exercise #1

Imagine yourself the central banker of a big country (such as the United States). Your objective is to maintain inflation within a narrow range with the policy tool of an overnight interest rate (such as the Federal fund rate). You have been seeing the following data lately.

YearsGDP Growth

Unemployment Rate

Inflation Rate

1985-1995 2.80% 6.30% 3.5

1995-2000 4.10% 4.80% 2.5 Would you choose to raise the target interest rate?

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U.S. Macroeconomic Data, Annual Averages, 1985-2000

% Growth in Unemployment Inflation ProductivityYears real GDP rate (%) rate (%) growth (%)

1985-1995 2.8 6.3 3.5 1.4

1995-2000 4.1 4.8 2.5 2.5

Was Greenspan right in 1996?

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0

AD2000

AD1980

LRAS1980

P200

0

P1990

P198

0

Y1990Y1980

Price Level (P)


LRAS1990 LRAS2000

AD1990

Y2000

Long-run growth and inflation

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Government intervention

In the long run, we are all dead!

Short-run adjustments are painful!

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0

SRAS1

AD1

SRAS3

AD2

LRAS

P1

P2

P3

Y1Y2

A

C

B

Price Level (P)



SRAS2

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Time

Y

0

Y1

Y2

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The usefulness of fiscal and monetary policy

A slow self-correcting mechanism Fiscal and monetary policy can help stabilize

the economy. A fast self-correcting mechanism

Fiscal and monetary policy are not effective and may destabilize the economy.

The speed of correction will depend on: The use of long-term contracts. The efficiency and flexibility of labor markets.

Fiscal and monetary policy are most useful when attempting to eliminate large output gaps.

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Fiscal policies

Government expenditure Taxation

Takes time to pass a legislation Takes time to implement

Supply-side policiesTaxation

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Monetary policy

Interest rate Discount rate Reserve requirement

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0

SRAS1

AD1AD2

LRAS

P1

P2

Y1Y2

A

B

Price Level (P)



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Time

Y

0

Y1

Y2

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0

SRAS2

AD2

SRAS1

AD1

LRAS

P1

P2

P3

Y1Y2

A

C

B

Price Level (P)


An increase in oil priceswith accommodation policy

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Time

Y

0

Y1

Y2

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0

SRAS1

AD1

SRAS3

LRAS1

P1

P2

Y1 Y2

A

B

Price Level (P)


An increase in productivity (due to technological changes)

SRAS2

LRAS2

Do nothing!

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The Fed’s Role in Stabilizing Financial Markets:Banking Panics

Suppose: Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to

meet the depositors demand. The bank fails and further erodes depositor confidence

which triggers additional failures.

The Fed to the rescue: Instill confidenceDiscount lendingOpen Market Operations

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The banking panics of 1930 - 1933 and the money supply

One-third of U.S. banks closed Depositors withdrew their funds Banks raised the reserve-deposit ratio

(banks were not willing to lend, considering loans too risky.)

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Key U.S. MonetaryStatistics, 1929-1933

Currency Reserve-deposit Bank Moneyheld by public ratio reserves supply

December 1929 3.85 0.075 3.15 45.9

December 1930 3.79 0.082 3.31 44.1

December 1931 4.59 0.095 3.11 37.3

December 1932 4.82 0.109 3.18 34.0

December 1933 4.85 0.133 3.45 30.8

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The banking panics of 1930 - 1933 and the money supply

In response to the panics of 1929-1933, deposit insurance was established in 1934.

Deposit insurance gives depositors an incentive to keep their money in the banks.

Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank.

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Recent crisis:No response to expansionary monetary policy?

Liquidity trapThe demand for money becomes infinitely

elastic, i.e. where the demand curve is horizontal, so that further injections of money into the economy will not serve to further lower interest rates.

If the economy enters a liquidity trap area, monetary policy will be unable to stimulate the economy.

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Recent crisis:No response to expansionary monetary policy?

Credit rationing Banks maintain an interest rate lower than the market-

clearing level. Excess demand for loans allows banks to choose the

more profitable projects. When investment becomes more risky, banks are more

cautious.

Joseph E. Stiglitz and Andrew Weiss's 1981 paper explains why the bank (or any lending institution for that matter) may credit ration its borrower if 1) the bank was unable to perfectly distinguish the risky borrowers from the safe ones 2) the loan contracts were subject to limited liability (if projects returns were less than the debt obligation, the borrower bears no responsibility to pay out her pocket).Stiglitz, J. & Weiss, A. (1981). Credit Rationing in Markets with Imperfect Information, American Economic Review, vol. 71, pages 393-410.

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What can the Fed do if Fed funds rate is near zero

Fed can buy other assets such as treasury bonds or stocks (affect long interest rate)

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Policymaking: Art or Science?

Requirements for Perfect Macroeconomic Policy Accurate knowledge of current economic

conditions Knowledge of the future path of the economy

without policy The precise value of potential output Complete and immediate control of fiscal and

monetary policy Knowledge of how and when the economy will

respond to policy changes

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Lags in the effect of macroeconomic policy: Inside Lag (of macroeconomic policy)

The delay between the date a policy change is needed and the date it is implemented

Outside Lag (of macroeconomic policy)The delay between the date a policy

change is implemented and the date by which most of its effects on the economy have occurred

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How to design macroeconomic policy?

“Cross the River by Groping the Stone Under Foot” or “Feeling for rocks while crossing a river”

“Feeling for rocks while crossing a river” connotes a gradual progress: When a step forward does not feel right, a step in another direction might be necessary.


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The passive role of Hong Kong

The linked exchange rate does not allow independent monetary policyUncovered interest rate parity restricts Hong

Kong’s interest rate to be very close to that of the US.

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Impact of an expansionary monetary policy in the US

Low US interest rate

Low HK interest rate

AD increases

Y increases in the long runP increases in the long run

short

Asset and property bubbleswealth effect?

Investment and consumption

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0

SRAS1

AD1

SRAS3

AD3

LRAS

Y1 Y2

A

C

B

Price Level (P)


Changes in aggregate demand due to changes in the US monetary policies

SRAS2

AD2

Y3

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Time

Y

0

Y1

Y3

Y2

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Adjustment of inflation

Time

P

0

P1

P3

P2

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Role of Hong Kong government?

Monetary policy: By adopting the linked exchange rate system, we have given

up our autonomy of monetary policy. Fiscal policy:

We still have autonomy fiscal policy. It is tempting to use fiscal policy to accommodate the shocks.

But fiscal policy is slow to take effect. By the time we see the effect, the US monetary policy might have shifted in the opposite direction. If so, the active HK’s fiscal policy may destabilize the output.

Alternative: Make Hong Kong economy more flexible in adjusting to shocks.

Improve the matching of job-seekers and vacancies. Encourage shorter job contract? Reduce the use of the government fiscal policy to stabilize

the economy (government policies tend to be slow!)

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End

1 Ka-fu Wong School of Economics and Finance University of Hong Kong Adjustment to shocks and the...

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