Three Journal About Macroeconomics, Fiscal Policy, And Mundell - Fleming

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MACROECONOMICS PAPER

Three Journal About Macroeconomics, Fiscal Policy,

and Mundell - Fleming

Lecture : Dias Satria SE., M.App.Ec.

Andistya Oktaning Listra (0910210022)Faculty Of Economy

Economic Development Major

University Of Brawijaya Malang



A. Natural Disasters Impacting a Macroeconomics Model withEndogenous Dynamics

RESUME

Natural disaster might depend on the pre-existing economic situation. Therecovery eff ect from the additional activity due to reconstruction might, in fact, havecompensated, at least partly, the direct damages of the disaster. Investigating thisproblem requires one to model economic fluctuations, and macroeconomists are stillquite divided on how best to do this. The dominant one today is known as realbusiness cycle (RBC) theory and is implemented within Stochastic Dynamic GeneralEquilibrium models. It originates from embedded into the general equilibriumframework with rational expectations. This theory assumes that economic fluctuationsarise from exogenous shocks and that the economic system is otherwise stable. Thesecond one is Endogenous Business Cycle (EnBC) theory, which proposes thateconomic fluctuations are due to intrinsic processes that endogenously destabilize theeconomic system. The existence of these two alternative theories of economicfluctuations is a significant obstacle in attempting to assess the economic cost of

natural disasters. Overcoming the controversy between the RBC and EnBC theoriesand achieving a constructive synthesis between the two would thus reduce in asignificant manner uncertainties in the assessment of disaster and policy costs. On theother hand, investigating the consequences of exogenous shocks, like naturaldisasters, can also provide useful insights into economic behavior in general and helpachieve a unified theory of business cycles.

Non-Equilibrium Dynamic Model (NEDyM) exhibits business cycles thatreproduce several realistic features of the historical data which natural disastersdestroy the productive capital through the use of a modified production function and inwhich reconstruction investments are explicitly represented. NEDyM to show that theparticular phase of a business cycle matters greatly in assessing the economic impacts

of natural disasters. In our EnBC model, this impact is enhanced by internal economicprocesses when the shock occurs during an expansion phase, while the opposite isthe case during a recession. The NEDyM investment flexibility summarizes manycharacteristics of an economy, and diff erences in can arise from many factors:

a. Investing more requires producing more investment goods, and this cannot bedone instantaneously.

b. What is true for the productive capital is also valid for human capital.

c. Diff erences in capital market and financial situation can explain differences ininvestment flexibility at the firm level , also making a diff erence betweendeveloped and developing countries.

d. Investment flexibility depends on company management and cultural factors.

To evaluate how the cost of a disaster depends on the pre-existing economicsituation, we apply the same loss of productive capital at di erent points in time alongff the models business cycle. To assess the total GDP loss, we use the di erenceff between the 20-year total production in a baseline scenario, with no disaster, and the



20-year total production in the disaster scenario; no discounting was applied inassessing this di erence.ff

CHAPTER 1

INTRODUCTION

Benson and Clay (2004), among others, have suggested that the overall cost of a natural disaster might depend on the pre-existing economic situation. The recoveryeff ects from the additional activity due to reconstruction might, in fact, havecompensated, at least partly, the direct damages of the disaster. Investigating thisproblem requires one to model economic fluctuations, and macroeconomists are stillquite divided on how best to do this. Two main theories have attempted, over theyears, to explain the causes and characteristics of business cycles. The dominant

one today is known as real business cycle (RBC) theory and is implemented withinStochastic Dynamic General Equilibrium models with rational expectations. Thistheory assumes that economic fluctuations arise from exogenous shocks and that theeconomic system is otherwise stable. The second one is Endogenous Business Cycle(EnBC) theory, which proposes that economic fluctuations are due to intrinsicprocesses that endogenously destabilize the economic system Both theories havetheir successes and shortcomings, but it is RBC theory that garners consensus in thecurrent economic literature.

The existence of these two alternative theories of economic fluctuations is asignificant obstacle in attempting to assess the economic cost of natural disasters,such as hurricanes or earthquakes, or of other exogenous shocks, e.g., the

implementation of climate policies aimed at reducing the emissions of greenhousegases. Indeed, to carry out such an assessment, one has to decide first within whichmacroeconomic setting to work, as the underlying economic hypotheses can stronglyinfluence the results. Overcoming the controversy between the RBC and EnBCtheories and achieving a constructive synthesis between the two would thus reduce ina significant manner uncertainties in the assessment of disaster and policy costs. Onthe other hand, investigating the consequences of exogenous shocks, like naturaldisasters, can also provide useful insights into economic behavior in general and helpachieve a unified theory of business cycles. The validation of RBC and EnBC modelsagainst 3the history of past disasters could provide evidence in support of such aunified theory. To do so, we apply the Non-Equilibrium Dynamic Model (NEDyM) of Hallegatte et al., which exhibits business cycles that reproduce several realistic

features of the historical data. We introduce into this model the disaster-modelingscheme of Hallegatte et al, in which natural disasters destroy the productive capitalthrough the use of a modified production function and in which reconstructioninvestments are explicitly represented. In the latter paper, however, disasters wereinvestigated in an economy initially at equilibrium. The main contribution of thepresent article is to consider a fluctuating economy, and to investigate the sensitivityof the economic consequences of natural disasters with respect to the phase of thebusiness cycle. From this, we summarize the main features of NEDyM emphasizingthe role of investment flexibility in the model solutions’ behavior.



CHAPTER 2

RESEARCH QUESTION

1. Why endogenous dynamic in macroeconomics model impacting bynatural disaster?

2. Why natural disasters also influence financial condition in the country?

3. How about macroeconomics cost of natural disaster?

4. How about the catastrophic natural disaster and economic growth?

5. What is endogenous business cycles and the economic response toexogenous shocks?

6. Why long term policy consequences of natural disasters?

7. Describe the implications for relief and post-disaster reconstruction?

8. What is political model of natural disasters?

9. What we should be looking at are the underlying social and economicprocesses within developing countries which structure the impact of naturaldisasters, rather than at disasters as unforeseen events requiring large scaleintervention?



CHAPTER 3

METHODS FROM MACROECONOMICS JOURNAL

1. The main changes applied to the basic Solow model, starting with its core set of equations where Y is production, K is productive capital, L is labor, A is totalproductivity, C is consumption, S is consumer savings, I is investment,

is the investment (or, equivalently, saving) ratio, ,, is the depreciation time, and

is the labor at full employment:



2. Goods market: A goods inventory H is introduced, opening the possibility of temporary imbalances between production and demand, instead of a marketclearing at each point in time. Thus

This inventory can be either positive or negative and it encompasses all sources of delay in the adjustment between supply and demand, including technical lags inproducing, transporting and distributing goods. Its situation aff ects pricemovements:

Thus price adjustments do not operate instantaneously and the conventionalmarket clearing conditions are verified only over the long term.

3. Labor market : The producer sets the optimal labor demand that maximizes

profits, as a function of real wage and marginal labor productivity:

But full employment is not guaranteed at each point in time, because (i) institutionaland technical constraints create a delay between a change in the optimal labor demand and the corresponding change in the number of actually employed workers:

and (ii) wages are partially rigid over the short term; they progressively restore the fullemployment rate by increasing if labor demand is higher than and decreasingwhen it is lower:

4. Household behavior : Like the Solow model, NEDyM uses a constant saving ratio but itmakes the tradeoff between consumption and saving more sophisticated byconsidering that households (i) consume (ii) make their savings available for investmentthrough the savings, and (iii) hoard up a stock of money that is not immediatelyavailable for investment.

5. Producer behavior : Instead of automatically equating investments and savings),NEDyM describes an investment behavior “`” It introduces a stock of liquid assets Fheld by banksand companies, which is filled by the diff erence between sales p(C+I)and wages wL, and by the savings S received from consumers. Theseassets are usedto redistribute share dividends. Div and to invest in the amount pI . This formulationcreates a wedge between investment and savings, reflected by changes in F:



The dynamics of the system is governed by an investment ratio that allocates theseassets between productive investments and share dividends:

The producer’s net profit follows the accounting definition of profit that is grossprofits minus capital depreciation:

and the investment ratio follows the prognostic rule:

The distribution between dividends and investment depends on the expected net profitsper capital unit compared with a standard of profitability ν. If the expected net profitper capital unit is higher than this standard, the producer increases his/her physical investments; if, on the contrary, the expected profit is lower than ν, investmentsare reduced. Assuming that observed values are the best guess of expected values ateach point in time leads to:

6. Cobb Douglas Function

Eff ective capital is K = ξK

is the potential productive capital, which is the stock of capital in the absence of any

disaster.



With this new function, a destruction of x% of the productive capital reduces productionby x%. The replacement of the productive capital K by the two new variables K0 and ξKmakes it necessary to modify the modeling of investment and to introduce thedistinction between regular investments, carried out to increase the production capacity,and reconstruction investments that follow a disaster. To capture how these constraints

may impact the pathways back to equilibrium, we bounded by the fraction of total

investment that reconstruction can mobilize.



Long-term averaged GDP losses due to the distribution of natural disasters for di erent types of economic dynamics of the table) or very low (not shown), theff economy is incapable of responding to the natural disasters through investmentincreases aimed at reconstruction. Total production losses, therefore, are very large,amounting to 0.15% of GDP when the flexibility is null. Such an economy behaves

according to a pure Solow growth model, where the savings, and therefore theinvestment, ratio is constant.

When investment can respond to profitability signals without destabilizing theeconomy, i.e. when αinv is non-null but still lower than 1.39, the economy has a newdegree of freedom to improve its situation and respond to productive capital shocks.Such an economy is much more resilient to disasters, because it can adjust its levelof investment in the disaster’s aftermath: for αinv = 1.0 (second row of the table),GDP losses are as low as 0.01% of GDP, a decrease by a factor of 15 with respect toa constant investment ratio, thanks to the added investment flexibility.



A).

CHAPTER 4

PREVIOUS STUDIES OR REFERENCES

1. TITLE

Understanding the Economic and Financial Impacts of Natural Disaster byCharlotte Benson and Edward J. Clay

2. FORMULATION OF THE PROBLEM

1. What is the impact of natural disasters in economic, financial, and publicpolicy?

2. Can disasters impose continuing pressures on public finance to the extentthat governments undertake mitigation and preparedness measures?

3. How about financial inventory to overcome lack of cost causes by naturaldisasters risk in the future?

3. METHODS

1. The quantitative investigations are partial, involving a combination of regression analysis, the use of charts to examine movement around trends,and “before-and-after” comparison of disaster impacts and of forecast andactual economic performance. The implied null hypothesis is that there is nodirect link between disaster shocks and the relevant aspect of economicperformance. Such analysis cannot always be definitive, but the results atleast provide a basis for further reflection and investigation. If impacts are notapparent at an aggregate level, the analysis moves on to consider possibleeffects within the composition of the relevant economic indicator. A qualitativepolitical-economic analysis is also employed in a complementary way toplace quantitative results within the specific economic and social policycontext of each case study country. Where similar qualitative resultsrepeatedly emerge from previous and current studies, this is taken to bepreliminary evidence of a more general finding about the economicconsequences of natural disasters.

2. A natural modeling option to represent disasters is to consider that theyreduce instantaneously the total productive capital K by an amount ∆K. Toavoid underestimating natural disaster impacts because of decreasing returnsin the production function the Cobb-Douglas production function by

introducing a term ξK, which is the proportion of capital that was notdestroyed. This new variable ξK is such that the eff ective capital is K = ξK ·K0, where K0 is the potential productive capital, which is the stock of capitalin the absence of any disaster. Instead of replacing K by ξK ·K0 in Eq. (A-2),we introduce the new production function:



With this new function, a destruction of x% of the productive capital reducesproduction by x%. The replacement of the productive capital K by the twonew variables K0 and ξK makes it necessary to modify the modeling of investment and to introduce the distinction between regular investments,carried out to increase the production capacity, and reconstructioninvestments that follow a disaster. Denoting by In the investments that

increase the potential capital K0, and by the reconstruction investmentsthat increase ξK, we have:

4. RESULT

Hypotheses:

The null hypothesis is that there is no relationship i.e. β1 = 0. We usually hopeHA is true. Look at the p value or sig value (based on a t statistic).

Y depend on X (Y depend on X factor for instance economic, financial, and

public policy which impacting by natural disaster )

Remember that we have a small sample and are trying to estimate arelationship between variables in a target population.

• Consider Y = β0 + β1 X + ε.

• If X changes, Y must change.

• If X increase by 1 unit, Y increases by β1 units.

• Unless, of course, β1 = 0.

• Then Y doesn’t depend on X.

• This is how our test works

: β1 = 0 (Y does not depend on X).

• : β1 ≠ 0 (Y does depend on X)

A Priori Considerations

Sign tests:

• The coefficient of P should be negative.

• The coefficient of Y should be positive (probably).

• If the a priori signs do not agree with those in the estimatedmodel, the regression may be worthless.

• Also consider the magnitudes of the coefficients effect of aregressor seem unbelievably large (or small).



Regression standard error

Forecast errors:

• The standard error is the average forecast error (differencebetween actual and values predicted by the estimated equation).

• Small values indicate that the estimated model fits the observeddata closely (min SE = 0).

Goodness of Fit of the Estimated Parameters

• The standard error (SE) and ‘t’ statistics.

The smaller the value of SE of the regression, the better is the fit of theregression line.

• ‘t’ statistic or t-ratio

RULE: If absolute value of the estimated t > Critical-t, then it issignificant.

Critical t , Large Samples,t ≅ 2N > 30Small Samples, critical ‘t’ is onStudent’s

t-table

D.F. = # observations, minus number of independent variables, minus

one. N < 30

Cobb Douglas Function

E ff ective capital is K = ξK

is the potential productive capital , which is the stock of capital in the

absence of any disaster.

With this new function, a destruction of x% of the productive capital reduces production by x%. The replacement of the productive capital K bythe two new variables K0 and ξK makes it necessary to modify themodeling of investment and to introduce the distinction between



B)

regular investments, carried out to increase the production capacity,and reconstruction investments that follow a disaster .

1. TITLE

Catastrophic Natural Disasters and Economic Growth by Eduardo Cavallo,Sebastián Galiani, Ilan Noy, and Juan Pantano


1. What is natural disasters affect economic growth is ultimately an empiricalone?

2. What is the path of gross domestic product (GDP) of the affected country inthe absence of natural disasters and to assess the disaster’s impact bycomparing the counterfactual to the actual path observed?

3.Why endogenous growth models provide less clear-cut predictions withrespect to output dynamics?

4. How to estimate the impact of large disasters with comparative casestudies?

5. How about computational issues which affected by the catastrophic eventand the relationship with vector of post-disaster outcomes for the exposedcountry and matrix of post-disaster outcomes for the potential controlcountries?

3. METHODS

1. be the GDP per capita that would be observed for country i at time t inthe absence of the disaster, for countries i = 1……,J + 1, and time periods =

1………T . be the number of periods before the disaster, with

. be the outcome that would be observed for country i at time t if country i

is exposed to the disaster and its aftermath from period . Of course,

to

the extent that the occurrence of a large disaster is unpredictable, it has noeffect on the outcome before the intervention, so for t

we have that

2.be the effect of the disaster for country i at time t, if country i is exposed to the intervention in periods

Note that we allow this effect to potentially vary over time. Again, theintervention, in our context, is the disaster and its aftermath. Therefore:



Let be an indicator that takes value one if country i is exposed to the

intervention at time t and value zero otherwise. The observed output per capita for country i at time t is :

3. Because only the first country (country “one”) is exposed to the interventionand only after period

Our parameters of interest are the lead-specificcausal effect of the catastrophic event on the outcome of interest

4. The outcome variable of interest, say GDP per capita, is observed for T

periods for the country affected by the catastrophic eventand the unaffected countries

be the number of available post-disaster periods. Let be the

vector of post-disaster outcomes for the exposed country, and

matrix of post-disaster outcomes for the potential controlcountries. Let the define a linear combination of pre-disaster outcomes:

4. RESULT



C)

One obvious choice for the set of linear combinations of pre-disaster outcomes

would be :

1.TITLE

Irregular Growth Cycle by Richard H. Day (The American Economic Review)


1. Why the interaction of the propensity to save and the productivity of capitalcan lead to growth cycles that exhibit the wandering, in case not coverage to

a cycle of any regular periodic?

2. What is “chaotic” trajectories which unstable, errors of estimation inparameters or initial conditions?

3. How about neoclassical model in Discrete times?

3. METHODS

1. Use mathematical theory of “chaos” which originated in the work of EdwardLorenz. A formal definition of chaos and sufficient conditions for chaotictransectories.

2. Provides a detailed analysis of Trygue Haavelmo’s growth model in anapplication of overlapping generations model and forth coming study of theclassical growth model

3. Standard neoclassical growth model modified by introducing a difference

equation in capital labor ratio

4. RESULT

In which s is the saving ratio, f the per capita production function, and the

natural rate of population growth. Aggregate output is of course given by theaggregate production function, where the aggregate

capital stock is and the supply of labor is = . The saving ratio

may dependence income, wealth, and the interest rate, but using y = f(k) and

the real interest rate , it reduces to a dependence on k alone.



CHAPTER 5

RESULT MACROECONOMICS JOURNAL

Hypotheses:

The null hypothesis is that there is no relationship i.e. β1 = 0. We usually hope HA istrue. Look at the p value or sig value (based on a t statistic).

Y depend on X (Y depend on X factor for instance economic, financial, and public policy which impacting by natural disaster )

Remember that we have a small sample and are trying to estimate a relationshipbetween variables in a target population.

• Consider Y = β0 + β1 X + ε.

•If X changes, Y must change.

• If X increase by 1 unit, Y increases by β1 units.

• Unless, of course, β1 = 0.

• Then Y doesn’t depend on X.

• This is how our test works

: β1 = 0 (Y does not depend on X).

• : β1 ≠ 0 (Y does depend on X)

A Priori Considerations

Sign tests:

• The coefficient of P should be negative.

• The coefficient of Y should be positive (probably).

• If the a priori signs do not agree with those in the estimated model, theregression may be worthless.

• Also consider the magnitudes of the coefficients effect of a regressor seem

unbelievably large (or small).

Regression standard error

Forecast errors:

• The standard error is the average forecast error (differencebetween actual and values predicted by the estimated equation).



• Small values indicate that the estimated model fits the observeddata closely (min SE = 0).

Goodness of Fit of the Estimated Parameters

• The standard error (SE) and ‘t’ statistics.

The smaller the value of SE of the regression, the better is the fit of the regressionline.

• ‘t’ statistic or t-ratio

RULE: If absolute value of the estimated t > Critical-t, then it is significant.

Critical t , Large Samples,t ≅ 2N > 30Small Samples, critical ‘t’ is on Student’s

t-table

D.F. = # observations, minus number of independent variables, minus one. N < 30

1. The main changes applied to the basic Solow model, starting with its core set of equations where Y is production, K is productive capital, L is labor, A is totalproductivity, C is consumption, S is consumer savings, I is investment,

is the investment (or, equivalently, saving) ratio, ,, is the depreciation time, and

is the labor at full employment:

2. Goods market: A goods inventory H is introduced, opening the possibility of temporary imbalances between production and demand, instead of a marketclearing at each point in time. Thus



This inventory can be either positive or negative and it encompasses all sources of delay in the adjustment between supply and demand, including technical lags inproducing, transporting and distributing goods. Its situation aff ects pricemovements:

Thus price adjustments do not operate instantaneously and the conventionalmarket clearing conditions are verified only over the long term.

3. Labor market : The producer sets the optimal labor demand that maximizesprofits, as a function of real wage and marginal labor productivity:

But full employment is not guaranteed at each point in time, because (i) institutionaland technical constraints create a delay between a change in the optimal labor

demand and the corresponding change in the number of actually employed workers:

and (ii) wages are partially rigid over the short term; they progressively restore the fullemployment rate by increasing if labor demand is higher than and decreasingwhen it is lower:

4. Household behavior : Like the Solow model, NEDyM uses a constant saving ratio but itmakes the tradeoff between consumption and saving more sophisticated byconsidering that households (i) consume (ii) make their savings available for investmentthrough the savings, and (iii) hoard up a stock of money that is not immediatelyavailable for investment.

5. Producer behavior : Instead of automatically equating investments and savings),NEDyM describes an investment behavior “`” It introduces a stock of liquid assets Fheld by banksand companies, which is filled by the diff erence between sales p(C+I)and wages wL, and by the savings S received from consumers. Theseassets are usedto redistribute share dividends. Div and to invest in the amount pI . This formulationcreates a wedge between investment and savings, reflected by changes in F:

The dynamics of the system is governed by an investment ratio that allocates theseassets between productive investments and share dividends:



The producer’s net profit follows the accounting definition of profit that is grossprofits minus capital depreciation:

and the investment ratio follows the prognostic rule:

The distribution between dividends and investment depends on the expected net profitsper capital unit compared with a standard of profitability ν. If the expected net profitper capital unit is higher than this standard, the producer increases his/her

physical investments; if, on the contrary, the expected profit is lower than ν, investmentsare reduced. Assuming that observed values are the best guess of expected values ateach point in time leads to:

6. Cobb Douglas Function

Eff ective capital is K = ξK

is the potential productive capital, which is the stock of capital in the absence of any

disaster.

With this new function, a destruction of x% of the productive capital reduces productionby x%. The replacement of the productive capital K by the two new variables K0 and ξKmakes it necessary to modify the modeling of investment and to introduce thedistinction between regular investments, carried out to increase the production capacity,



and reconstruction investments that follow a disaster. To capture how these constraints

may impact the pathways back to equilibrium, we bounded by the fraction of total

investment that reconstruction can mobilize.



Long-term averaged GDP losses due to the distribution of natural disasters for di erent types of economic dynamics of the table) or very low (not shown), theff economy is incapable of responding to the natural disasters through investmentincreases aimed at reconstruction. Total production losses, therefore, are very large,amounting to 0.15% of GDP when the flexibility is null. Such an economy behaves

according to a pure Solow growth model, where the savings, and therefore theinvestment, ratio is constant.

When investment can respond to profitability signals without destabilizing theeconomy, i.e. when αinv is non-null but still lower than 1.39, the economy has a newdegree of freedom to improve its situation and respond to productive capital shocks.Such an economy is much more resilient to disasters, because it can adjust its levelof investment in the disaster’s aftermath: for αinv = 1.0 (second row of the table),GDP losses are as low as 0.01% of GDP, a decrease by a factor of 15 with respect toa constant investment ratio, thanks to the added investment flexibility.

One obvious choice for the set of linear combinations of pre-disaster outcomes



would be :

In which s is the saving ratio, f the per capita production function, and the natural rate

of population growth. Aggregate output is of course given by the aggregate production

function, where the aggregate capital stock is and the

supply of labor is = . The saving ratio may dependence income, wealth,

and the interest rate, but using y = f(k) and the real interest rate , it reduces to

a dependence on k alone.

Policy Implications

The findings from the study have implications for national development andmacroeconomic policies, public finance, the generation and use of information, and the

financing of disaster costs. A precondition for improvement in all these areas is goodgovernance. National Development Policy and the Macroeconomic Natural hazards

warrant more serious consideration in the formulation of national economic policies andstrategies. Risk assessments should be made from a broad macroeconomic standpoint,exploring areas of both sensitivity and resilience. Assessments should seek tounderstand the underlying factors determining vulnerability, including the potentiallycomplex and dynamic interlink ages between various influences and the scope for riskreduction. Vulnerability has to be assessed according to the particular type of hazard.

1. Regular assessment of hazard risk is required to ensure that risk managementstrategies are appropriate. From a macroeconomic perspective, vulnerability canshift quickly, particularly in countries experiencing rapid growth and socio economicchange, including urbanization.

2. For geographically large countries, where nation wide disasters are rare, regionalanalysis is potentially more appropriate than country-level analysis for understandingvulnerability and designing relevant policies.

3. Risk management necessarily involves the private sector and civil society, as well asthe public sector. The private sector should be encouraged and supported inenhancing its understanding of natural hazard risks and adopting appropriate riskmanagement tools. Both structural and nonstructural measures may be required.

4. Post disaster reconstruction needs to be better planned and carefully orchestrated toexploit potential organizational, technological, and other improvements that could bemade in rebuilding an economy while keeping priority development objectives ontrack.

5. Governments should consider preplanning possible reconstruction and rehabilitationprograms on the basis of disaster scenarios and, within that, identifying criticalprojects that should receive priority in post disaster funding. There is a case for exploring economic policy options through disaster scenarios that include the likelyeffects of fiscal changes and monetary measures in order to develop guidelines for policymakers in responding to disasters (see “Public Finance,” below).



6. National or economy wide disaster impacts, including total financial losses, shouldbe reassessed as a matter of course 12 to 18 months after an event. This task mightbe undertaken as part of an end-of-project report for a recovery loan or in a paper for consideration at an annual consortium or roundtable meeting.

B. Fiscal theory, and fiscal and monetary policy in the financialcrisis

RESUME

Interest rates near zero, money and government bonds are nearly perfectsubstitutes, especially for the banks and financial institutions at the center of economicevents. Conventional monetary policy analysis aimed at the split of government debtholdings between “monetary” and “debt” assets seems rather irrelevant; the big eventsseem to be the huge demand for both kinds of government debt, and the large interestrate spreads that have opened up between government and non-government debt. Themassive fiscal deficits, credit guarantees, and Federal Reserve purchases of riskyprivate assets raises the question of the fiscal limits of monetary policy. All analyses of monetary policy operate against a fiscal backdrop. At some point the fiscal constraintsof monetary policy must take hold. The fiscal price equilibrating mechanism feelsexactly like “aggregate demand.” Suppose the price level is too low. Then the value of debt is higher than expected future surpluses. People try to get rid of government debt,buying goods and services instead. This extra demand raises the price level to itsequilibrium level. More deeply, “aggregate demand” is really just the mirror image of demand for government debt. The household budget constraint says that after-taxincome must be consumed, invested, or result in purchase of government debt. Theonly way to consume or invest more is to hold less government debt.

However, there is somewhere a limit to how much taxes a government canraise, so at some point any monetary policy runs into its fiscal limit. At some point, thegovernment cannot run a “Ricardian” regime, and inflation results no matter what thegovernment attempts regarding the split of its liabilities between money and bonds.Argentina has found that limit. So far, the US may has not — if the fiscal theory governsour price level, it is by choice. But there is some limit, some point where the governmentsimply cannot raise the present value of future surpluses, and US economists may berudely surprised when it arrives. In addition, interest rates on government bonds fell todramatic lows, including some negative rates. In combination with reserves paying

interest, the distinction between government bonds and money (reserves) was a third-order issue for financial institutions, especially compared to the very high interest rates,lack of collateralizability, and dramatic illiquidity of any instrument that carried a whiff of credit risk. In short, financial institutions didn’t want more money and less bonds. Theywanted more of both, and less of other assets, and in massive quantities. The “special”or “liquidity” services we usually associate with money applied with nearly equal force toall government debt to these actors. The asset pricing literature has concluded thattime-varying discount rates account for essentially all stock market price fluctuations.This event suggests that we might similarly account for “aggregate demand”



fluctuations by changes in the discount rate for government debt rather than (or as wellas) changes in expectations of future surpluses. People fly to quality quite generally inrecessions. Perhaps this flight is a crucial part of lower “aggregate demand.” MV = PYwith constant velocity (“stable money demand”) and long and variable lags seems alikely casualty. The Fed has pretty clearly accommodated a large shift in moneydemand. When that shift reverses, the Fed can (subject to a fiscal limit) reverse course

and soak up that money. Simply looking at current aggregates is not a serious sign of future inflation.

CHAPTER 1

INTRODUCTION

The fiscal theory off ers an attractive perspective. First, with interest rates near zero, money and government bonds are nearly perfect substitutes, especially for thebanks and financial institutions at the center of economic events. Conventional

monetary policy analysis aimed at the split of government debt holdings between“monetary” and “debt” assets seems rather irrelevant; the big events seem to be thehuge demand for both kinds of government debt, and the large interest rate spreadsthat have opened up between government and non-government debt. Second, themassive fiscal deficits, credit guarantees, and Federal Reserve purchases of riskyprivate assets raises the question of the fiscal limits of monetary policy. All analyses of monetary policy operate against a fiscal backdrop. At some point the fiscal constraintsof monetary policy must take hold. That point may be coming faster than we think.

After a quick review of the fiscal theory, the following points:

1. Fall 2008 saw a large increase in demand for both money and government debt.This makes sense in the fiscal theory as a deflationary decrease in the discountrate for government debt. Many of the Government’s innovative policies can beunderstood as ways to accommodate this demand, which a conventional swap of money for government debt does not address.

2. Surpluses can generate inflation (the same thing as “stimulate” here) if people donot expect future taxes. However, no irrationality or market failure is required for this expectation. prospective deficits are just as “stimulative” as current deficits, theGovernment’s announcements can be read both ways, and I show that we canmeasure the state of private expectations in the bond market.

3. Credit guarantees make matters much worse than actual deficits suggest. I alsopoint out that since the present value of deficits matters, if taxes have any eff ect on

growth, the ‘Laff er limit’ of taxation may come much sooner than static analysissuggests.

4. Fiscal inflations, and in particular inflations that come from collapsing expectationsof deficits, may have quite diff erent output eff ects. Thus a fiscal inflation, an eventoutside recent US experience, may well lead to stagflation, not recovery.



CHAPTER 2

RESEARCH QUESTION

1. Why fiscal theory of the price level focuses on the valuation equation for government debt?

2. Will fiscal policy stimulus stimulate?

3. Why “aggregate demand” is really just the mirror image of demand for government debt?

4. Can price level determine a frictionless economy?

5. Describe the two effects in credit guarantees which most obviously, having tomake good on these guarantees on top of large budget deficits can be the piece of poor surplus news that kicks us against the fiscal limit and nominal credit

guarantees mean that government finances are much worse if the price level goesdown, and much better if there is inflation?

6. What is the measure of fiscal limit which determine by the price level in thedynamic laffer curve?



CHAPTER 3

METHODS FROM FISCAL POLICY JOURNAL

1. The fiscal theory of the price level focuses on the valuation equation for governmentdebt,

where is the real stochastic discount factor, which we can also think of as a

discount rate are real primary surpluses. Thisequation is an equilibrium condition, not a budget constraint. It operates just like thestandard asset pricing equation for valuing a stock as the present value of itsdividend payments. The Government may choose a “Ricardian regime” in which itadjusts taxes and spending ex-post so this equation holds for any price level Pt, butno budget constraint logic forces it to do so. Analogously, no constraint forcesMicrosoft to raise earnings in response to an “off -equilibrium” or “bubble” in its stockprice.

2. More deeply, “aggregate demand” is really just the mirror image of demand for government debt. The household budget constraint says that after-tax income mustbe consumed, invested, or result in purchase of government debt,

3. The valuation equation (1) can determine the price level even in a frictionlesseconomy with . But to understand monetary policy with we alsoneed a money demand function, that captures the “special” nature of money,



4. The timing of the fiscal equation (1) is quite diff erent with long-term debt. For example, if debt consists of a constant coupon c that is redeemed each period, withno other debt purchases and sales, then we have

5. Each period. Equation (1) still holds, but the market value of long term debtfluctuates overtime as well as the price level. However, most US debt is rolled over every few years, so if we take a time interval of a few years we will not go too far wrong in the qualitative analysis

6. We can accommodate a “flight to quality” event in our fiscal framework byrecognizing that the discount rate for government debt declined dramatically.In our fiscal framework, R declined in

7. In our fiscal framework, let Dt denote private debt owned by the government inexchange for additional Treasury debt. Our fiscal equation becomes

8. The fiscal valuation equation

9. With one-period debt, the fiscal equation is

is debt issued at time t − 1,coming due at time t.

10.



11. Real revenue from debt sales are

12. where the nominal bond price is

13. Substituting from (4) at time t +1,we obtain

14. We also know from past fiscally - induced currency collapses that the turning point

comes suddenly and irretrievably, as do stock market collapses.

15. Nominal credit guarantees mean that government finances are much worse if the

price level goes down, and much better if there is inflation. Surpluses are not

independent of the price level. Our equation is really

We are used to thinking of the static Laff er curve, in which tax revenue T is

generated by a tax rate τ from income Y as and The marginal revenue generated

from an increase in taxes is



A).

CHAPTER 4

PREVIOUS STUDIES OR REFERENCES

1. TITLE

Prospective Deficits and the Asian Currency Crisis by Craig Burnside, MartinEnchenbaum, and Sergio Rebelo.


1. Why alternative explanation of Asian currency crisis reflected profligate fiscalpolicy?

2. What is the empirical motivation of the crisis background/

3. What is the model of Asian currency crisis from continuous time, perfectforesight endowment economy populated by infinitely lived representativeagent and government?

4. How to characterize the time at which the fixed exchange rate regimecollapses, and the post - crisis behavior economy.

5. How about determinants of speculative attacks in version on the modelcalibrated for analyze the nature of optimal monetary policy in our model?

3. METHODS



4. RESULT

1. The fiscal theory of the price level focuses on the valuation equation for governmentdebt,

where is the real stochastic discount factor, which we can also think of as a

discount rate are real primary surpluses. Thisequation is an equilibrium condition, not a budget constraint. It operates just like thestandard asset pricing equation for valuing a stock as the present value of itsdividend payments. The Government may choose a “Ricardian regime” in which itadjusts taxes and spending ex-post so this equation holds for any price level Pt, butno budget constraint logic forces it to do so. Analogously, no constraint forcesMicrosoft to raise earnings in response to an “off -equilibrium” or “bubble” in its stockprice.

2. More deeply, “aggregate demand” is really just the mirror image of demand for

government debt. The household budget constraint says that after-tax income mustbe consumed, invested, or result in purchase of government debt,

3. The valuation equation (1) can determine the price level even in a frictionlesseconomy with . But to understand monetary policy with we alsoneed a money demand function, that captures the “special” nature of money,

4. The timing of the fiscal equation (1) is quite diff erent with long-term debt. For example, if debt consists of a constant coupon c that is redeemed each period, withno other debt purchases and sales, then we have

5. Each period. Equation (1) still holds, but the market value of long term debtfluctuates overtime as well as the price level. However, most US debt is rolled over every few years, so if we take a time interval of a few years we will not go too far wrong in the qualitative analysis

6. We can accommodate a “flight to quality” event in our fiscal framework byrecognizing that the discount rate for government debt declined dramatically.In our fiscal framework, R declined in



7. In our fiscal framework, let Dt denote private debt owned by the government inexchange for additional Treasury debt. Our fiscal equation becomes

8. The fiscal valuation equation

9. With one-period debt, the fiscal equation is

is debt issued at time t − 1,coming due at time t.

10.

11. Real revenue from debt sales are

12. where the nominal bond price is

13. Substituting from (4) at time t +1,we obtain



14. We also know from past fiscally - induced currency collapses that the turning point

comes suddenly and irretrievably, as do stock market collapses.

15. Nominal credit guarantees mean that government finances are much worse if the

price level goes down, and much better if there is inflation. Surpluses are not

independent of the price level. Our equation is really

We are used to thinking of the static Laff er curve, in which tax revenue T is

generated by a tax rate τ from income Y as and The marginal revenue generated

from an increase in taxes is



C. Mundell–Fleming model

RESUME

The Mundell-Fleming model is an economic model first set forth by RobertMundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereasthe traditional IS-LM Model deals with economy under autarky (or a closed economy),the Mundell-Fleming model tries to describe an open economy. Typically, the Mundell-Fleming model portrays the relationship between the nominal exchange rate and an M

economy's output (unlike the relationship between interest rate and the output in the IS-LM model) in the short run.The Mundell-Fleming model has been used to argue that aneconomy cannot simultaneously maintain a fixed exchange rate, free capital movement,and an independent monetary policy. This principle is frequently called "the UnholyTrinity," the "Irreconcilable Trinity," the "Inconsistent trinity" or the Mundell-Fleming"trilemma."

Changes in money supply

An increase in money supply shifts the LM curve downward. This directlyreduces the local interest rate and in turn forces the local interest rate lower than theglobal interest rate. This depreciates the exchange rate of local currency through capital

outflow. (Hot money flows out to take advantage of higher interest rate abroad andhence currency depreciates.) The depreciation makes local goods cheaper comparedto foreign goods and increases export and decreases import. Increased net exportleads to the shifting of the IS curve (which is Y = C + I + G + NX) to the right to the pointwhere the local interest rate equalizes with the global rate. At the same time, the BoP issupposed to shift too, as to reflect(1)depreciation of home currency and (2)an increasein current account or in other word, the increase in net export.

Changes in government spending



An increase in government expenditure shifts the IS curve to the right. The shift causesthe local interest rate to go above the global rate. The increase in local interest causescapital inflow, and the inflow makes the local currency stronger compared to foreigncurrencies. Strong exchange rate also makes foreign goods cheaper compared to local

goods. The level of income of the local economy stays the same. The LM curve is not

at all affected. A decrease in government expenditure reverses the process.

Changes in global interest rate

An increase in the global interest rate causes an upward pressure on the local interestrate. The pressure subsides as

the local rate closes in on the global rate. When a positive differential between theglobal and the local rate occurs,

holding the LM curve constant, capital flows out of the local economy. This depreciatesthe local currency and helps

boost net export. Increasing net export shifts the IS to the right. This shift continues tothe right until the local

interest rate becomes as high as the global rate. A decrease in global interest ratecauses the reverse to occur.

Three Journal About Macroeconomics, Fiscal Policy, And Mundell - Fleming

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