04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
We cannot predict the future with any degree of certainty
But expectations about the future often determine the future course of an economy
“Managing” the public’s expectations is perhaps the most important objective of public policy
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
Modeling the formation of expectations:
◦ Adaptive Expectations (AE): People base their expectations of the future only on past observations
◦ Rational expectations (RE):People base their expectations on all available current information, including information about prospective future policies
◦ Critical differenceCritical difference: under RE, economic decisions change ONLY if there is “news” or new information about the future. Under AE, “news” has no impact on current decisions
Expected inflation plays a crucial role in determining current inflation and interest rates
A principal objective of monetary policy: ◦ to manage the public’s expectations of future
inflation
How can this be achieved?
04/21/23Econ 7920/Chatterjee
For expected inflation to be low, the public must believebelieve that the Central Bank is committedcommitted to fighting inflation
The only way this can happen is if the Central Bank has credibilitycredibility with the private sector: it’s past actions confirm its commitment to keeping inflation low
Credibility is difficult to attain: often requires significant short-run sacrifices (high interest rates, unemployment and recessions)
One factor to consider: does Central Bank independence matter?
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
Can inflationary expectations be controlled by non-monetary measures?
A popular policy measure: impose wage and price controls
If the government mandates that it is illegal for prices and wages to increase above a pre-specified ceiling, wouldn’t that stabilize expectations of future inflation?
Wage and Price controls simply do not work. Why?
04/21/23Econ 7920/Chatterjee
Extremely difficult to commit to and monitor such policies and punish violators
These policies inevitably create huge shortages and involve a misallocation of scarce resources becomes self-perpetuating
04/21/23Econ 7920/Chatterjee
Inflation targeting:◦ Central Bank announces a target rate of inflation
(usually 2-3 percent)◦ It raises or lowers interest rates to keep inflation at the
target rate
Advantage: as long as there is credibility, inflationary spirals can be avoided
Disadvantage: if the economy faces a large supply-side shock (an oil price increase), maintaining the target can be difficult
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
Does “Say’s Law” always work?
Consider the following sequence:◦ For some reason, consumers suddenly expect bad times in the near
future cut back on spending◦ Firms face lower orders for goods and services cut back on
employment and investment lay off workers and keep machines idle
◦ The rising unemployment causes a reduction household incomes further cut-backs in spending further reduction in production of goods
◦ Leads to a downward spiral in economic activity severe recession (self-fulfilling prophecy)
“Paradox of Poverty in the Midst of Plenty” – Keynes (1936)
How can monetary and fiscal policy correct this “paradox”?
04/21/23Econ 7920/Chatterjee
In a recession, the Central bank can implement an expansionary expansionary monetary policy◦ Increasing money supply and lowering interest rates
Households◦ Consumption more attractive than savings◦ “Durable” consumption (houses, cars, appliances)
cheaper Firms
◦ Cost of investment (financing new capital equipment, construction, etc) cheaper
04/21/23Econ 7920/Chatterjee
Expansionary monetary policy may not be effective if◦ Expectations of future demand are severely
depressed
◦ The gap between actual output and potential output is small (can generate inflationary pressures)
◦ The economy is in a “liquidity trap”
◦ Prices are actually falling or expected to fall (deflationdeflation)
04/21/23Econ 7920/Chatterjee
When nominal interest rates reach a critically low level (positive but close to zero): people might prefer holding money to assets (why?)
In such cases, injecting more money does not affect interest rates and thereby the incentives to spend and invest
04/21/23Econ 7920/Chatterjee
Deflation: price level declines over time◦ Due to declining productivity and demand◦ Gap between actual and potential output
Monetary policy is ineffective in a deflation:◦ Let r = real rate of interest
i = nominal rate of interest = rate of inflation
Then,r = i -
With deflation, < 0 r > 0
04/21/23Econ 7920/Chatterjee
Consider an example:◦ Suppose, due to an expansionary monetary policy, the nominal
interest rate is low, at i = 1%◦ But prices are falling at the rate of 5% = -5%◦ Then, the real rate of interest is:
r = i - = 1-(-5) = 6%
Therefore, the real cost of borrowing is 6% even though the nominal cost is only 1%
Facing a declining price level and a rising real interest rate, households and firms postpone spending
Monetary policy completely ineffective
04/21/23Econ 7920/Chatterjee
1980s: Under pressure from the Ministry of Finance, the Bank of Japan kept interest rates low◦ Economy “awash” with liquidity◦ Created speculative bubbles in equities and real
estate◦ Economy started over-heating towards the end of
1980s◦ Inefficiencies in the corporate sector slowed
productivity◦ Financial liberalization of 1980s: more
competition among banks more risk-taking
04/21/23Econ 7920/Chatterjee
Yasushi Mieno takes over as Governor of the Bank of Japan in 1989: promises to “cool” economy down◦ Interest rate rises from 2.5% in Dec 1989 to 6% in Aug 1990◦ Speculative bubble bursts in summer 1990: stock market
falls by more than 40% ◦ Firms and households significantly cut back on spending◦ Sharp economic slowdown begins in 1990:Land prices fell
quickly, mortgage defaults and bankruptcies increased
Throughout the 1990s, Japan experienced deflation and was stuck in a liquidity trap, in spite of monetary policy interventions
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
“Irresponsible Monetary Policy” was proposed as a solution by Paul Krugman of MIT (1998):
◦ Set an inflation target inflation target of 2-4%◦ Commit to the target and keep increasing money
supply in a sustained fashion◦ Eventually, public start expecting future inflation◦ Currency starts depreciating◦ Spending, investment, and demand for exports
restart the growth process…
04/21/23Econ 7920/Chatterjee
Fiscal policy (government spending, taxation, and subsidies) can be an effective tool in ◦ a recession◦ when expectations of future demand are severely
depressed
Keynes (1936): through deficit spending, a government can influence expectations of the private sector:◦ Deficit spending: government spends more than it
receives in tax revenues (mainly financed through borrowing)
◦ Government spending creates new jobs multiplier multiplier effect effect on the economy
04/21/23Econ 7920/Chatterjee
Basic idea: ◦ An initial amount of government spending creates new
incomes (through jobs created in the public sector)◦ A fraction of this new income is spent on goods and
services generates new income and spending, and so on…
◦ Similar to a “ripple” effect◦ The final increase in income and spending is much
larger than the initial increase in government spending “multiplier effect” economic expansion
What about the deficit?◦ The income generated increases tax revenues over time,
making the deficit sustainable
04/21/23Econ 7920/Chatterjee
Suppose people spend a “b” fraction of their income (marginal propensity to consume)◦ Example: b = 0.75 people spend $0.75 of
every $1 of new income The government increases spending by $1 Total spending and income generated:
04/21/23Econ 7920/Chatterjee
Spending Iterations New spending/income ($)
Round 1 (government) 1
Round 2 (private) b(1)=0.75
Round 3 (private) b(0.75)=0.56
Round 4 (private) b(0.56)=0.42
Round 5 (private) b(0.42)=0.32
And so on… …
Total increase in spending/income =1+0.75+0.56+0.42+…
....1 32 bbb
In general, the multiplier effect is given by:
In our example, b = 0.75. Then,
◦ Increase in income =
◦ A $1 increase in government spending increases total income by $4
◦ Also referred to as the “income multiplier”
A multiplier effect can also be generated by cutting taxes (the “tax multiplier”)
04/21/23Econ 7920/Chatterjee
( consume to propensity Marginal1spending government in increase Initial
Income in Increase)b
425.01
75.011
If the economy’s capacity utilization rate (gap between potential and actual output) is well below 100%◦ When resources are idle (high unemployment and
shut-down factories) producers can increase production without raising prices
As capacity utilization nears 100%, deficit spending can overheat the economy and create inflationary pressures smaller multiplier effect
04/21/23Econ 7920/Chatterjee
Factors that can reduce the size of the multiplier effect:◦ Government spending financed by higher taxes
◦ New income is fully spent on imports (does not affect GDP)
◦ New income is fully saved by households to provide for future expected tax increases (“Ricardian Equivalence”)
◦ “Crowding OutCrowding Out” of private investment by raising market interest rates
◦ Sometimes, the Central Bank may raise interest rates to offset any inflationary expectations (say, if capacity utilization is near 100%)
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
The U.S. government uses a forecasting model developed by Data Resources Inc. (DRI) to estimate the potential effects of fiscal policy
Estimates of Fiscal Policy Multipliers:
04/21/23Econ 7920/Chatterjee
Assumption Government spending increase
Tax cut
No crowding out 1.93 1.19
Crowding out 0.60 0.26
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
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s of
19
58
dolla
rs
0
5
10
15
20
25
30
perc
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lab
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e
04/21/23Econ 7920/Chatterjee
04/21/23Econ 7920/Chatterjee
Asserts that the Great Depression was largely due to an exogenous fall in the demand for goods & services
Supporting evidence: ◦ output, consumption, and investment declined
steadily from 1929-1934◦ Government spending remained largely
unchanged during this period
Stock market crash exogenous fall in consumption ◦ Oct-Dec 1929: S&P 500 fell 17%◦ Oct 1929-Dec 1933: S&P 500 fell 71%
Drop in investment◦ “correction” after overbuilding in the 1920s◦ widespread bank failures made it harder to obtain
financing for investment (the FDIC did not exist then)
ContractionaryContractionary fiscal policy◦ Congress raised tax rates and cut spending
(deficits were considered “bad” for economy)
Asserts that the Depression was largely due to huge fall in the money supply
M1 fell 25% during 1929-33
The severity of the Depression was due to a huge deflation: the price level fell 25% during 1929-33
This deflation was probably caused by the fall in money supply
04/21/23Econ 7920/Chatterjee
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