#### Transcript Mankiw 5/e Chapter 9: Intro to Economic Fluctuations

```CASE STUDY
Volcker’s Monetary Tightening
 Late 1970s:  > 10%
 Oct 1979: Fed Chairman Paul Volcker
announced that monetary policy
would aim to reduce inflation.
 Aug 1979-April 1980:
Fed reduces M/P 8.0%
 Jan 1983:  = 3.7%
How do you think this policy change
would affect interest rates?
slide 0
Volcker’s Monetary Tightening, cont.
The effects of a monetary tightening
on nominal interest rates
model
short run
long run
Liquidity Preference
Quantity Theory,
Fisher Effect
(Keynesian)
(Classical)
prices
sticky
flexible
prediction
i > 0
i < 0
actual
outcome
8/1979: i = 10.4%
4/1980: i = 15.8%
1/1983: i = 8.2%
slide 1
EXERCISE:
Analyze shocks with the IS-LM model
Use the IS-LM model to analyze the effects of
1. A boom in the stock market makes
consumers wealthier.
2. After a wave of credit card fraud, consumers
use cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects
of the shock on Y and r .
b. determine what happens to C, I, and the
unemployment rate.
slide 2
What is the Fed’s policy instrument?
What the newspaper says:
“the Fed lowered interest rates by one-half point today”
What actually happened:
The Fed conducted expansionary monetary policy to
shift the LM curve to the right until the interest rate fell
0.5 points.
The Fed targets the Federal Funds rate:
it announces a target value,
and uses monetary policy to shift the LM curve
as needed to attain its target rate.
slide 3
What is the Fed’s policy instrument?
Why does the Fed target interest rates
1) They are easier to measure than the
money supply
2) The Fed might believe that LM shocks are
more prevalent than IS shocks. If so, then
targeting the interest rate stabilizes income
better than targeting the money supply.
slide 4
Interaction between
monetary & fiscal policy
 Model:
monetary & fiscal policy variables
(M, G and T ) are exogenous
 Real world:
in response to changes in fiscal policy,
or vice versa.
 Such interaction may alter the impact of
the original policy change.
slide 5
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different:
slide 6
Response 1: hold M constant
If Congress raises G,
the IS curve shifts
right
If Fed holds M
constant, then LM
curve doesn’t shift.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y2  Y1
Y1 Y2
Y
r  r2  r1
slide 7
Response 2: hold r constant
If Congress raises G,
the IS curve shifts
right
r
To keep r constant,
Fed increases M to
shift LM curve right.
r2
r1
LM1
IS2
IS1
Results:
Y  Y3  Y1
LM2
Y1 Y2 Y3
Y
r  0
slide 8
Response 3: hold Y constant
If Congress raises G,
the IS curve shifts
right
To keep Y constant,
Fed reduces M to
shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y  0
Y1 Y2
Y
r  r3  r1
slide 9
CASE STUDY
The U.S. economic slowdown of 2001
~What happened~
1. Real GDP growth rate
1994-2000: 3.9% (average annual)
2001: 1.2%
2. Unemployment rate
Dec 2000: 4.0%
Dec 2001: 5.8%
slide 10
CASE STUDY
The U.S. economic slowdown of 2001
~Shocks that contributed to the slowdown~
1. Falling stock prices
From Aug 2000 to Aug 2001: -25%
Week after 9/11: -12%
2. The terrorist attacks on 9/11
• increased uncertainty
• fall in consumer & business confidence
Both shocks reduced spending and
shifted the IS curve left.
slide 11
The Great Depression
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
5
120
1929
percent of labor force
billions of 1958 dollars
240
0
1931
1933
1935
1937
1939
slide 12
The Spending Hypothesis:
Shocks to the IS Curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for
goods & services -- a leftward shift of the IS
curve
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause
slide 13
The Spending Hypothesis:
Reasons for the IS shift
1. Stock market crash  exogenous C
 Oct-Dec 1929: S&P 500 fell 17%
 Oct 1929-Dec 1933: S&P 500 fell 71%
2. Drop in investment
 “correction” after overbuilding in the 1920s
obtain financing for investment
3. Contractionary fiscal policy
 in the face of falling tax revenues and
increasing deficits, politicians raised tax rates
and cut spending
slide 14
The Money Hypothesis:
A Shock to the LM Curve
 asserts that the Depression was largely due
to huge fall in the money supply
 evidence:
M1 fell 25% during 1929-33.
But, two problems with this hypothesis:
1. P fell even more, so M/P actually rose
slightly during 1929-31.
2. nominal interest rates fell, which is the
opposite of what would result from a
leftward LM shift.
slide 15
The Money Hypothesis Again:
The Effects of Falling Prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by
the fall in M, so perhaps money played
an important role after all.
 In what ways does a deflation affect the
economy?
slide 16
The Money Hypothesis Again:
The Effects of Falling Prices
The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P  (M/P )
 consumers’ wealth 
 C
 IS shifts right
 Y
slide 17
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of unexpected deflation:
debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders, then aggregate spending falls,
the IS curve shifts left, and Y falls
slide 18
The Money Hypothesis Again:
The Effects of Falling Prices
The destabilizing effects of expected deflation:
e




r  for each value of i
I  because I = I (r )
planned expenditure & agg. demand 
income & output 
slide 19
Why another Depression is unlikely
 Policymakers (or their advisors) now know
 The Fed knows better than to let M fall
so much, especially during a contraction.
 Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
slide 20
Imports and Exports
as a percentage of output: 2000
Percentage40
of GDP
35
30
25
20
15
10
5
0
Imports
Exports
Italy
Japan
U.K.
U.S.
slide 21
Three experiments
1. Fiscal policy at home
3. An increase in investment demand
slide 22
1. Fiscal policy at home
r
An increase in G
or decrease in T
reduces saving.
r
*
1
S 2 S1
NX2
NX1
Results:
I  0
I (r )
NX  S  0
I1
S, I
slide 23
NX and the Government Budget Deficit
4
Percent
of GDP 3
8 Percent
of GDP
6
Budget deficit
(right scale)
2
4
1
2
0
0
-1
-2
-2
-4
Net exports
(left scale)
-3
-4
1950
-6
-8
1960
1970
1980
1990
2000
slide 24
Expansionary
fiscal policy
the world
interest rate.
r
NX2
r2*
S1
NX1
r
*
1
Results:
I  0
I (r )
NX  I  0
I (r )
*
2
I (r1* )
S, I
slide 25
3. An increase in investment demand
r
S
r*
EXERCISE:
Use the model to
determine the impact
of an increase in
investment demand
on NX, S, I, and net
capital outflow.
NX1
I (r )1
I1
S, I
slide 26
3. An increase in investment demand
r
I > 0,
S = 0,
S
NX2
r*
net capital
outflows and
net exports
fall by the
amount I
NX1
I (r )2
I (r )1
I1
I2
S, I
slide 27
2
140
1
120
0
100
-1
80
-2
60
-3
40
-4
20
-5
0
1975
1980
1985
1990
1995
1998:2 = 100
Percent of GDP
U.S. Net Exports and the
Real Exchange Rate, 1975-2002
2000
Net exports (left scale)
Real exchange rate (right scale)
slide 28
Four experiments
1. Fiscal policy at home
3. An increase in investment demand
4. Trade policy to restrict imports
slide 29
1. Fiscal policy at home
A fiscal expansion
reduces national
saving, net
capital outflows,
and the supply of
dollars in the
foreign exchange
market…
…causing the
real exchange
rate to rise
and NX to
fall.
ε
S 2  I (r *)
S 1  I (r *)
ε2
ε1
NX(ε )
NX 2
NX 1
NX
slide 30
An increase in r*
ε
reduces
investment,
increasing net
ε1
capital outflows
and the supply of ε
2
dollars in the
foreign exchange
…causing the
market…
real exchange
rate to fall and
NX to rise.
S 1  I (r1 *)
S 1  I (r2 *)
NX(ε )
NX 1
NX 2
NX
slide 31
3. An increase in investment demand
An increase in
investment
ε
reduces net
capital outflows
ε2
and the supply
of dollars in the
ε1
foreign
exchange
market…
…causing the
real exchange
rate to rise
and NX to
S1  I 2
S1  I 1
NX(ε )
NX 2
NX 1
NX
slide 32
4. Trade policy to restrict imports
At any given value
ε
of ε, an import
quota
ε2
 IM  NX
 demand for
ε1
dollars shifts
right
doesn’t affect S or
I , so capital flows
and the supply of
dollars remains
fixed.
S I
NX (ε )2
NX (ε )1
NX1
NX
slide 33
4. Trade policy to restrict imports
Results:
ε > 0
(demand
increase)
NX = 0
(supply
fixed)
IM < 0
(policy)
EX < 0
(rise in ε )
ε
S I
ε2
ε1
NX (ε )2
NX (ε )1
NX1
NX
slide 34
Inflation and nominal exchange rates
Percentage 10
change
9
in nominal
exchange 8
rate
7
6
5
4
3
2
1
0
-1
-2
-3
-4
South Africa
Depreciation
relative to
U.S. dollar
Italy
New Zealand
Australia
Spain
Sweden
Ireland
Belgium
Germany
UK
France
Appreciation
relative to
U.S. dollar
Netherlands
Switzerland
Japan
-3
-2
-1
0
1
2
3
4
5
6
7
8
Inflation differential
slide 35
CASE STUDY
The Reagan Deficits revisited
actual
closed small open
1970s 1980s
change economy economy
G–T
2.2
3.9



S
19.6
17.4



r
1.1
6.3


no change
I
19.9
19.4


no change
NX
-0.3
-2.0

ε
115.1 129.4

no
change
no
change


Data: decade averages; all except r and ε are expressed
as a percent of GDP; ε is a trade-weighted index.
slide 36
```