Transcript ISMP_2012_L2_post

The full dynamic short-run model
Chairman Bernanke
J. M. Keynes
1
The full Keynesian model of the business cycle
i
r
IS-MP
Y
πe
u
Potential
output =
AF(K,L)
Ypot
π
2
2
The Dynamic Model
This is state-of-the-art modern Keynesian model
Short-run model of business cycles
Combines
- IS (consumption, investment, fiscal, later trade)
- MP (Taylor rule)
- Phillips curve
Closed economy
3
The Taylor rule
1. John Taylor suggested the following rule to implement the dual
mandate:
(TR)
i t = πt + r* + θ π (πt - π*) +θY yt
Here r* is the equilibrium real interest rate, π inflation rate, π* is
inflation target, y is output gap (Y - Y*), θ π and θY are parameters.
2. Has both normative* and predictive** power.
____________________
*Theoretical point: Can be derived from minimizing loss function such as
L = λ π (πt - π*) 2 + λ Y (lnYt - lnY* ) 2
** We showed this last time with empirical Taylor rule, predictions and actual (see
next slide).
4
Actual and Taylor rule federal funds rate
10
8
6
4
2
0
-2
Actual
Taylor rule
-4
-6
88
90
92
94
96
98
00
02
04
06
08
10
5
Full Dynamic IS-MP analysis
Key equations:
1. Demand for goods and services:
2. Business real interest rate:
3. Phillips curve:
4. Inflation expectations:
5. Monetary policy:
yt = - α rtb + μ*Gt + εt
rtb = it – πte + σt = rt + σt
π t = πte + φ yt + ηt
π e t = π t-1
i t = πt + r* + θ π (πt - π*) +θY yt , i > 0
Notes:
• Equation (1) is our IS curve from last time with risk.
• Phillips curve in (3) substitutes y for u by Okun’s Law
• Business interest rate is real short rate plus risk and term premium (σt )
• Jones uses simplified version of these: no risk and other.
• Jones solves for AS-AD as function of inflation; we stick with interest
rates.
6
Algebra of Dynamic IS-MP analysis
Solution of equations:
(IS)
yt = μ*Gt - α ( it – πte + σt ) + εt
(MP)
i t = [φ (1+ θ π ) + θY ] yt + r* - θ π π* + (1+ θ π ) ( πte + ηt )
This is derived by substitution. Check my algebra.
7
Interpretation of Dynamic IS-MP
(IS)
(MP)
yt = μ*Gt - α ( it – πte + σt ) + εt
A
B
i t = [φ (1+ θ π ) + θY ] yt + r* - θ π π* + (1+ θ π ) ( πte + ηt )
C
D
E
A = standard multiplier on spending
B = risk enters in as negative element on investment
C = slope of MP due to inflation and output term in Taylor rule
D = lower inflation target raises Fed interest rates
E = expected inflation or inflation shock raises Fed interest rate.
8
The graphics of dynamic IS-MP
Federal
funds rate
MP(πe, π*, r*, ηt )
it *
IS(πe, G , εt , σt )
Yt
Yt = real output (GDP)
9
1. What are the effects of fiscal policy?
• A fiscal policy is change in purchases (G) or in taxes (T0, τ),
holding monetary policy constant.
• In normal times, because MP curve slopes upward,
expenditure multiplier is reduced due to crowding out.
10
IS shock (as in fiscal expansion)
MP
i
IS(G’)
IS(G)
Y = real output (GDP)
11
Multiplier Estimates by the CBO
3.0
Multiplier from G,T on GDP
2.5
2.0
1.5
1.0
0.5
0.0
G: Fed
G: S&L
Trans: indiv
Tax:
Mid/Low
Income
Tax: High
Income
Congressional Budget Office, Estimated Impact of the ARRA, April 2010
Bus Tax
12
Inflationary shock
MP(ηt > 0)
MP(ηt = 0)
i
it**
IS
Yt**
Y = real output (GDP)
13
Dual mandate v single mandate
Taylor rule for ECB versus the Fed:
(Fed) it = πt + r* + θ π (πt - π*) +θY yt
(EBC) it = πt + r* + θ π (πt - π*)
Therefore MP curve steeper for ECB:
(MP)
i t = [φ (1+ θ π ) + θY ] yt + r* - θ π π* + (1+ θ π ) ( πte + ηt )
14
ECB v Fed
Note added after class:
I had the slopes backwards. The Fed is steeper (higher
coefficient). Eating arithmetic humble pie. Note the interest
rate diagram is explained by this.
15
IS shock (Fed v. ECB)
i
MP (Fed)
MP (ECB)
IS(G’)
IS(G)
Y = real output (GDP)
16
Prediction: Fed should respond more to IS
shocks such as those of 2001 - 2012
7
Fed interest rate
ECB interest rate
6
5
4
3
2
1
0
01
02
03
04
05
06
07
08
09
10
11
12
17
What about in the “liquidity trap”
or “zero interest rate bound”
18
6
US short-term interest rates, 1929-45 (% per year)
Liquidity
trap in US in
Great
Depression
5
4
3
2
1
0
1930
1932
1934
1936
1938
1940
1942
1944
19
US in current recession
Federal funds rate (% per year)
20
Policy has
hit the
“zero lower
bound” four
years ago.
16
12
8
4
0
1975
1980
1985
1990
1995
2000
2005
2010
20
Japan short-term interest rates, 1994-2012
Liquidity trap from 1996 to today:
16 years and counting.
21
Fiscal policy in liquidity trap
r = real
interest rate
IS
IS’
MP
re
Y = real output (GDP)
22
Monetary expansion in liquidity trap
r = real
interest rate
IS
MP
MP’
re
Y = real output (GDP)
23
Can you see why macroeconomists emphasize the
importance of fiscal policy in the current environment?
“Our policy approach started with a major commitment to fiscal
stimulus. Economists in recent years have become skeptical about
discretionary fiscal policy and have regarded monetary policy as a
better tool for short-term stabilization. Our judgment, however, was
that in a liquidity trap-type scenario of zero interest rates, a
dysfunctional financial system, and expectations of protracted
contraction, the results of monetary policy were highly uncertain
whereas fiscal policy was likely to be potent.”
Lawrence Summers, July 19, 2009
24
Summary on IS-MP Model
This is the workhorse model for analyzing short-run
impacts of monetary and fiscal policy
Key assumptions:
- Inflexible prices
- Unemployed resources
Now on to analysis of Great Depression in IS-MP
framework.
25