How Central Banks View the World David Andolfatto November 2003 1 A Basic Model Earlier in the course, we talked about the theory of consumption and saving. In the context of a two-period model, where individuals faced a given stream of income (y1, y2 and could borrow or lend freely at a (gross) real interest ) rate R, we derived a consumption function cD 1 (y1 , y2 , R). With preferences given by U = ln(c1 ) + β ln(c2 ), the consumption function took the form: cD = 1 1 1+ β y1 + y2 . R This consumption function is consistent both with Friedman’s Income Hypothesis : cD 1 = bW, where b = function: where a = 1 1+ (1) Permanent β and W equals wealth; as well as the Keynesian consumption 1 1+ β cD 1 = a + by1 , y2 and b = 1 . R 1+β In neoclassical theory, the level of output is determined by equilibrium in the labour market. This concept of equilibrium views the labour market as a centralized market where competition among buyers and sellers of labour results in a real wage that clears the market. In labour market search theory, the labour market is viewed as a decentralized market, where the equilibrium level of employment (and unemployment) is determined by the search decisions of workers and the recruiting decisions of firms. Neither of these approaches is the way that central banks (CBs) view the labour market. The viewpoint adopted by the CB is that the labour market resembles a dysfunctional neoclassical market, where the real wage fails to adjust rapidly to clear the market. The real wage is viewed as adjusting gradually over time to clear the market; when the labour market clears, the level of output 1 is said to be at ‘potential.’ Let yP denote ‘potential’ output. Because the labour market is generally not in equilibrium, the level of aggregate demand is typically either above or below potential output. I’ll return to the concept of aggregate demand in a moment, but for now, let me talk a little bit more about consumption. Let y2e denote the private sector forecast of future GDP. Assume that the private sector forms an inflation forecast πe and that this expectation of inflation is also exogenous (central bankers seem inclined to think that inflation expectations have a life of their own). Let i denote the nominal interest rate. From the Fisher equation, we know that: R= (1 + i) (1 + π e ) (2) . Substituting (2) into (1), we can derive: cD = 1 y2e 1 + πe 1+β 1+i + 1 1+β y1 . Notice that if we hold πe fixed, then an increase in the nominal interest rate will lead to an increase in consumer demand (since the real interest rate is lower). Now, think back to our lectures on capital and investment. Let x denote current capital spending (and the future capital stock) and let y2 = z e F (x), where F is an increasing and concave function and z e > 0 denotes the expected productivity of capital spending. Recall that the investment demand function xD is determined by equating the expected marginal product of capital to the real interest rate; i.e., ze F (xD ) = R. For the production function F (x) = xα , 0 < α < 1, we can solve for the investment demand function: xD = = ze α 1−α ; R e 1−α e z α(1 + π ) (1 + i) 2 (3) . Notice that investment demand is increasing in ze and πe ; and decreasing in i. If households have ‘rational expectations’, then their forecast of future GDP should be consistent with the investment choices made by firms; i.e., y2e = ze (xD )α. Observe that y2e is increasing in ze and πe; and is decreasing in i. We are now ready to construct the aggregate demand function for this model economy. Aggregate demand is simply the sum of consumer and investment demand (we are abstracting from the government sector and assuming a closed economy); i.e., e e D e e y D = cD (4) 1 (y1 , i, π , z ) + x (i, π , z ). Notice that yD is increasing in (y1, πe, ze ) and decreasing in i. Remember now that we (that is, central banks) are viewing (πe , ze ) as exogenous parameters (they may fluctuate for reasons unknown). The CB also views itself as being able to influence the nominal interest rate. For simplicity, let us suppose that the CB can choose i directly. We now turn to the question of how contemporaneous GDP is determined. Since the labour market does not clear in the neoclassical sense, the assumption is that workers and firms will simply supply to the market whatever is demanded from them; i.e., y1 = y D . (5) Combining (4) and (5), we derive: D e , z e ) + xD (i, πe , z e ). (6) You can think of (6) as one equation in the one unknown (y1). The following diagram provides a diagrammatic representation of the ‘equilibrium’ level of output in this model economy (note that, in general, yP may be to either the left or right of y1∗) y1 = c1 (y1 , i, π . 3 Notice that according to this world view, the CB can influence the level of GDP by altering the nominal interest. An increase in the nominal interest rate will (for a given e ) increase the real interest rate, which then serves to depress both consumer and investment spending. Firms react to this reduction in demand by supplying less output (and contracting their workforce). The reverse happens if the CB lowers the nominal interest rate. π 4 2 Stabilizing Output Fluctuations Most central bankers appear to hold a view (taught to them in their undergraduate macro courses 20 or 30 years ago) that markets are driven by ‘animal spirits’ (a phrase coined by Keynes). These animal spirits manifest themselves as wild fluctuations in expectations that are not based on any change in economic ‘fundamentals.’ These fluctuations in expectations are sometimes viewed as being ‘irrational.’ It is also possible to take the view that these fluctuations are ‘rational’ to the extent they become self-fulfilling. In either case, it seems clear that the CB should try to prevent these animals spirits from causing ’unwarranted’ fluctuations in GDP. The way the CB can try to achieve such an objective is by altering the interest rate in response to what it perceives to be developments that might lead to GDP either falling below or rising above ’potential’ GDP. In the context of the model above, one can think of modelling ‘animal spirits’ as exogenous fluctuations in ze and πe. Let imagine that the economy is initially at its potential yP . Suppose now, that for some crazy reason, that individuals become unduly ‘pessimistic’ about future business conditions, leading to a fall in ze (the expected productivity of current capital spending). From the model above, we see that the direct effect of this pessimism is a drop in desired capital spending. This drop in capital spending leads to an expected decline in future GDP, which serves to reduce household wealth, which in turn leads to a decline in consumer demand. Together then, this shock leads to a decline in aggregate demand. Firms react to reduced demand by contracting the supply of output (and letting go workers). The economy heads into recession for no good reason. If the CB observes output declining below potential then, it reacts to this development by cutting the interest rate in an attempt to stimulate aggregate demand. Notice that this policy would only work to the extent that the nominal interest rate is positive. If the nominal interest rate is zero (as is currently the case in Japan), then the CB is powerless to stimulate the economy (the economy is said to be in a ‘liquidity trap’). The reverse would happen should the CB see output rising above potential. In this case, the CB would view the economy as ‘overheating’ and so would respond by increasing the interest rate. 5 3 Stabilizing Inflation These days, central banks seem more concerned with stabilizing inflation rather than output. Perhaps this is because central banks have come to the realization that they were not especially good at stabilizing output. However, they do seem to have the power to stabilize the inflation rate. Since fluctuations in inflation are viewed as something undesirable, why not concentrate on inflation instead of output? In fact, many countries (Canada included) have recently adopted inflation targets as a primary objective of the CB. In order to understand how the CB can influence inflation, we need a theory of the inflation rate. We have already discussed in class an old theory of inflation (the quantity theory). According to the quantity theory: (1 + π ) = 1+µ 1+γ , where µ represents the rate of growth of the money supply and γ represents the rate of growth of money demand (which is assumed to grow at the same rate as real output). This simple theory holds up remarkably well in terms of explaining the level of inflation over long periods of time. However, the theory seems to break down over shorter time intervals. Consequently, central bankers tend to prefer an alternative theory of inflation that is based on the Phillips curve, which is an alleged empirical relationship that appears (in the eyes of central bankers, anyway) to hold in the data. A typical Phillips curve takes the following form: π = π e + φ(y1 − y P ), (7) where φ > 0. What equation (7) tells us is that if output is at potential, then the actual inflation rate is determined by the expected inflation rate. If output is above potential, then the actual inflation rate turns out to be higher than expected. Conversely, if output is below potential, then inflation turns out to be lower than expected. Now, remember that crazy fluctuations in z e induce unwarranted fluctuations in y1 . As a result, actual inflation will fluctuate as well. To the extent that the CB views these fluctuations in inflation as undesirable, it may want 6 to adjust the interest rate to counteract any undesirable movement in z e . As it turns out, the way that the CB can do this is by stabilizing output at potential. However, what if the economy is subject to a different type of shock? In particular, what if fluctuations are coming not from z e but from πe ? In this case, stabilizing output at its potential will not minimize fluctuations in inflation. In fact, if there was a positive ‘inflation shock’ (an increase in πe , in order to stabilize inflation the CB would have to raise interest rates sufficiently high in order to send the economy into recession (so that y1 falls below potential). Alternatively, suppose that π e is currently very high (as it was in Canada during the 1970s) and suppose that the CB was determined to lower π e (a policy adopted by the Bank of Canada in the early 1980s). The way that the CB could try to achieve such an outcome is by raising interest rates through the roof (in fact, interest rates approached 20% in the early 1980s). This high interest rate policy would have the effect of sending the economy into a dramatic recession and (according to the Phillips curve) result in lower realized rates of inflation. The idea here is that after observing several periods of low inflation, individuals would eventually revise downward their expectations of inflation πe . Eventually, this is exactly what happened in Canada (and many other countries). It was this painful episode that makes central bankers today so concerned about keeping inflation (and inflation expectations) at low levels. 7