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 prices prediction short run
Liquidity Preference
(Keynesian) sticky
 i > 0 long run
Quantity Theory,
Fisher Effect
(Classical) flexible
 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.
b.
use the IS-LM diagram to show the effects of the shock on Y and r .
determine what happens to unemployment rate.
C , I , and the slide 2

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

Why does the Fed target interest rates instead of the money supply?
1) They are easier to measure than the money supply
2) The Fed might believe that more prevalent than IS
LM shocks are shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. slide 4

 Model: monetary & fiscal policy variables
( M , G and T ) are exogenous
 Real world:
Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.
 Such interaction may alter the impact of the original policy change. slide 5

 G
> 0
 Suppose Congress increases G .
 Possible Fed responses:
1.
2.
3.
hold M constant hold r constant hold Y constant
 In each case, the effects of the  G are different: slide 6

Response 1: hold
M constant r If Congress raises G , the IS curve shifts right
If Fed holds M constant, then LM curve doesn’t shift.
Results:
 Y  Y
2
 Y
1 r r
2
 r
1 r
2 r
1
Y
1
Y
2
LM
1
IS
IS
1
2
Y slide 7

Response 2: hold r constant r If Congress raises G , the IS curve shifts right
To keep r constant,
Fed increases M to shift LM curve right.
Results:
 Y  Y
3
 Y
1
0 r
2 r
1
LM
1
LM
2
Y
1
Y
2
Y
3
IS
IS
1
2
Y 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.
Results:
 Y  0 r r
3
 r
1 r
3 r
2 r
1 r
Y
1
Y
2
LM
2
LM
1
IS
IS
1
2
Y 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

240
220
200
180
160
140
120
1929
Unemployment
(right scale)
1931 1933
Real GNP
(left scale)
1935 1937 1939
30
25
20
15
10
5
0 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
 widespread bank failures made it harder to 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

 Policymakers (or their advisors) now know much more about macroeconomics:
 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
Percentage 40 of GDP
35
30
25
20
15
10
5
0
Canada France Germany Italy
Imports Exports
Japan U.K.
U.S.
slide 21

1.
Fiscal policy at home
2.
Fiscal policy abroad
3. An increase in investment demand slide 22

1.
r
An increase in or decrease in reduces saving.
G
T r
1
*
NX
2
S
2
S
1
NX
1
Results:
0
 NX S 0
I
1
I ( r )
S, I slide 23

NX and the Government Budget Deficit
Percent of GDP
4
3
2
1
0
-1
-2
-3
-4
1950
Budget deficit
(right scale)
1960
Net exports
(left scale)
1970 1980 1990 2000
0
-2
-4
-6
-8
4
2
8 Percent of GDP
6 slide 24

2.
r
Expansionary fiscal policy abroad raises the world interest rate.
r
2
* r
1
*
NX
2
NX
1
S
1
Results:
0
 NX I 0
I r I r
I ( r )
S, I slide 25

3.
r
S
EXERCISE:
Use the model to determine the impact of an increase in investment demand on NX , S , I , and net capital outflow.
r *
I
1
NX
1
I ( r )
1
S, I slide 26

3.
r
NX
2
S
ANSWERS:
 I > 0,
 S = 0, net capital outflows and net exports fall by the amount  I r *
NX
1
I
1
I
2
I ( r )
2
I ( r )
1
S, I slide 27

2
-1
-2
-3
-4
1
0
-5
1975
U.S. Net Exports and the
Real Exchange Rate, 1975-2002
1980 1985 1990 1995
Net exports (left scale)
Real exchange rate (right scale)
2000
140
120
100
80
60
40
20
0 slide 28

1.
Fiscal policy at home
2.
Fiscal policy abroad
3. An increase in investment demand
4. Trade policy to restrict imports slide 29

1.
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
ε
2
ε
1
S
2
 I r
S
1
 I r
NX
2
NX
1
NX ( ε )
NX slide 30

2.
An increase in r* reduces investment, increasing net capital outflows and the supply of dollars in the
ε
ε
1
ε
2
S
1
 I r
S
1
 I ( r
2
* ) rate to fall and
NX to rise.
NX
1
NX
2
NX ( ε )
NX slide 31

3.
An increase in investment reduces net capital outflows and the supply of dollars in the foreign exchange real exchange rate to rise and NX to fall.
ε
ε
2
ε
1
S
1
 I
2
S
1
 I
1
NX
2
NX
1
NX ( ε )
NX slide 32

4.
At any given value of ε , an import quota
  IM   NX
 demand for dollars shifts
ε
ε
2
ε
1 doesn’t affect S or
I , so capital flows and the supply of dollars remains fixed.
NX
1
NX ( ε )
2
NX ( ε )
1
NX slide 33

4.
Results:
 ε > 0
(demand increase)
 NX = 0
(supply fixed)
 IM < 0
(policy)
 EX < 0
(rise in ε )
ε
ε
2
ε
1
NX
1
NX ( ε )
2
NX ( ε )
1
NX slide 34

Inflation and nominal exchange rates
Percentage 10 change in nominal
9 exchange 8 rate
7
6
5
Italy
South Africa
4
3
2
1
Belgium
New Zealand
Sweden
Australia
Ireland
Canada
Spain
France
UK
0
-1
-2
Germany
-3
Netherlands
Switzerland
Japan
-4
-3 -2 - 1 0 1 2 3 4 5 6 7 8
Inflation differential
Depreciation relative to
U.S. dollar
Appreciation relative to
U.S. dollar slide 35

CASE STUDY
The Reagan Deficits revisited
1970s 1980s actual change closed economy small open economy
G – T 2.2
3.9
  
S 19.6
17.4
   r 1.1
6.3
  no change
I
NX
ε
19.9
-0.3
115.1
19.4
-2.0
129.4



Data: decade averages; all except
 no change no change no change r and ε are expressed

 as a percent of GDP; ε is a trade-weighted index.
slide 36