Adjustment to shocks and
the role of government policies
Ka-fu Wong
School of Economics and Finance
University of Hong Kong
** Prepared for the Professional Development Seminar for Economics Teachers, October 28, 2009.
1
Outline
 AS-AD model revisited
 Self-adjustment mechanism
 Time paths of output and price level
 Was Greenspan right in 1996
 Long-run growth and inflation
 The role of the government
 The great depression and the recent crisis
 The passive role of Hong Kong
2
Exercise #1
 Imagine yourself the central banker of a big country
(such as the United States). Your objective is to
maintain inflation within a narrow range with the
policy tool of an overnight interest rate (such as the
Federal fund rate). You have been seeing the following
data lately.
Years
GDP Growth
Unemployment Rate
Inflation Rate
1985-1995
2.80%
6.30%
3.5
1995-2000
4.10%
4.80%
2.5
 Would you choose to raise the target interest rate?
3
AS-AD model revisited
Planned aggregate expenditure
PAE = C + I + G + NX
C=a1+a2(Y-T)+a3r+a4W
I=b1+b2r
NX = d1+d2q
Real interest rate
Real exchange rate
Nominal exchange rate
r=i-p
q = ep*/p
e = domestic currency per foreign currency
p*= price of foreign good in foreign currency
4
Equilibrium output at a given price level
Y = PAE
5
Determination of Short-Run Equilibrium Output
Planned aggregate expenditure PAE
Y = PAE
Expenditure line
PAE = 960 + 0.8Y
Slope = 0.8
960
Equilibrium Algebraically
• At equilibrium: Y=PAE
• PAE = 960 + 0.8Y
• Y=960+0.8Y
• 0.2Y = 960
• Y = 960/0.2 = 4,800 in equilibrium
45o
4,800
Output Y
6
Aggregate Demand
 A relation between the equilibrium output and the price
level.
Y = PAE (p1)
⇒ Y1
Y = PAE (p2)
⇒ Y2
Y = PAE (p3)
⇒ Y3
…
7
The Aggregate-Demand curve
Price
Level
(P)
P ↓ ⇒ real wealth ↑
⇒ consumption ↑
⇒ interest rates ↓ ⇒ consumption ↑, investment ↑
⇒ exchange rate ↓ ⇒ net export ↑
P1
P2
AD
0
Y1
Y2
Quantity of
output (Y)
8
The short-run aggregate-supply curve
Price
Level
(P)
SRAS (Pe)
P1
In the short run,
P↓⇒Y↓
sticky wages,
sticky prices, or
misperceptions.
P2
0
Y2
Y1
Quantity of
Output (Y)
9
Aggregate Demand and Aggregate Supply
Price
Level
(P)
AS
Output, Y, and the price
level , P, adjust to the
point at which the
aggregate-supply, AS,
and aggregate-demand,
AD, curves intersect.
P*
AD
0
Y*
Quantity of
Output (Y)
10
The Long-run Aggregate-supply curve
Price
Level
(P)
LRAS
P1
In the long run, Y depends on:
labor,
capital,
natural resources, and
technology.
… but not on P.
P2
Thus, the LRAS curve is
vertical at YN.
0
YN
Natural rate of
output
Quantity of
Output (Y)
11
The Long-run equilibrium
Price
Level
(P)
LRAS
SRAS
In the long run, AD meets
LRAS at point A.
A
P*
Expected price level
adjusts to equal the actual
price level.
AD
0
YN
Natural rate of
output
Quantity of
Output (Y)
12
Self-adjustment towards the long-run
equilibrium
Price
Level
(P)
LRAS
SRAS1
A
P1
AD
0
Y2
Y1
Quantity of
Output (Y)
13
Slow shifts in SRAS
due to Long-term Wage and Price Contracts
 Union wage contracts set wages for several years.
 Contracts setting the price of raw materials and parts
for manufacturing firms also cover several years.
 These long-term contracts reflect the inflation
expectations or price level expectation at the time they
are signed.
14
The Output Gap and Inflation
Relationship of output
to potential output
Behavior of inflation
1. No output gap
Y = Y*
Inflation remains unchanged
(Price level remains unchanged)
2. Expansionary gap
Y > Y*
Inflation rises
3. Recessionary gap
Y < Y*
Inflation falls
(Price level rises)
(Price level falls)
15
Self-adjustment of recessionary gap
Price
Level
(P)
LRAS
SRAS1
SRAS2
SRAS3
A
P1
B
P2
AD
0
Y2
Y1
Recessionary gap
Quantity of
Output (Y)
16
Self-adjustment of expansionary gap
Price
Level
(P)
LRAS
SRAS3
SRAS2
SRAS1
B
P2
A
P1
AD
0
Y1
Y2
Expansionary gap
Quantity of
Output (Y)
17
A Contraction in aggregate demand
Price
Level
(P)
LRAS
SRAS1
SRAS2
A
P1
B
P2
C
P3
AD2
0
SRAS3
Y2
Y1
AD1
Quantity of
Output (Y)
18
Adjustment of output
Y
Y1
Y2
0
Time
19
Adjustment of price level
P
P1
P3
0
Time
20
Exercise #2
Impact of an increase in oil prices
Price
Level
(P)
LRAS
SRAS2
SRAS1
Sketch the possible time
paths showing the impact
of this oil shock if the
government and the central
bank do nothing to
accommodate the shock.
B
P2
C
P1
AD1
0
Y2
Y1
Quantity of
Output (Y)
21
An increase in oil prices
Price
Level
(P)
LRAS
SRAS2
SRAS1
B
P2
C
P1
AD1
0
Y2
Y1
Quantity of
Output (Y)
22
Adjustment of output
Y
Y1
Y2
0
Time
23
Adjustment of price level
P
P2
P1
0
Time
24
An increase in productivity (due to
technological changes)
Price
Level
(P)
LRAS1
LRAS2
SRAS1
SRAS2
SRAS3
A
P1
P2
B
AD1
0
Y1
Y2
Quantity of
Output (Y)
25
Adjustment of output
Y
Y2
Y1
0
Time
26
Adjustment of price level
P
P1
P2
0
Time
27
Exercise #1
 Imagine yourself the central banker of a big country
(such as the United States). Your objective is to
maintain inflation within a narrow range with the
policy tool of an overnight interest rate (such as the
Federal fund rate). You have been seeing the following
data lately.
Years
GDP Growth
Unemployment Rate
Inflation Rate
1985-1995
2.80%
6.30%
3.5
1995-2000
4.10%
4.80%
2.5
 Would you choose to raise the target interest rate?
28
U.S. Macroeconomic Data, Annual
Averages, 1985-2000
Was Greenspan right in 1996?
Years
% Growth in Unemployment Inflation
real GDP
rate (%)
rate (%)
Productivity
growth (%)
1985-1995
2.8
6.3
3.5
1.4
1995-2000
4.1
4.8
2.5
2.5
29
Long-run growth and inflation
Price
Level
(P)
LRAS1980 LRAS1990 LRAS2000
P200
0
P1990
P198
0
AD2000
AD1990
AD1980
0
Y1980
Y1990
Y2000
Quantity of
Output (Y)
30
Government intervention
Short-run adjustments are painful!
In the long run, we are all
dead!
31
A Contraction in aggregate demand
Price
Level
(P)
LRAS
SRAS1
SRAS2
A
P1
B
P2
C
P3
AD2
0
SRAS3
Y2
Y1
AD1
Quantity of
Output (Y)
32
Adjustment of output
Y
Y1
Y2
0
Time
33
The usefulness of fiscal and monetary
policy
 A slow self-correcting mechanism
 Fiscal and monetary policy can help stabilize the
economy.
 A fast self-correcting mechanism
 Fiscal and monetary policy are not effective and may
destabilize the economy.
 The speed of correction will depend on:
 The use of long-term contracts.
 The efficiency and flexibility of labor markets.
 Fiscal and monetary policy are most useful when
attempting to eliminate large output gaps.
34
Fiscal policies
 Government expenditure
 Taxation
 Takes time to pass a legislation
 Takes time to implement
 Supply-side policies
 Taxation
35
Monetary policy
 Interest rate
 Discount rate
 Reserve requirement
36
A Contraction in aggregate demand
Price
Level
(P)
LRAS
SRAS1
A
P1
B
P2
AD2
0
Y2
Y1
AD1
Quantity of
Output (Y)
37
Adjustment of output
Y
Y1
Y2
0
Time
38
An increase in oil prices
with accommodation policy
Price
Level
(P)
LRAS
SRAS2
SRAS1
A
P1
B
P2
C
P3
AD1
0
Y2
Y1
AD2
Quantity of
Output (Y)
39
Adjustment of output
Y
Y1
Y2
0
Time
40
An increase in productivity (due to technological
changes)
Price
Level
(P)
LRAS1
LRAS2
SRAS1
SRAS2
SRAS3
A
P1
P2
Do nothing!
B
AD1
0
Y1
Y2
Quantity of
Output (Y)
41
The Fed’s Role in Stabilizing Financial Markets:
Banking Panics
 Suppose:
 Depositors lose confidence in their bank.
 They attempt to withdraw their funds.
 Bank may not have enough reserves (fractional) to meet the
depositors demand.
 The bank fails and further erodes depositor confidence which
triggers additional failures.
 The Fed to the rescue:
 Instill confidence
 Discount lending
 Open Market Operations
42
The banking panics of 1930 - 1933 and the
money supply
 One-third of U.S. banks closed
 Depositors withdrew their funds
 Banks raised the reserve-deposit ratio
(banks were not willing to lend, considering loans too
risky.)
43
Key U.S. Monetary
Statistics, 1929-1933
Currency
held by public
Reserve-deposit
ratio
Bank
reserves
Money
supply
December 1929
3.85
0.075
3.15
45.9
December 1930
3.79
0.082
3.31
44.1
December 1931
4.59
0.095
3.11
37.3
December 1932
4.82
0.109
3.18
34.0
December 1933
4.85
0.133
3.45
30.8
44
The banking panics of 1930 - 1933 and the
money supply
 In response to the panics of 1929-1933, deposit
insurance was established in 1934.
 Deposit insurance gives depositors an incentive to
keep their money in the banks.
 Deposit insurance reduces the incentive for depositors
to pay attention to the financial strength of their bank.
45
Recent crisis:
No response to expansionary monetary policy?
 Liquidity trap
 The demand for money becomes infinitely elastic, i.e.
where the demand curve is horizontal, so that further
injections of money into the economy will not serve
to further lower interest rates.
 If the economy enters a liquidity trap area, monetary
policy will be unable to stimulate the economy.
46
Recent crisis:
No response to expansionary monetary policy?
 Credit rationing
 Banks maintain an interest rate lower than the market-clearing
level.
 Excess demand for loans allows banks to choose the more
profitable projects.
 When investment becomes more risky, banks are more
cautious.
Joseph E. Stiglitz and Andrew Weiss's 1981 paper explains why the bank (or any
lending institution for that matter) may credit ration its borrower if 1) the bank
was unable to perfectly distinguish the risky borrowers from the safe ones 2) the
loan contracts were subject to limited liability (if projects returns were less than
the debt obligation, the borrower bears no responsibility to pay out her pocket).
Stiglitz, J. & Weiss, A. (1981). Credit Rationing in Markets with Imperfect
Information, American Economic Review, vol. 71, pages 393-410.
47
What can the Fed do if Fed funds rate is near
zero
 Fed can buy other assets such as treasury bonds or
stocks (affect long interest rate)
48
Policymaking: Art or Science?
 Requirements for Perfect Macroeconomic Policy
 Accurate knowledge of current economic conditions
 Knowledge of the future path of the economy
without policy
 The precise value of potential output
 Complete and immediate control of fiscal and
monetary policy
 Knowledge of how and when the economy will
respond to policy changes
49
Policymaking: Art or Science?
 Lags in the effect of macroeconomic policy:
 Inside Lag (of macroeconomic policy)
The delay between the date a policy change is
needed and the date it is implemented
 Outside Lag (of macroeconomic policy)
The delay between the date a policy change is
implemented and the date by which most of its
effects on the economy have occurred
50
Policymaking: Art or Science?
 How to design macroeconomic policy?
 “Cross the River by Groping the Stone Under Foot”
or “Feeling for rocks while crossing a river”
 “Feeling for rocks while crossing a river” connotes a
gradual progress: When a step forward does not feel
right, a step in another direction might be necessary.
51
The passive role of Hong Kong
 The linked exchange rate does not allow independent
monetary policy
 Uncovered interest rate parity restricts Hong Kong’s
interest rate to be very close to that of the US.
52
Impact of an expansionary monetary policy in
the US
Low US interest rate
Low HK interest rate
Investment and
consumption
Asset and property bubbles
wealth effect?
AD increases
Y increases in the short
long run
P increases in the long run
53
Changes in aggregate demand due to changes
in the US monetary policies
Price
Level
(P)
LRAS
SRAS2
SRAS1
B
SRAS3
A
C
AD3
0
Y3
Y1
Y2
AD1
AD2
Quantity of
Output (Y)
54
Adjustment of output
Y
Y2
Y1
Y3
0
Time
55
Adjustment of inflation
P
P2
P1
P3
0
Time
56
Role of Hong Kong government?
 Monetary policy:
 By adopting the linked exchange rate system, we have given up our
autonomy of monetary policy.
 Fiscal policy:
 We still have autonomy fiscal policy. It is tempting to use fiscal policy
to accommodate the shocks.
 But fiscal policy is slow to take effect. By the time we see the effect,
the US monetary policy might have shifted in the opposite direction. If
so, the active HK’s fiscal policy may destabilize the output.
 Alternative:
 Make Hong Kong economy more flexible in adjusting to shocks.
 Improve the matching of job-seekers and vacancies.
 Encourage shorter job contract?
 Reduce the use of the government fiscal policy to stabilize the
economy (government policies tend to be slow!)
57
End
58