Modern Macroeconomic
Practice
Gavin Cameron
University of Oxford
OUBEP 2006
the theory of short-run fluctuations
Keynesian Cross
IS Curve
IS-LM-BP
Money Market
AS-AD model
LM Curve
NAIRU
FX Market
AD curve
AS curve
BP Curve
Productivity
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
2
a modern framework
IS Curve
Monetary Reaction
(MR)
IS-MR-PC model
Phillips Curve
(PC)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
3
the Phillips Curve
• In 1958, A.W. Phillips of the LSE found relation an empirical
relationship between unemployment and inflation in the UK – the
Phillips curve.
• Original interpretation:
• There is a permanent trade-off between inflation and
unemployment.
• Problem:
• After sustained inflation, the empirical relationship broke down.
• New interpretation:
• There is a trade-off between unemployment and unexpected
inflation:
output=equilibrium output+ b(unexpected inflation)
• Therefore output deviates from its equilibrium level by the extent to
which inflation deviates from its expected level.
• But in the long-run, there is no such trade-off.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
4
what affects the IS curve?
•
•
•
•
Aggregate expenditure comprises five components:
• consumption
• investment
• primary government spending (i.e. net of transfers)
• net exports (i.e. exports minus imports)
• inventories (i.e. changes in stocks held by businesses)
The level of income (both current and expected) is a major determinant of
consumption, government spending and net exports.
The real exchange rate is a major influence on net exports.
The interest rate is also an influence on consumption and investment (with the
latter being also dependent upon output expectations and ‘animal spirits’).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
5
shocks to the economy
• Why might the economy get ‘shocked’ away from equilibrium?
• IS-curve shocks
• an investment boom;
• a pre-election government spending spree;
• a sudden rise in the real exchange rate;
• a consumer boom abroad;
• a boom in the housing market;
• an unexpected cut in interest rates;
• a slump in share prices.
• Phillips curve shocks
• a sudden rise in oil prices;
• the invention and diffusion of a new technology;
• labour market changes.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
6
an IS curve shock
interest rates
inflation
LRAS
LRPC
C
C
D
B
SRPC (πe=π2)
D
B
A
A
IS2
SRPC (πe=π1)
IS1
Y*
•
Y
Y*
Y
An investment boom shifts the AD curve outwards. At first, expectations lag behind events, so output
and inflation rise (‘unexpected inflation’) to point B. The monetary response leads to higher interest
rates for long enough to ‘crowd-out’ excess spending (point C) and then return inflation to its original
level (point D).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
7
monetary policy reaction
inflation
• The monetary authority will
seek to offset a demand
shock by raising interest
rates.
• In order to reduce inflation,
unemployment must rise
above its equilibrium!
LRPC
C
D
B
A
SRPC (πe=π1)
Y*
Y
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
8
monetary policy reaction II
inflation
LRPC
C
D
E
A
Y*
• Some monetary authorities
will be more averse to
inflation, some more averse to
SRPC (πe=π2)
unemployment.
B
• An inflation-averse authority
will seek to bring down
inflation quickly by moving to
SRPC (πe=π1)
E.
• The slope of the SRPC also
matters – if it is steep then
disinflation is relatively quick.
Y • It will be steeper when there is
less inflation inertia and less
real wage rigidity.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
9
a policy problem – data revisions!
Per cent
1.5
Revisions to level of UK market sector output between
May and June 2005
1.2
0.9
0.6
0.3
0.0
-0.3
1992
1994
1996
1998
2000
2002
2004
Source: Inflation Report, August 2005
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
10
monetary policy
•
•
•
•
•
•
‘Having regard to human nature and our institutions, it can only be a foolish
person who would prefer a flexible wage policy to a flexible money policy,
unless he can point to advantages from the former that are not obtainable
from the latter’ J.M.Keynes, 1936.
Monetary policy can be implemented through either changes in the money
supply or interest rate, or through direct controls on lending.
Changes in the interest rate will affect the interest-sensitive components of
aggregate demand. The exact size and timing of these effects will differ from
country to country.
If economy is at equilibrium output, interest rate cuts will lead to an
inflationary boom, which eventually will lead only to higher prices.
If economy is below equilibrium output, interest rate cuts will tend to raise
output (as well as prices) and shift the economy back towards equilibrium.
Typical lag effect on output one year, inflation two years.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
11
the limits to monetary policy
• But there are problems with the use of monetary policy:
• Measurement of output: where are we? where are we going?
how fast? will we know when we get there?
• Lags in the monetary policy process: implementation
(recognition & administrative lags) and operational;
• What kind of monetary policy? Interest rates, open-market
operations, quantitative controls, credit controls.
• The liquidity trap & credit channel – will policy actually affect
the interest rates and lending policies faced by agents?
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
12
Taylor rules and inflation targeting
•
•
•
•
•
After the inflationary difficulties of the 1970s and 1980s, many countries
moved towards having independent central banks and the use of inflation
targets.
This form of ‘constrained discretion’ seems to work because it takes control of
monetary policy out of the hands of politicians!
In practice, most monetary authorities operate something called a ‘Taylor
rule’. That is, they raise the real interest rate (the nominal rate minus
expected inflation) whenever inflation is above target or when capacity
constraints appear in the economy (since these may predict future inflation).
We can think of a monetary policy reaction function, where
r=
inflation target + equilibrium real r
+ a(output – equilibrium output) + b (inflation – inflation target)
The coefficient a measures how averse the monetary authority is to output
deviations and b measures how averse it is to inflation deviations.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
13
UK inflation performance
Source: Carlin and Soskice (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
14
fiscal policy
•
•
•
•
‘If the Treasury were to fill old bottles with bank notes, bury them at suitable
depths in disused coal mines which are then filled up with town rubbish, and
leave them to private enterprise… to dig them up again, there need be no
more unemployment. It would, indeed, be more sensible to build houses and
the like, but if there are political and practical difficulties in the way of this,
the above would be better than nothing’ J.M. Keynes, 1936.
Changes in the government’s fiscal stance (that is, the difference between
government spending and taxation) will change the level of aggregate
demand.
If economy is at equilibrium output, increases in spending (or tax cuts) will
lead to an inflationary boom, which eventually will lead only to higher prices.
If economy is below equilibrium output, increases in spending (or tax cuts)
will tend to raise output (as well as prices) and shift the economy back to
equilibrium.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
15
the limits to fiscal policy
• But there are problems with the use of fiscal policy:
• Measurement of output: where are we? where are we going?
how fast? will we know when we get there?
• Lags in the fiscal policy process: implementation (recognition &
administrative lags) and operational;
• What kind of fiscal policy? Spending (on what?) or tax cuts (for
whom?);
• Will spending ‘crowd-out’ other spending, either directly or
indirectly (through interest rates, inflation, or the exchange rate)?
• Will consumers pierce the veil? Will they attempt to offset the
actions of the government (Ricardian Equivalence)?
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
16
fiscal rules
•
•
•
Even now that most monetary policy is conducted by independent monetary
authorities, there is still the problem that politicians may pursue fiscal policies
that are incompatible with stable inflation.
Consequently, some countries have adopted fiscal rules. The two most
famous are:
• The Stability and Growth Pact (revised!): countries should aim to run no
more than a 1% deficit over the business cycle; cannot borrow more than
3% of GDP (cf. France and Germany!) in any one year; government debt
should be kept below 60% of GDP.
• Gordon Brown’s Golden Rule: over the business cycle borrowing should
equal net government investment; government debt should be kept
below 40% of GDP.
A fiscal rule that states that debt must be kept below a level of X% of GDP
implies that the average deficit over the cycle must be approximately equal to
the average growth rate of GDP times the target level of X%. For Britain, with
an average growth rate of 2% and a target of 40%, the average deficit must be
kept around 0.8%.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
17
how does monetary policy work?
Source: Carlin & Soskice, p12
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
19
transmission mechanisms
Market rates
Domestic
demand
Total
demand
Asset prices
Official
rate
Domestic
inflationary
pressure
Net external
demand
Expectations&
confidence
Inflation
Import
prices
Exchange rate
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
20
higher interest rates do not always tighten financial conditions
Index, 10/20/03=100
100.6
Percent
5.0
Fed Funds Rate (left)
FCI (right)
100.4
4.0
100.2
100.0
3.0
99.8
99.6
2.0
99.4
1.0
J A S O N D J F M A M J
2005
2004
J
A S O N D
J F M A
2006
99.2
Source: Goldman Sachs
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
21
Euro area responses to a 1% rise in ECB repo rate for two years
Real GDP
Year 1
Year 2
Consumer prices
Year 3
Year 1
Year 2
Year 3
ECB
-0.34
-0.71
-0.71
-0.15
-0.30
-0.38
NCB
-0.22
-0.38
-0.31
-0.09
-0.21
-0.31
NIGEM
-0.34
-0.47
-0.37
-0.06
-0.10
-0.19
Note: The table shows responses of real GDP and consumer prices to a two-year increase of 100 basis points
in the policy-controlled interest rates of the euro area. Figures are expressed in per cent from baseline.
Simulations are performed using the ECB’s area-wide model, the national central banks’ macroeconometric
models and the multi-country model of the NIESR
Source: ECB Monthly Bulletin, October 2002, p45
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
22
the Keynes view
• “But this long run is a
misleading guide to current
affairs. In the long run we
are all dead. Economists set
themselves too easy, too
useless a task if in
tempestuous seasons they
can only tell us that when
the storm is long past the
ocean is flat again.” J.M.
Keynes, 1936.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
23
recent developments
• Euroland growth has been slow since 2000;
• US recovery from recession in 2000-1 has been good, although
employment has not recovered as much as output;
• The UK has grown steadily;
• Japan may be picking up; China and India continue to grow rapidly.
• World monetary policy has been extraordinarily relaxed since 2000,
with interest rates of around 0% in Japan, 1% in the USA and 2% in
Euroland.
• But short-term interest rates are now rising around the world.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
24
recent performance
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
25
recent loose monetary policy
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
26
…even on a real basis
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
27
breaking the rules?
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
28
rising debt
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
29
bond yields low despite rule-breaking!
Source: CESifo (2006).
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
30
inflationary pressure
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
31
contango!
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
32
rising yield expectations
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
33
excess liquidity?
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
34
focus on the USA
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
35
focus on Japan
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
36
focus on Japan
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
37
Junker vs Trichet
Source: BIS Annual Report (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
38
global imbalances
Source: CESifo (2006)
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
39
global prospects
•
•
•
•
•
•
While the US continues to run such large ‘twin deficits’, there is the possibility
of a disorderly correction to global imbalances. Not clear how different
Bernanke will be to Greenspan yet.
In the absence of such a correction, continued broad growth with some
inflationary pressure is likely.
Corporate profits have been very strong in the USA and wage growth has
been weak – not much more scope for profits to outperform revenues.
In Europe, on the other hand, corporate profits may rise faster than revenues
as the economy picks up – assuming no more oil price rises.
Very hard to predict changes in China. Likely to be modest upward
movement of renminbi and modest decline in share of investment in GDP
(46% in 2005!). Current policy hugely distorts price mechanism: credit too
cheap, exchange rate too low, labour market distortions.
The need for reform in Chinese banking system and credit allocation and to
deal with inflation and excess capital investment must be balanced against
risk of sudden adjustment.
OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME
40