The Limits of Demand Management
5.4 Policy responses to shocks Macroeconomic Policy So far: Dynamic AS-AD model Central bank only follows its predetermined Taylor Rule (except in case of shift in monetary policy) Government is not intervening to reduce the initial shock. Today: What can a government do to influence the growth performance of the economy? Aggregate demand policies: Fiscal policy and Monetary policy (CB) Macroeconomic stabilization (Chapter 17) Supply-side policies / structural reforms (not treated in detail in this course) What should it do?
Introduction Outline The effects of policy interventions in theory 1. Supply shock 1. Demand shock 2. Neoclassicals vs. Keynesians 2. Macroeconomic policy and business cycles 3. Impulse Propagation Mechanism 1. Policy lags 2. Literature Chapter 16 : 16.1 + 16.2 (16.2.3 was already covered together with Chapter 6) 16.3.1 + 16.3.2 16.4.1 + 16.4.4 Not necessary: 16.3.3, 16.4.2, 16.4.3
1. Policy responses to shocks Supply shock & demand policies What can policy makers do in case of a negative demand or supply shock? Fiscal policy Monetary policy Expansionary versus contractionary Reminder: fiscal policy under flexible exchange rates is NOT or only little effective in a small & open economy, under fixed exchange rates it is monetary policy that is ineffective. Both are effective in an economy without free international capital flows or in a big & open economy with flexible exchange rate (EU or US). Different consequences in case of Supply shock Demand shock Consequence depend also on how expectations are formed and speed of adjustment
1.1 Policy responses to shocks – supply shock Adverse supply shock ~ aY gap If s >0 Shift in the AS curve: s Stagflation: both unemployment and inflation LAS increase. AS´ We study three possible measures to bring the economy AS Inflation B quickly back to the LAS curve. A LAD AD 0 Output gap
1.1 Policy responses to shocks – supply shock Supply shock & demand policies – Option 1 Suppose we try to fight resulting unemployment with expansionary demand policies... We successfully fight unemployment, but at a cost LAS of increased inflation in the AS´ long-run. C New eq: at C (LAD curve Inflation B would need to shift up). A LAD AD´ AD 0 Output gap
1.1 Policy responses to shocks – supply shock Supply shock & demand policies – Option 2 ... or we try to fight the inflationary impact of the adverse supply shock through a contractionary policy. We successfully fight π but at a cost of increased LAS AS´ unemployment (via point D ) until we return AS to the long-run eq. at A . Inflation B A LAD D AD AD´´ 0 Output gap
1.1 Policy responses to shocks – supply shock Supply shock & demand policies – Option 3 Third option: Central bank announces credibly that inflation will be at its target level. Aim: stop the underlying inflation from increasing to allow a swift return to the initial AS curve and initial equilibrium. Role of expectations: importance of forward looking component of underlying inflation Foward looking component: inflation target set by the CB (in the LR inflation is determined by money supply!) If a country suffers from high inflation: high inflation expectations drive actual inflation further up If the CB can now make a credible statement that it will not increase money supply, inflation expectations are low nominal wages & prices set low actual inflation decreases.
1.1 Policy responses to shocks – supply shock Supply shock & demand policies – Option 3 Third option: Central bank announces credibly that inflation will be at its target level. If people expect inflation to be at its target level, AS curve shifts back to its LAS original position. AS´ AS We return directly to the long-run equilibrium at A . Inflation B A LAD AD 0 Output gap
1.2 Policy responses to shocks – demand shock Adverse demand shock An adverse demand shock brings the economy from point A to point B… LAS AS Inflation A B AD AD´ 0 Output gap
1.2 Policy responses to shocks – demand shock Adverse demand shock AD policy change to offset demand shock To go back to point A: Expansionary fiscal or expansionary monetary policy We return directly to the long-run equilibrium at A . LAS No fear for high inflation AS (above target level) Inflation A B AD AD´ 0 Output gap
2. Neoclassicals versus Keynesians Neoclassicals vs Keynesians What is the role of demand management policies in practice? In theory this works. But are they actually successful? Mixed results The debate: Keynesians Neoclassicals Milton Friedman John Maynard Keynes 1912-2006 1883-1946 Do we need to adjust? What is the speed of adjustment?
2. Neoclassicals versus Keynesians Rational expectations & adjustments The speed of price adjustment depends on the expectations formation mechanism If expectations are backward looking, depending only on the past, the adjustment takes a long time (see next slide) But backward looking expectations are not “consistent”, i.e. they imply that people make systematic errors. In the case of rational expectations, expectations are “consistent” i.e. people do not make systematic errors, The agents “know” the model, and the speed of adjustment can be very high.
2. Neoclassicals versus Keynesians Recall: shift of the AS curve Adaptive expectations: Rational expectations: Underlying π = previous Underlying π = long run year’s observed inflation inflation direct shift slow shift of As t via from AS t to As t+n LAS As t+1 to AS t+n AS t AS t+1 Inflation AS t+n ~ t A ~ t t t 1 B ~ LAD t n t n C AD 0 Output gap ~ aY s t t gap t
2. Neoclassicals versus Keynesians Shift of the AS-curve Why does the short run AS-curve shift? Year t: AS t in A: inflation in year t < underlying (expected) inflation (compare with inflation in C, the intersection AS – LAS) Underlying inflation falls Based on the new underlying inflation, firms and unions negotiate the (expected) real wage which should bring the economy to U n nominal wages Short-run AS-curve shifts downwards (to the right) Year t+1: AS t+1 Inflation lower than expected real wages higher than expected U t+1 > U n , but U t+1 < U t since inflation closer to expected inflation than in t real wages in t+1 < real wages in t Labor cheaper than in t firms are willing to employ more workers and produce more
2. Neoclassicals versus Keynesians Key elements of Keynesian theory Keynesians: Prices are sticky Adjustment of prices and wages takes time nominal rigidities, long term contracts Backward-looking component dominates wage indexation Consequence: short run AS curve shifts only slowly We are not always on the LAS curve. We have free capacities that can be used In case of recession, we should intervene to get back to LAS quickly “In the long - run we are all dead”
2. Neoclassicals versus Keynesians The Keynesian case In the case of a negative demand shock… ...what if the LAS underlying inflation only adjusts very AS AS Inflation AS slowly? B A Starting point: left C of the LAS curve AD 0 Output gap
2. Neoclassicals versus Keynesians The Keynesian case Favorable demand policy brings Government economy quickly intervention is back to LAS. Inflation desirable… Gain: earlier back to LAS trend GDP. (fiscal policy under fixed exchange rates, monetary AS policy under flexible exchange rates, both in closed or big and open economy) B A … rather than wait C for underlying AD inflation to adjust AD AD enough to get back 0 Output gap to the trend.
2. Neoclassicals versus Keynesians Key elements of the Neoclassics Neoclassics: Prices are flexible Fast adjustment of prices and wages Foward-looking component dominates Consequences: short run AS curve shifts quickly back to the equilibrium on the LAS (anticipations adjust quickly) We will never be far away from the equilibrium No free capacities (unemployment at its natural level) No room for demand management policies
2. Neoclassicals versus Keynesians The neoclassical case – no shock Expansionary policy stimulates the economy, BUT… (fiscal policy under fixed exchange rates, monetary policy under flexible exchange rates, both in closed or big and open economy) LAS Short-run: output gain AS Inflation B A Starting point: ON AD the LAS curve AD AD 0 Output gap
2. Neoclassicals versus Keynesians The neoclassical case – no shock ...underlying inflation reacts to the impact of the policy. Long-run: no LAS output gain, but AS higher inflation AS AS C Inflation B A AD AD 0 Output gap
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