UNIVERSITY OF CALIFORNIA Economics 134 DEPARTMENT OF ECONOMICS Spring 2018 Professor David Romer LECTURE 10 THE ZERO LOWER BOUND IN THE IS-MP-IA FRAMEWORK FEBRUARY 21, 2018 I. I NTRODUCTION II. T HE IS-MP-IA M ODEL E XTENDED A. Assumptions 1. The nominal interest rate can’t be negative 2. Expected inflation depends on actual inflation 3. Discussion B. The AD Curve 1. Where we are headed 2. The IS-MP diagram 3. Deriving the AD curve C. A Little Bit about the Case of Money Targeting III. E XAMPLES A. A Large, Long-Lasting Fall in Planned Expenditure 1. The initial situation 2. The shock 3. Aside: Why doesn’t the AD curve shift left by the same amount at each inflation rate? 4. The dynamics of the economy 5. What happens when there is a rebound in planned expenditure 6. How seriously should we take this? B. The Case of “Anchored” Expectations 1. Overview 2. A model of anchored expectations 3. The effects of a large, long-lasting fall in planned expenditure 4. A concern: how long can this last?
Economics 134 David Romer Spring 2018 L ECTURE 10 The Zero Lower Bound in the IS-MP- IA Framework February 21, 2018
Announcements • Problem Set 2 is being distributed. • It is due at the beginning of lecture a week from today (Feb. 28). • Optional problem set work session: Monday, Feb. 26, 6:45–8:15, in 597 Evans Hall. • A packet of “sample exam questions” is also being distributed.
Announcements (cont.) • For next time, you do not need to read the paper by Temin and Wigmore. • My upcoming office hours: • This week: Usual time: Thursday (2/22), 4–5:30. • Next week and the week after: Monday (2/26 and 3/5), 3:30–5:00.
Economics 134 David Romer Spring 2018 L ECTURE 9 The Conduct of Postwar Monetary Policy (concluded)
Bad Idea: Inflation Responds Little to Slack π π 0 IA 0 π 1 IA 1 AD Y 0 Y Y IA will shift down only very slowly in response to Y < Y.
What Policies Are Likely to Be Followed If Policymakers Believe Inflation Responds Little to Slack? π π 0 IA 0 AD 1 AD 0 � ,Y 1 Y Y 0 Y � . Result: Inflation doesn’t fall. No reason to have Y < Y
What If Policymakers Believe Inflation Responds Little � ? to Slack and Have an Overly Optimistic Estimate of Y π π 1 IA 1 π 0 IA 0 AD 1 � actual Y � believed Y Y � believed . Result: Inflation rises. No reason to have Y < Y
If It Is Monetary Policymakers Who Have These Ideas, What Will Be Going on in IS-MP? r MP 0 MP 1 IS 0 � actual Y � believed Y Y � believed . Fed shifts MP down to get Y = Y
How Were Ideas Reflected in Monetary Policy Choices in the Early and Late 1970s? • No reason to for contractionary policy because they thought it wouldn’t curb inflation. • Unrealistic estimates of the natural rate led to expansionary policy. • Fed officials pushed for other policies to control inflation, such as price controls.
Percent 10 15 20 -5 0 5 Jan-34 Jan-37 Jan-40 Eccles Jan-43 Jan-46 Jan-49 Jan-52 Jan-55 Jan-58 Martin Jan-61 Inflation Rate Jan-64 Figure 2 Jan-67 Jan-70 Burns Jan-73 Jan-76 Jan-79 Volcker Jan-82 Jan-85 Jan-88 Jan-91 Greenspan Jan-94 Jan-97 Jan-00 Jan-03
What Does Romer and Romer’s Analysis Suggest about a Question We Discussed Early in the Course? • Why did the rise of stabilization policy not cause the economy to quickly become much more stable? • Romer and Romer’s analysis provides support for the “the tools were used badly” hypothesis.
The Unemployment Rate after “Romer & Romer Dates”
Percent 10 15 20 -5 0 5 Jan-47 May-49 The CPI Inflation Rate after “Romer & Sep-51 Jan-54 May-56 Sep-58 Jan-61 May-63 Sep-65 Romer Dates” Jan-68 May-70 Sep-72 Jan-75 May-77 Sep-79 Jan-82 May-84 Sep-86 Jan-89 May-91 Sep-93 Jan-96 May-98 Sep-00 Jan-03 May-05 Sep-07 Jan-10
Interpreting Regression Results – Example: Taylor’s Estimates of the Pre-Volcker Monetary Policy Rule Note: Numbers in parentheses are t-statistics (coefficient estimate divided by the standard error).
Interpreting Regression Results – Example (cont.) • For the 1960–1979 sample, Taylor finds a coefficient on inflation = 0.813, with t -statistic = 12.9. • Since the t -statistic is >> 2, we can reject the hypothesis that the coefficient is 0. • But what is the 2-standard error confidence interval? Can we reject the hypothesis that the coefficient is 1?
Interpreting Regression Results – Example (cont.) • Coefficient on i nflation = 0.813, t -statistic = 12.9. • t - statistic ≡ coefficient/standard error, so standard error = coefficient/ t -statistic. • So: standard error = 0.813/12.9 = 0.063. • The two-standard error confidence interval is from 2 standard errors below point estimate to 2 standard errors above. • So: 2-standard error confidence interval = (0.687,0.939). • 1 is outside this confidence interval, so we can reject (“at the 5% leve l”) the hypothesis that the coefficient is 1.
Economics 134 David Romer Spring 2018 L ECTURE 10 The Zero Lower Bound in the IS-MP- IA Framework
I. I NTRODUCTION
II. T HE IS-MP-IA M ODEL E XTENDED
Key Assumptions: 1 The nominal interest rate cannot be negative • The central bank would like to set r = r(Y, π ). • Since the real interest rate, r, equals i – π e , this means that r cannot be less than 0 – π e . • Thus: + ≥ π π) π e r ( Y , ) if r ( Y , 0 = r − π e 0 otherwise
Key Assumptions: 2 • Expected inflation is an increasing function of actual inflation. • That is, π e = π e ( π ), where π e ( π ) is an increasing function.
One Comment Before We Proceed • We will continue to use the usual IS-MP-IA model (that is, the model without the zero lower bound) in cases where it is appropriate.
Where We Are Headed: The Aggregate Demand Curve Accounting for the Zero Lower Bound π AD Y
The IS and MP Curves Accounting for the Zero Lower Bound: Step 1 r r(Y, π ) 0 – π e ( π ) IS Y
The IS and MP Curves Accounting for the Zero Lower Bound: Step 2 r MP 0 – π e ( π ) IS Y
Deriving the AD Curve MP( π 0 ) r 0 – π e ( π 0 ) IS 0 Y π π 0 Y Y 0
Deriving the AD Curve MP( π 0 ) r MP( π 1 ) MP( π 2 ) 0 – π e ( π 2 ) 0 – π e ( π 1 ) 0 – π e ( π 0 ) IS 0 Y π π 0 π 1 π 2 π 0 > π 1 > π 2 Y Y 0 Y 1 Y 2
Deriving the AD Curve (continued) r MP( π 2 ) 0 – π e ( π 2 ) IS 0 Y π π 2 Y Y 2
Deriving the AD Curve (continued) r MP( π 2 ) MP( π 3 ) 0 – π e ( π 3 ) 0 – π e ( π 2 ) IS 0 Y π π 2 π 2 > π 3 π 3 Y Y 3 Y 2
Deriving the Aggregate Demand Curve: Conclusion π AD Y
A Little Bit about the Case of Money Targeting • Continue to assume that expected inflation is lower when actual inflation is lower. • Suppose that at some inflation rate, π 0 , the nominal interest rate is zero. Thus the real interest rate is 0 – π e ( π 0 ). • Now consider lower inflation, π 1 (so π 0 > π 1 ). • The lowest possible real interest rate is 0 – π e ( π 1 ), which is higher than the real interest rate at π 0 , 0 – π e ( π 0 ). Thus, r must be higher. • That is, it is still true that when the economy is at the zero lower bound, lower inflation raises r.
III. E XAMPLES
Example: A Large, Long-Lasting Fall in Planned Expenditure r MP( π 0 ) 0 – π e ( π 0 ) IS 0 IS 1 Y 1 Y 0 (= Y) Y AD 0 π AD 1 π 0, π 1 IA 0 , IA 1 Y 1 Y 0 (= Y) Y
Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? π AD if r = r(Y, π ) AD if r = 0 – π e ( π ) Y
Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (continued) r r r = r(Y, π ) 0 – π e ( π ) IS 0 IS 0 IS 1 IS 1 Y 1 Y 0 Y 1 Y 0 Y Y A given shift of the IS curve causes a bigger fall in Y (at a given π ) if r = 0 – π e ( π ) than if r = r(Y, π ).
Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (continued) π AD if r = r(Y, π ) AD if r = 0 – π e ( π ) Y
Why Doesn’t the AD Curve Shift Left by the Same Amount at Each Inflation Rate? (concluded) π AD 0 AD 1 Y
A Large, Long-Lasting Fall in Planned Expenditure (cont.) r MP( π 1 ) MP( π 2 ) 0 – π e ( π 2 ) Note: Because 0 – π e ( π 1 ) inflation does not respond IS 1 immediately to shocks, π 1 = π 0 Y π AD 1 (and so IA 1 is the same as IA 0 ). IA 1 π 1 π 2 IA 2 Y 2 Y 1 Y Y
The Effects of a Large Rebound in Planned Expenditure r MP( π 2 ) 0 – π e ( π 2 ) IS 3 IS 1 Y π AD 1 IA 2 π 2 AD 3 Y 2 Y 4 Y Y
How Seriously Should We Take This? The main message, which we should take very seriously: When the economy is at the zero lower bound, a key force keeping the economy stable is inoperative.
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