5.9 financial markets and central bank online test
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Week-20.pptxUnderstanding Business Cycle Fluctuations 2
Chapter 22
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Learning Objectives
Discuss the sources of fluctuations in output and inflation.
Use AS/AD tools to analyze changes in output and inflation.
Explain the challenges and tradeoffs that monetary policymakers face in stabilizing the economy.
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A recession is a decline in activity, not just a dip in growth rate.
Exact length is ambiguous.
Dating the peaks and troughs involves judgment.
Recessions differ along several dimensions: depth, duration, and diffusion.
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How Do Policymakers Achieve Their Stabilization Objectives?
The aggregate demand-aggregate supply framework is useful in understanding how monetary and fiscal policymakers seek to stabilize output and inflation using stabilization policy.
When shifting their reaction curve, central bankers shift AD.
They cannot shift the SRAS curve.
This means monetary policymakers can neutralize demand shocks, but cannot offset supply shocks.
Positive supply shocks that raise output and lower inflation provide policymakers with an opportunity.
Central bankers can guide the economy to a new, lower inflation target without inducing a recessionary output gap.
Fiscal policy can work to stabilize the economy
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Monetary Policy
A reduction in consumption and investment, shifts the dynamic aggregate demand curve to the left
Current inflation would fall below expected inflation and current output to fall below potential output.
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Monetary Policy
Drop in consumer or business confidence:
AD0 AD1
Economy: points 01
Stabilization requires shifting AD back to where it started.
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Monetary Policy
Policymakers will conclude that the long-run real interest rate has fallen.
If the inflation target stays the same, the drop in aggregate expenditure prompts them to shift the monetary policy reaction curve to the right.
This reduces the level of the real interest rate.
The AD curve now shifts right, back to its original level.
The policy response means the economy will be back at long run equilibrium.
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Monetary Policy
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Monetary Policy
In practice, it is extremely difficult to keep inflation and output from fluctuating when aggregate expenditure changes.
There are two reasons:
It takes time to recognize what has happened.
Changes in interest rates do not have an immediate impact on the economy.
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Discretionary Fiscal Policy
There are two types of fiscal policy:
Automatic stabilizers
Operate without any further actions on the part of the government.
Examples: unemployment insurance and the proportional nature of the tax system.
Discretionary policy
Relies on fiscal policymakers’ decisions.
Changes aggregate expenditures shifting the dynamic aggregate demand curve.
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Discretionary Fiscal Policy
Fiscal policy can act just like monetary policy to offset shifts in the dynamic aggregate demand curve and stabilize inflation and output.
Two shortcomings:
Discretionary fiscal policy works slowly.
It is almost impossible to implement effectively.
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Discretionary Fiscal Policy
Because economic data only become available several months after they are collected, the economy is often halfway through a recession before there is a consensus that a downturn has actually started.
This means that discretionary fiscal policy is likely to have its biggest impact well after it is most needed.
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Discretionary Fiscal Policy
Economics clearly collides with politics where fiscal stimulus is concerned.
For economists, the best policies are the ones that influence a few key people to change their behavior, avoiding rewarding people who do what they would have done anyway.
For politicians, the best policies are programs that reward the largest number of people possible.
Discretionary fiscal policy is a poor stabilization tool.
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Positive Supply Shocks and the Opportunity They Create
What happens when production costs fall - a positive supply shock?
The SRAS curve shifts to the right.
This drives up inflation and output immediately.
Current inflation is below expected inflation and expectations initially fall.
This leads to inflation above expected inflation so expectations start to rise and the SRAS curve shifts to the left.
This continues until the economy returns to the original long-run equilibrium.
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Positive Supply Shock
Fall in production costs shifts SRAS Right.
Economy 01
Inflation is above expected inflation and SRAS moves back to original level.
Economy 10
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Positive Supply Shocks and the Opportunity They Create
A positive supply shock creates an opportunity for policymakers to guide the economy to a new, lower inflation target without inducing a recession.
Central bankers will shift the monetary policy reaction curve to the left.
The AD shifts left as well.
This continues until it reaches the point where the new SRAS curve intersects the LRAS curve.
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Positive Supply Shocks and the Opportunity They Create
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What Accounts for the Great Moderation?
The 1990s brought unprecedented economic stability - the “Great Moderation” in the volatility of real growth.
From 1991 to 2001 there were 10 years of solid growth and inflation fell steadily.
The volatility of inflation and growth dropped by more than half.
This prosperity and stability was shared across the industrialized world.
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What Accounts for the Great Moderation?
There are three possible explanations for this worldwide economic performance:
Everyone was extremely lucky.
Economies have become more flexible in absorbing external economic disturbances.
Monetary policymakers have figured out how to do their job more effectively.
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What Accounts for the Great Moderation?
Difficult to argue that the stability was just good fortune—financial markers were not calm.
Advances in information technology have increased manufactures’ flexibility in responding to changes in demand.
Resulting in dramatic declines in inventories at every stage of the production process.
Innovations in mortgages and other forms of personal credit made it easier for households and businesses to borrow.
Rising levels of risky debt eventually led to record defaults during the financial crisis.
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What Accounts for the Great Moderation?
That leaves monetary policy as the only remaining explanation.
Central bankers must focus on raising real interest rates when inflation goes up and lowering them when inflation goes down.
Keeping inflation low and stable is necessary for reducing economic volatility, the deep recession that began in December 2007 shows that it is not sufficient.
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As of 2019, gross government debt in advanced economies exceeded 100 percent of GDP.
Policy makers have been looking for a way to make it easier to manage these heavier debt loads.
Some suggest that countries should issue GDP-linked bonds that tie the size of debt loads to their economy’s cyclical performance.
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What Happens When Potential Output Changes?
What happens when YP increases due to an increase in productivity?
The long-run aggregate supply curve will shift to the right as YP increases.
An increase in productivity reduces costs of production, so it is a positive supply shock as well.
The SRAS curve will shift right.
Remember that the SRAS curve intersects the LRAS curve at the point where current inflation equals expected inflation.
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What Happens When Potential Output Changes?
An increase in YP shifts SRAS right and shifts LRAS right.
But SRAS still crosses LRAS where = e.
SRAS shifts the same distance as LRAS.
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What Happens When Potential Output Changes?
In the short-run, output and inflation are determined by the intersection of SRAS and AD.
Since AD is unchanged, the economy is at point 1 in the short-run.
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What Happens When Potential Output Changes?
In the long run, output must go to the new level of potential output, YP1.
How it gets there depends on what monetary policymakers do.
If policymakers are happy with their inflation target, they will work to move the economy to the point on the LRAS curve consistent with their target.
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What Happens When Potential Output Changes?
But the higher level of potential output comes along with a lower r*.
Returning inflation to its higher level means shifting the MPRC to the right.
This shifts AD to the right.
The policy adjustment will drive output and inflation up until they reach their new LR equilibrium level at the original inflation target and YP1.
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What Happens When Potential Output Changes?
With T unchanged, policymakers shift AD right.
The economy moves to the new level of potential output and the original T at point 2.
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What Happens When Potential Output Changes?
If policymakers now do nothing, expected inflation exceeds current inflation
The SRAS curve to the right.
Inflation falls even further
Long run in this case is at a new lower inflation target at the new potential output.
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What Happens When Potential Output Changes?
With a new, lower T: policymakers allow the economy to move to point 3.
They do this by leaving the monetary policy reaction curve alone.
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What Happens When Potential Output Changes?
In the 1990s the LRAS curve shifted to the right, and the Fed took the opportunity to reduce their implicit inflation target.
At the time, this was referred to as opportunistic disinflation.
Declines in inflation
Real-business cycle theory: prices and wages are flexible, so inflation adjusts rapidly, current output always equals potential output, and all business-cycle fluctuations arise from changes in potential output
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What Are the Implications of Globalization for Monetary Policy?*
Shifting the factors of production from domestic to foreign factories is the same as U.S. producers finding a new, cheaper technology to produce domestically.
Improvements in technology increase potential output
Our conclusion is that globalization and trade do reduce inflation in the short run.
And just like any positive supply shock they provide an opportunity to reduce inflation permanently.
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In order to set their policy-controlled interest rate as accurately as possible, central bankers need to know the size of the output gap.
This requires measuring the level and growth rate of both current and potential real GDP accurately.
Although it directly affects nominal GDP, the practical implication of the statistical discrepancy is that it makes us unsure about the current level of real output.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
Short run fluctuations in output and inflation are caused by either demand shifts or supply shifts.
By shifting their monetary policy reaction curve, policymakers offset demand shocks.
Unfortunately, supply shocks are a different story.
There is no way to neutralize them.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
Monetary policymakers can shift the AD curve, but cannot move the SRAS curve.
Central bankers can choose how aggressively they react to deviations of inflation from their target caused by supply shocks.
Picking the slope of their MPRC, which determines the slope of the AD curve.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
The more aggressively policymakers are keeping current inflation close to target, the steeper their monetary policy reaction curve,
The flatter the AD curve.
By controlling the slope of AD, policymakers choose the extent to which supply shocks translate into changes in output or changes in inflation.
The more central bankers stabilize inflation, the more volatile output will be, and vice versa.
There is a tradeoff.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
A relatively flat AD curve implied by the steep monetary policy reaction curve means:
A negative supply shock prompts a large decline in current output and a small increase in current inflation.
By reacting aggressively, policymakers ensure that inflation (and inflation expectations) remain close to their target.
Stable inflation means volatile output.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
When policymakers worry about more short-run fluctuations in output than about temporary movements in inflation, they will choose a relatively flat monetary policy reaction curve.
The result is a steep AD curve.
Inflation rises and output falls
The output gap is small while the deviation of inflation from expected inflation is large
Expected inflation rises significantly and slowly adjusts back to target.
Stable output means volatile inflation.
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Can Policymakers Stabilize Output and Inflation Simultaneously?*
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The decade following the financial crisis and the resulting recession saw the U.S. economy grow at a very modest average annual rate of 1.6 percent.
The conventional explanation for the postcrisis downshift is that the trend growth rate of potential output slowed sharply.
An alternative hypothesis, by former Treasury Secretary Lawrence Summers, is that the poor performance reflects an unusually prolonged shortfall of aggregate demand rather than diminished supply, called “secular stagnation.”
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