copyright 1998 r.h. rasche ec 827 macroeconomic models iii

Copyright 1998 R.H. Rasche

EC 827

Macroeconomic Models III


Macroeconomic Models

Conditional Forecasting


Sources of Exogenous Shocks to Macroeconomy

Fiscal Shocks - changes in government purchases (G) or net taxes (T)

Monetary Shocks - Changes in the Nominal Money Stock or its growth rate

Supply Shocks - changes in the level of “natural output”


Macro Model - Basic Graphsr

Y

Y

pSP

LP

LM

IS

IS = Commodity Mkt Equilibrium

LM = Asset Market Equilibrium

SP = Short-Run Phillips Curve

LP = Long-Run Phillips Curve

YN = “natural output”

YN


Macroeconomy - Initial Conditions

Assume:

– Initial inflation rate = 0.0

– Initial Real Output = Natural Output

– Initially no unexpected inflation (actual and expected inflation are equal)

– Nominal Money Stock is held constant at some value M0.

Alternative initial conditions are possible (e.g. positive inflation and expected inflation); but these parameters keep difficulties to a minimum.


Unanticipated Fiscal Stimulus I

r

Yp

SPLP

LM

IS

1. IS curve shift up (or right) as a result of increase in G or decrease in T.

2. Economy moves along fixed SP curve if action is not anticipated.

3. Output increases, but p must also increase.

4. p >0 means P increases and M/P falls inducing shift in LM

IS’

YYN


Unanticipated Fiscal Stimulus II

r

Yp

SPLP

LM

IS’

Y

LM’

1. Positive inflation generates higher pricelevel.

2. Higher Price level with fixed Nominal Money Supply reducessupply of Real Balances

3. LM curve Shifts up

4. Real interest rateincreases; real outputfalls, inflation is lower,but still higher thaninitial value (0.0)

YN


Unanticipated Fiscal Stimulus III

r

Yp

SPLP

IS’

Y

LM’

1. Left with a situationwhere inflation turnedout to be different thanagents forecast it to be(YN < Y).

2. State of the economycan’t remain here indefinitely unless weassume that agents never correct their forecast errors!

YN


Unanticipated Fiscal Stimulus IV

Three Potential Outcomes:

1. The LM curve continues to adjust back towards the initial level of income. Why? People would have to be continually re-adjusting to the shock

2. The IS curve shifts left again, e.g. if there has been a temporary government program which has now ended

3. The fiscal shock generated some positive effect on YN, e.g. education spending.


Anticipated Fiscal Stimulus I What happens to the economy if the fiscal stimulus is

announced in advance of the action.

Depends on whether agents think that the announcement is credible. Talk is cheap; if not believed then it is the same as making no announcement.

If announcement is credible, then effect on economy depends on how agents forecast.


Anticipated Fiscal Stimulus II If agents make forecasts based only on history of

economy, then the prospective fiscal change is not something they consider in constructing their forecasts.

Their expectations of future inflation do not depend on information about future fiscal policy.

– any changes in inflation resulting from the preannounced policy are unexpected changes

– economy reacts as to the unanticipated stimulus

If so: at time of the stimulus, inflation expectations adjust, SP curve shifts.


Anticipated Fiscal Stimulus -Perfect Foresight

r

Yp

SPLP

LM1. At the announcement, the SP shifts upwards, then the policy shifts the IS out.

2. People forecast higher inflation, which rapidly shifts the LM curve left, until output returns to natural levels.

3. The inflation rate will remain high until the policy is reversed.

IS

SP’

LM’


Fiscal Stimulus What is the initial effect of a fiscal shock in an

environment where agents make perfect forecasts of inflation, or the ultimate effect in a world where agents make forecasting errors but eventually will correct them?

on real output?

– on the price level?

– on inflation?

– on real interest rates?

– on nominal interest rates?


Deficits and Inflation What is the impact of the deficit created by the fiscal

stimulus (anticipated or unanticipated) on:

– interest rates?

– sustained inflation?

– the price level?


Unanticipated Money Supply Stimulus

r

Yp

SPLP

LM

IS

1.LM curve shifts downas nominal money supply is increased.

2. Economy moves along fixed SP curve if action is not anticipated

3. Output increases, but p must also increase

4. p > 0 means P increases and M/P is somewhat reduced which induces an offsetting shift in LM

LM’

YYN


Unanticipated Monetary Stimulus II

r

Yp

SPLP

IS’

Y

LM’

1. Left with a situation where inflation turned out to be different than agents forecast it to be (YN < Y).

2. State of the economy can’t remain here indefinitely unless we assume that agents never correct their forecast errors!

3. Will the policy be cancelled? Will inflation cut the LM back? Will YN increase?

YN


Anticipated Monetary Stimulus I

Issues here are the same as in fiscal policy:

– is the pre-announced policy taken seriously, so that agents react to the information?

– how do agents make forecasts of inflation (form inflation expectations)

– if agents make forecast conditional on future values of exogenous (including fiscal and monetary policy variables, how accurate are their forecasts and are they free to act?


Anticipated Monetary Stimulus II

Any revision of inflation forecast based on policy announcement means that SP curve will shift when policy is implemented.

Perfect forecast of the inflation effects of the announcement means that SP intersects LP at the new actual inflation rate and Y = YN

IS-LM intersection will have to occur at. Y=YN for all markets to be in equilibrium.


Anticipated Monetary Stimulus III

r

Yp

SPLP

LM

IS

SP’

1. Since Y must = YN, new IS-LM intersection must occur at Y=YN.

2. Increase in P that results from a perfect forecast of inflation will shift the LM back to its original position (since IS is not shifted by monetary stimulus).

3. real rate unchanged

4. ex-post nominal rate higher.

LM’


Anticipated Monetary Stimulus IV

Does this end the story of the response to a monetary stimulus when conditional forecasts of inflation are accurate?

Depends on the nature of the monetary shock

– changes in the level of the nominal money stock.

– changes in the growth rate of the nominal money stock.


Anticipated Monetary Stimulus V

Change in the level of Money Stock

– agents who make perfect inflation forecasts will realize that no future changes in price level are required to maintain IS/LM intersection at YN

– such agents will forecast zero inflation for future periods.


Anticipated Increase in Level of Nominal Money Stock

Ultimate Effects in Expectational Equilibrium:

– real interest rate (r) is unchanged

– p = pe = 0 again

– Y = YN again

– implies that demand for real balances is unchanged

Conclusion: P must change proportional to the change in M!


Anticipated Increase in Growth Rate of Nominal

Money Stock Permanent change in the growth rate of the nominal money stock.

– Agents who make perfect conditional forecasts of inflation based on this path for exogenous variable will see that continuous inflation is required to keep real balances unchanged so that LM curve will continue to intersect IS at YN.

– SP curve will remain permanently higher.

– Inflation expectations will be validated.


Sustained Inflation Sustained inflation is always a monetary phenomenon!

– other sources of shocks to the economy can change the price level (transitory inflation) but a continuing inflation requires continuous growth in the nominal money stock.

p must be equal to M growth to keep IS/LM intersection at Y = YN in expectational equilibrium


Anticipated Shocks and Forecasting Techniques

Initial reaction of economy to anticipated shocks depends critically upon theory of how expectations are formed

Competing theories

– Adaptive or backward looking expectations - inflation expectations (forecasts) are conditioned only on history of economy

– Rational or forward looking expectations - inflation expectations (forecasts) are conditioned on future paths of exogenous variables

copyright 1998 r.h. rasche ec 827 macroeconomic models iii

Documents

y ynyn slide

lm curve

r y p sp lp lm

rasche ec

initial inflation rate

positive inflation

natural output ynyn

level of natural output