Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Macro Handout 19: Inflation Targeting and International Finance

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1 Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Macro Handout 19: Inflation Targeting and International Finance Inflation Targeting Review: Increase in Government Spending No Inflation Targeting An increase in government purchases directly increases the final goods and services. At a given inflation rate (), final goods and services purchased increase. Geometrically, an increase in government purchases shifts the aggregate demand (AD) curve right: FP Question: What would the real interest rate (r) equal, if the inflation rate () were percent, given that the Fed does not change its inflation policy? π (%) AD Question: How many final goods and services would be purchased if the inflation rate () were percent, given that all other factors relevant to demand remained the same? π (%) FP At a given inflation rate () AD r (%) Government purchases more More goods and services (G&S) purchased AD G&S Aggregate demand (AD) curve shifts right

2 2 FP Question: What would the real interest rate (r) equal, if the inflation rate () were percent, given that the Fed does not change its inflation policy? π (%) AD Question: How many final goods and services would be purchased if the inflation rate () were percent, given that all other factors relevant to demand remained the same? π (%) LRAS FP AS AD r (%) 2,000 G$S Then, government purchases equal taxes initially and the deficit equals 0. To create a deficit we increase government purchases in period 1. Infl Govt Con Invest Int Rate Rate Period GDP Purch Deficit Purch Purch r (%) (%) 0 2, , , , , , , , , , Macro Lab 18.1: Crowding Out Pieces of the Pie: No Deficit Govt 500 Con Govt Pieces of the Pie: Deficit 600 Con Inv Inv In the long run, GDP = GDP P = 2,000 In the long run, GDP = GDP P = 2,000

3 3 Inflation Targeting In 2012, the Fed adopted inflation targeting. In historic shift, Fed sets inflation target By Jonathan Spicer Wed Jan 25, :35 EST (Reuters) - The Federal Reserve took the historic step on Wednesday of setting an inflation target, a victory for Chairman Ben Bernanke that brings the Fed in line with many of the world's other major central banks. The U.S. central bank, in its first ever "longer-run goals and policy strategy" statement, said an inflation rate of 2 percent best aligned with its congressionally mandated goals of price stability and full employment.. Inflation targeting uses autonomous monetary policies to achieve a predetermined inflation rate target: First, the Fed chooses a target inflation rate. Second, the Fed pursues autonomous monetary policies to meet the target. That is, the Fed shifts the Fed policy (FP) curve and therefore the aggregate demand (AD) curve to achieve its target inflation rate. Review: Autonomous monetary policies. Shifts of the entire Fed policy (FP) curve: Autonomous contractionary monetary policy: The Fed becomes tougher on inflation by shifting the entire Fed policy (FP) curve right. At a given inflation rate (), the Fed increases the real interest rate (r). Autonomous expansionary monetary policy: The Fed becomes easier on inflation by shifting the entire Fed policy (FP) curve left. At a given inflation rate (), the Fed decreases the real interest rate (r). We illustrate the effect of an autonomous contractionary monetary policy below: FP Question: What would the real interest rate (r) equal, if the inflation rate () were percent, given that the Fed does not change its inflation policy? π (%) FP AD Question: How many final goods and services would be purchased if the inflation rate () were percent, given that all other factors relevant to demand remained the same? FP π (%) At a given inflation rate () Real interest rate (r) increases r (%) Loans become more costly Households and firms purchase less Fewer goods and services purchased Autonomous contractionary monetary policy AD AD G&S Aggregate demand (AD) curve shifts left

4 4 Review: Increase in Government Spending Inflation Targeting: Macro Lab 19.1: Inflation Targeting Inflation Targeting: The Fed chooses a target inflation rate and then pursues autonomous monetary policies to meet the target. That is, the Fed shifts the monetary policy (MP) curve to achieve its target inflation rate. Govt Con Invest Int Rate Infl Rate Period GDP Purch Deficit Purch Purch r (%) (%) 0 2, , , , , , , , , , In this case, the Fed counters the increases in government purchases, an expansionary fiscal policy, with a contractionary monetary policy. To illustrate AD curve shifts we keep the inflation rate () constant Expansionary Contractionary autonomous fiscal policy monetary policy Fed becomes on inflation Fed the real interest rate(r) Households and firms purchase goods G increases C and I GDP = C + I + G GDP GDP AD curve shifts π (%) AD curve shifts AD GDP

5 5 Macro labs 18.1 and 19.1 both create a deficit by increasing government purchases while leaving taxes unchanged. The labs differ in the Fed s response: Macro lab 18.1: The Fed does not target inflation; that is, the Fed does not respond with an autonomous contractionary monetary policy in response the expansionary fiscal policy. The Fed only applies the Taylor principle. Macro lab 19.1: The Fed targets inflation; that is, the Fed responses with an autonomous contractionary monetary policy in response the expansionary fiscal policy to prevent the inflation rate from rising. The table below compares the results from the two labs to determine the long run impact of inflation targeting and more generally the long run impact of autonomous monetary policies. No Inflation Targeting Inflation Targeting: 2.0% Govt Con Invest Int Rate Infl Rate Period GDP Purch Deficit Purch Purch r (%) (%) 0 2, , , , , , , , , , , , , , , , , , , , Focus on the long run effect of inflation targeting. In the long run, the Fed s autonomous monetary policy: Has no effect on the real economy. Has no effect on real o o o o o Has an effect only on the rate. When the Fed targets it remains at 2.0 percent; when the Fed does not target it rises from 2.0 to percent. These results illustrate an important macroeconomic principle which has a fancy name: Classical dichotomy: In the long run, monetary policy: Does not affect the economy. Does affect.

6 6 Foreign Exchange Rates Friday, December 11, :00 am: Japanese Yen 121 British Pound 1.52 Euro 1.10 We are going to focus on the Euro. To keep the arithmetic straightforward: Exchange Rate in per Euro = buys $1.10 Exchange Rate in Euros per Dollar =.91 $1.00 buys.91 We must choose one of the two ways to express the exchange rate and then stick with it: Euros per Dollar Exchange Rates and Prices Price of a Chevy Volt = $30,000 Price of a BMW 740i = 60,000 Exchange Rate.50 per $ per $ per $1.00 Price of Volt $30,000 $30,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. Price of BMW 60,000 $ 60,000 $ 60,000 $ in Europe in U.S. in Europe in U.S. in Europe in U.S. Dollar ( Euro) Dollar ( Euro) Who benefits from a weak dollar Who benefits from a strong dollar benefit? hurt? benefit? hurt? consumers consumers consumers consumers Question: How is the exchange rate determined? Claim: In the market for foreign exchange.

7 7 Foreign Exchange Market for Europeans Demand American Goods and Services Foreign Exchange Market for Euros per Dollar S G&S Europe Demand Foreign Exchange Market Supply United States Equ Exch Rate Americans Demand Europoean Goods and Services D G&S Exchange Rate.50 per $ per $ per $1.00 Price of Volt 15,000 $30,000 30,000 $30,000 60,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. Price of BMW 60,000 $120,000 60,000 $60,000 60,000 $30,000 in Europe in U.S. in Europe in U.S. in Europe in U.S. As the exchange rate in terms of Euros per Dollar increases. ã é Do U.S. produced Do European produced goods and services become goods and services become more or less expensive for more or less expensive for Europeans?. Americans?. Do Europeans demand Do Americans demand more or fewer U. S. produced more or fewer European produced goods and services?. goods and services?. Do Europeans demand Do Americans supply more or fewer?. more or fewer?. Is the demand curve for Is the supply curve for in the foreign exchange market in the foreign exchange market upward or downward sloping? upward or downward sloping? sloping. sloping.

8 8 Foreign Exchange Market and Net Exports Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar S G&S S G&S Equ Exch Rate D G&S D G&S U.S. Exports U.S. Imports U.S. Net Exports = Demand Curve: How many would Supply Curve: How many would Europeans demand, if the exchange rate Americans supply, if the exchange rate were Euros per Dollar given that all were Euros per Dollar given that all else relevant to demand remains the same? else relevant to supply remains the same? Question: Why do Europeans demand? Question: Why to Americans supply? Answer: To purchase American goods and Answer: To obtain Euros in order to and services. European goods and services. European Purchases American Purchases of American of European Goods and Services Goods and Services U.S. Exports U.S. Imports In equilibrium: European Purchases American Purchases of American of European Goods and Services Goods and Services U.S. Exports U.S. Imports U.S. Net Exports =

9 9 Question: What are we missing? U.S. Net Exports < 0 U.S. Net Exports = U.S. Exports U.S. Imports U.S. Exports < U.S. Imports Net of Goods into U.S. Question: How does the U.S. pay for the goods? Net of Assets from U.S. Sources of Demand and Supply in Foreign Exchange Markets Purchase of Goods and Services (Imports and Exports) Purchase of Assets: Stocks, Bonds, Europeans Demand American Assets Europeans Demand American Goods and Services Europe Demand Foreign Exchange Market Supply United States Americans Demand Europoean Goods and Services Americans Demand European Assets In equilibrium: U.S. Purchases U.S. Purchases European Purchases European Purchases of European + of European = of American + of American Assets Goods and Services Goods and Services Assets U.S. Imports U.S. Exports Benchmark Case: European Purchase of American Assets Equals U.S. Purchases of European Assets Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar S G&S S G&S Eur U.S. Assets Equ Exch Rate Assets D G&S D G&S U.S. Exports U.S. Imports U.S. Net Exports = 0

10 10 Net Exports and the Real Interest Rate Question: What would occur if real interest rates rose in the U.S.? Europeans find American Assets attractive The demand curve for Americans find European Assets attractive The supply curve for Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar S G&S+A Euros per Dollar S G&S+A Europeans demand more U.S. assets S G&S Equ Exch Rate D G&S+A D G&S+A Americans demand fewer European assets D G&S U.S. Exports U.S. Imports U.S. Net Exports < 0 Summary U.S. Real Interest Rate Increases Exchange Rate U.S. Net Exports

11 Amherst College Department of Economics Economics 111 Section 5 Fall 2015 Greek Debt Crisis Greek Treasury promises to pay the owner x,xxx Euros on January 15, 2011 Macro Handout 20: Greek Crisis Greek Treasury promises to pay the owner x,xxx Euros on February 15, 2011 Greek Treasury promises to pay the owner x,xxx Euros on March 15, 2011 Greek Government Finances Tax Revenue Euros Greek Treasury Euros Bondholders Euros Purchases of Goods and Services Transfer Payments January 2011 September 2011: Specter of Greek Default Emerges Became apparent that tax payments could not meet the government s payments. Moody's cuts Greece's credit rating. Questions: What is the basic problem and how can it be solved?

12 November 2011 January 2012: Austerity, Protests, Political Turmoil, and Negotiations for a Bailout from the European Central Bank The Socialist Greek Prime Minister George Papandreou calls for austerity moves: sharp increases in taxes and spending cuts. Violent protests erupt amid a 48-hour general strike. Greek Prime Minister George Papandreou loses his majority in Parliament and resigns. A unity government is formed by the opposing Conservative and Socialist parties naming Lucas Papademos as prime minister. Nationwide strike called to protest new cutbacks. The unity Greek Prime Minister Papademos heads to Brussels to negotiate a bailout from the European Central Bank. Benchmark Case: Net Exports = 0 Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar Euros per Dollar 2 Exh Rate of Eur per Dol: Nov 1,2011 Jan 19, Nov 2 Dec 2 Jan S G&S U.S. Assets D G&S Equ Exch Rate Eur Assets U.S. Exports U.S. Imports U.S. Net Exports = 0 Question: What effect did the crisis have on the attractiveness of European and American assets? Europeans find Americans find American Assets European Assets attractive attractive The demand curve for The supply curve for Foreign Exchange Market Demand Curve: European Demand for Supply Curve: American Demand Euros per Dollar Euros per Dollar S G&S+A Euros per Dollar S G&S+A Europeans demand more U.S. assets S G&S Equ Exch Rate D G&S+A D G&S+A Americans demand fewer European assets D G&S U.S. Exports U.S. Imports U.S. Net Exports < 0 The equilibrium exchange rate in terms of Euros per Dollar.

13 3 Danger of Speculation Question: What would occur if individuals expected the Dollar to become dramatically stronger and hence the Euro dramatically weaker in the near future? Suppose that you have 8,000 deposited in a Paris bank that you plan to use in January when you will be vacationing in France. expect the dollar to strengthen with the exchange rate rising from.80 per $1.00 today to 1.00 per $1.00 in January. Claim: You would convert your Euro assets into Dollar assets 8,000 Today: Exchange Euros for Exchange Rate.80 per $1.00 $ January: Exchange for Euros Exchange Rate 1.00 per $1.00 If others share your view They will also convert their Euro assets into Dollar assets ã é Demand curve for Supply curve for shifts to the shifts to the é ã Exchange rate This cycle could then continue. Question: Who is hurt by a strong dollar? Foreign Exchange Market for Euros per Dollar Equ Exch Rate January 2012 February 2012: Austerity and a Bailout Agreement An tentative agreement is negotiated: o Greece's leaders agree on austerity moves. o Bondholders agree to a bond swap which would reduce the payments that Greece must make to the bondholders. o European Central Bank (ECB) support the Greek Treasury with short term loans. New Greek elections are scheduled for early May to seal the agreement.

14 4 March 2012 April 2012: Relative Calm Relative calm emerges before May elections to form a new government. May 2012 July 2012: Greek Elections and the Return of Political Turmoil Greek voters rejected the austerity programs advocated derailing its implementation. Greek leaders could not form a new government. New elections were scheduled for June.

15 5 July 2012 December 2012: New Government Formed and More Austerity The June elections allow the Conservatives to form a government. The Conservative Prime Minister, Antonis Samaras, implements the austerity program. In November,Greek parlliment passed an austerity package that included pension cuts for retired public employees, and increase in the retirement age from 65 to 70, and wage cuts for current public employees. January 2013 December 2013: More Austerity and a Little Progress The Greek parliament abolishes 15,000 state jobs in April. In July, the parliament passes a plan for thousands of more layoff and wage cuts for public employees. In November, Greece s credit rating is raised by Moody. January 2014 May 2014: More Progress of a Sort In January, Greece posts a budget surplus In May, Greece s credit rating is raised by Fitch Exh Rate of Euros per Dollar: October 2011 May 2014

16 6 June 2014 December 2014: Turmoil Unemployment rises to nearly 30 percent. Samaras austerity program is under attack and he reshuffles his cabinet in June. In December, Stavros Dimas, the government s candidate for Greek president fails to win majority supply in parliament. In December, the Conservative government falls as a result of the austerity measures it advanced Exh Rate of Euros per Dollar: October 2011 December 2014

17 7 January 2015 December 2015: More Political Turmoil and a Deal Syriza, the anti-austerity coalition party, wins the election in January. It ran on a platform that the austerity program endorsed was too severe and it would negotiate a better deal. For several months, negotiations took place, but Syriza failed to gain many concessions. In July, an austerity program is put before Greek voters in a referendum that was not substantially less austere. More than 60 percent of them vote against it. In July and August Syriza tried to negotiate a new agreement. Much turmoil took place: violent protests in the streets, Cabinet reshuffling, etc. Eletions are sheduled for September. Syriza wins again in November. In November, Syriza proposed an austerity program that did not differ substantially from the one it opposed in January. This program passed the Greek parliament in November Exh Rate of Euros per Dollar: October 2011 December Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15