Supply and Demand over the Business Cycle

Transcription

1 Session 9. The Model at Work. v Business Cycles v The Economy in the Long Run: Recession and recovery Monetary expansion The everyday business of the central bank v Summing up: The IS/LM Model in Closed Economies v Fiscal Policy and the Role of Governments v Appendix: The Crisis Supply and Demand over the Business Cycle Fluctuations around trend are driven mostly by demand factors. Periods of high growth are those when firms get close to their capacity limit. If pushed too far, it will lead to inflation. US Business Cycle 7 Real GDP Growth 95 Real GDP Growth (%) Capacity Utilization Capacity Utilization (Index) Macroeconomics Sources: Bureau of in Economic the Global Analysis Economy (GDP) and Federal Reserve G.17 Release (capacity utilization, end of ) 1

2 The Long-Run Equilibrium (Closed Economy) We start with the two equations describing the equilibrium on money market and on the goods market: Y = C (Y, Y e, T, r, wealth) + I (r, Profitability) + G M P = L(r,Y) In the long-run prices are flexible. We have now three endogenous variables interest rates (r), output (Y), and prices (P). To solve this model we claim that in the long run output is determined by the factors of production (labor, capital) and their productivity. Supply and Demand Equilibrium Real interest rate Long-run aggregate supply LM Equilibrium Real interest rate IS Y LR Output 2

3 Summing up the Model Changes in the economic environment lead to changes in demand. In the short run demand determines output. If demand is below potential, the economy is in a recession, if demand is above potential the economy is in an expansion. Real interest rate Long-run aggregate supply Recession Overheating Y potential Output Summing up the Model Changes in the economic environment lead to changes in demand. In the short run demand determines output. If demand is below potential, the economy is in a recession, if demand is above potential the economy is in an expansion. In April 2012, CPI inflation (measured as the annual change in the consumer price index) stood at 1.3 per cent (1.1 per cent in March 2012). Riksbank (Swedish Central Bank) 3

4 Recession and Recovery: How price adjustment leads to the long-run equilibrium Real interest rate Initial interest rate Interest rate after adjustment Long-run aggregate supply LM * IS 2. If the economy starts below potential, then demand is low and prices start falling. The fall in the price level increases demand and shifts the LM curve. 1. The economy is in a period of low growth or in a recession if it operates below potential Actual output Y LR Output Monetary Expansion and Adjustment to Long-Run Equilibrium Real interest rate Equilibrium interest rate Long-run aggregate supply IS LM 3. With demand exceeding the profitmaximizing level of supply (for the current price level), prices in the economy start to increase, 4. Increase in Prices which lowers demand. 1. Increase in Money Equilibrium interest rate * 2. The economy is in a demand-driven boom (it is overheating) if it operates above potential. Y LR Actual output Output 4

5 The Everyday Business of the Central Bank Real interest rate Equilibrium interest rate IS LM Long-run aggregate supply 2. Increase in spending 1. Increase in Productivity 1. Potential output in the economy increases (LRAS) 2. This is matched with an increase in investment to take advantage of the new productivity (IS) 3. What should monetary policy do? Y LR New Y LR Output Changes in the Economic Environment v The long-run aggregate supply curve shifts to the right whenever the potential output in the economy increases: 1. Productivity in the economy increases 2. Factors of production (capital or labor) increase 3. Other growth conditions improve (political, macroeconomic stability, distortions) v IS curve shifts to the right whenever the demand for goods goes up: 1. Government spending goes up 2. Taxes go down (including taxes on capital) 3. Investment or consumer confidence go up 4. Other factors that increase demand v LM curve shifts to the right whenever the liquidity in the economy increases: 1. Money supply increases 2. Prices decrease 3. Financial markets innovation reduces the need to hold money (velocity goes up) 5

6 How to Use the Model The economy is in general equilibrium when all markets clear, i.e. when the three curves intersect in one point. In disequilibrium, the following applies (if there is no change in policy or any other variable): 1. Short run equilibrium is where the IS and the LM curves intersect. This means that in the short run demand determines output. 2. Long run equilibrium is where the IS and the LRAS curves intersect. 3. Adjustment to the LR equilibrium is via price changes that shift the LM curve to the point where the IS and the LRAS curves intersect. Understanding Fiscal Policy: Government size Government size varies across countries. In general, advanced (richer) countries have larger governments. Government size is also a function of whether key services (education, healthcare) are provided by the government. Government Spending (% of GDP, 2011) United States Sweden South Africa Slovenia Morocco Mexico Lebanon Japan Germany China Chile France

7 Government Consumption versus Total Expenditures Government spending can be decomposed into Government consumption (part of GDP) and transfers As a % of GDP France Korea UK USA Gov. Consumption Gov. Expenditures Understanding Fiscal Policy: Government size From early 1970s until mid-1990s government size measured as the ratio of government spending to output has been increasing steadily. In recent years, however, in many countries there was reversal of this trend until the current crisis. Government Spending (% of GDP) US SWEDEN FRANCE GERMANY JAPAN 7

8 Understanding Fiscal Policy: Government Budget (the US) Government Balance Two definitions: Overall (Financial) Balance Taxes Government Consumption Transfers Interest payments Primary Balance Taxes Government Consumption Transfers 8

9 Primary balance and the overall budget balance Imbalances between expenditures and revenues appear as a deficit (or a surplus) in Government budgets. The primary balance reflects the difference between all expenditures and revenues without including interest payments on the debt. 4 Government Balance as % of GDP (2011) US JAPAN GERMANY ITALY UK Financial balance Primary balance Debt in industrialized countries The growth of government expenditures has not been matched by a parallel increase in government revenues (taxes). As a result, many governments have become heavily indebted in the last three decades. Government Debt as % of GDP US JAPAN GERMANY KOREA ITALY UK

10 Debt in industrialized countries (Gross versus Net) When looking at government debt, we have to distinguish between gross and net debt as some governments hold some of their debt through, for example, pension plans for public employees (they might also hold other financial assets). Government Debt as % of GDP (2011) US JAPAN GERMANY ITALY UK Gross Net Government debt: Current and future liabilities (US) But if you want to be accurate about all assets and liabilities you need to look at future assets and liabilities as well. A combination of demographic changes and increasing health care costs implies large future deficits and exploding debt levels for many advanced economies. 10

11 Debt and deficits: Are they sustainable? The relevant question is how to ensure that debt is stable. The easiest way to assess sustainability is to ask the following question: How large should the primary surplus be in order to ensure that the Debt-to-GDP ratio stays constant? The answer can be derived from the following relationship: Required Primary-surplus-to-GDP ratio = = (interest rate growth of GDP)*Debt/GDP The dynamics of debt and deficits Required Primary surplus = (interest rate growth of GDP)*Debt/GDP Example: r = 4%, g = 2%, Debt/GDP = 120% Required primary surplus: 2.4% What if you deviate? Example: r = 4%, g = 2%, Debt/GDP = 120%, Primary surplus: 0% Debt/GDP in 10 years= 142%; in 20 years= 173% What if growth is faster? Example: r = 4%, g = 3%, Debt/GDP = 120%, Primary surplus:2.4% Debt/GDP in 10 years= 109%; in 20 years= 96% What if markets do not trust the government? Example: r = 6%, g = 2%, Debt/GDP = 120%, Primary surplus:2.4% Debt/GDP in 10 years= 144%; in 20 years= 184% 11

12 Government debt: the Fiscal Gap (US) Dealing with healthcare and pension systems (Charles Ponzi is back) Pay-as-you go pension systems (or health care systems) can be equivalent to pyramid schemes that rely on an increasing number of individuals joining the investors pool. With shrinking populations, the game is over. 12

13 What Is Really the Issue? Wrong understanding of what is feasible combined with political motivation to avoid spending cuts or tax increases. During good times we assume that there will never be a recession again and we make budgetary plans that are not sustainable. The big sin is overspending in good times. In 2005 Germany ran a 3.4% deficit. Budgets since 1960 Greece Italy Portugal USA Denmark Years with deficits (%) 80% 100% 100% 92% 48% Last surplus The Failure of Politics to Address Long-Term Sustainability President Clinton on Monday proposed paying off the national debt by 2015 after issuing a new budget outlook that adds $1 trillion more to the overall budget surplus over the next 15 years. CNN, June 26, This is not at all the situation in our European economies. Our fundamentals are solid, we have a positive current account position, we have a level of savings in our economies that is the level required to finance our investments. We have a sound fiscal position. EU Economic and Monetary Affairs Commissioner Joaquin Almunia. January 22,

14 Default? "Nobody doubts that the United States has the economic capacity to pay its bills," Bernanke said. "It's really a question of, do we have the political will to do that. Demonstration of political will, that's what the markets are watching." Jan Default: Government Business When a company defaults we learn that their business model is not viable. Our wealth and possibly future income will be lower. This is a real shock. When a government defaults, it simply decides to change who will pay for the spending that it has already done. It is a redistribution of resources. Resources are not destroyed (although the crisis that follows can destroy some of them). 14

15 Paying for Government Debt Default or Taxes? Who holds their Government Debt? (%) Japan Domestic Foreign Greece Who defaults first? The Fundamentals 15

16 Is it really the government who makes the decision to default? There is a self-fulfilling nature in sovereign defaults: when trust disappears, interest rates go up so the cost of paying back increases. Lack of trust can cause a default. But if it is a liquidity problem, who should step in? The central bank (or the IMF or some of your friends) 1800 Solvency or Liquidity? Central Banks and Sovereign Debt Government Debt held at the US Federal Reserve Billions USD

17 Session 9: Summary v The IS/LM model is a model of aggregate demand. The IS curve represents the demand for goods in the economy (this is the link between demand and interest rates). The LM curve represents the liquidity in the system. v In the short run prices are fixed and aggregate demand determine the level of output. Firms produce to meet the demand at the given price. The long-run equilibrium of the economy is captured by the potential level of output. In the longrun the economy tends to potential output, which is the level of output at which there are no pressures for inflation to increase or decrease. At this level firms maximize profits given the amount of capital, the amount of labor and the technology they can use in production. v The self-adjusting mechanism to restore equilibrium is through prices. When the economy is overheating, prices increase, which reduces the liquidity in the economy and increases interest rates. This leads to a drop in output. When the economy is in a recession, prices decline, which increases the liquidity and lowers interest rates. Lower interest rates stimulate investment and consumption. v Monetary and fiscal policies can be used to help the economy recover faster from a recession. Appendix: The Model with Growth Rates v Prices vs. inflation. So far we assumed that prices are fixed in the short run. But the model in fact works better when we modify this assumption to say that inflation is stable in the short run (neither accelerating nor decelerating). After all, in reality we often observe positive inflation rates. v To make this model operational we will think about liquidity not just as M/ P, but as (% M π). In other words we will monitor whether money supply grows at the same rate as inflation. If the growth rates are the same, then there is no change in liquidity. v Exam question Jan-Feb 2008: In 1991 Argentina adopted a currency board arrangement in order to control inflation (through an arrangement called The Convertibility Plan). During the previous few years Argentina had experienced very high inflation, which at some point reached 10,000%. While inflation was increasing in the years from 1987 to 1990, output was contracting with growth rates of between -2% and -7% per year. Why was the economy contracting in the years when there was inflation? 17

18 Appendix: Hyperinflations and Recessions Real interest rate Long-run aggregate supply LM 1. The LM curve can be stable if money grows at 1,000% and inflation is 1,000%, i.e. liquidity is not changing. In this environment a reduction in investment or consumer confidence will lead to a recession even with inflation at 1,000%! Equilibrium Real interest rate Y LR IS Output 2. During hyperinflations prices grow faster than money. This reduces liquidity and shifts the LM curve to the left again there is a recession even with high inflation. 18