DP/P = (DP/P) e t+1 + g [Y Y P ] + r. AD Curve (substitute MP Curve into IS Curve)

Transcription

1 DP/P LRAS SRAS 1 DP/P = (DP/P) e t+1 + g [Y Y P ] + r AD1 Y P Y AD Curve (substitute MP Curve into IS Curve) Y = [C + I + G + NX d f MPC T] * 1 (d + x) * [r + l (DP/P) e t+1 ] 1 - [mpc(1-t)] 1 - [mpc(1-t)]

2 Rational Expectations Lucas Critique; Policy effects depend on the public s expectations about the policy. Formation of expectations change when the behavior of a forecasted variable changes. Example: Term Structure relationship of short-term and long-term interest rates If investors expect short-term rates to be low for an extended time => lower long-term rates => AD If investors expect short-term rates to be low temporarily => no change in long-term rates => no change AD

3 Expectations Theory Key Assumption: Bonds of different maturities are perfect substitutes Implication: RET e on bonds of different maturities are equal Investment strategies for two-period horizon 1. Buy $1 of one-year bond and when it matures buy another one-year bond 2. Buy $1 of two-year bond and hold it Expected return from strategy 2 (1 + i 2t )(1 + i 2t ) (i 2t ) + (i 2t ) 2 1 = 1 1 Since (i 2t ) 2 is extremely small, expected return is approximately 2(i 2t )

4 Expected Return from Strategy 1 (1 + i t )(1 + i e t+1) i t + i e t+1 + i t (i e t+1) 1 = 1 1 Since i t (i e t+1) is also extremely small, expected return is approximately i t + i e t+1 From implication above expected returns of two strategies are equal: Therefore 2(i 2t ) = i t + i e t+1 More generally for n-period bond: Solving for i 2t i t + i e t+1 i 2t = 2 i nt = i t + i e t+1 + i e t i e t+(n 1) n In words: Interest rate on long bond = average short rates expected to occur over life of long bond

5 Federal Reserve Policies: 1.Open market operations to increase banking system reserves and lower the fed funds interest rate to %. 2.QE (quantitative easing) creation of money to buy assets. This credit easing unclogs credit channels (ex. MBS) by boosting liquidity and decreasing interest rates. Investors sell securities to the Fed and then invest proceeds in other assets (portfolio rebalancing) which raises their prices. Lower interest rates increase borrowing and investment and therefore economic growth. Rising stock prices increase consumption spending. Higher liquidity boosts foreign asset prices, lowers the dollar s value and increases exports. Lower interest rates decrease government borrowing costs and the future taxation burden. 3.Intent the Fed announced that is plans to keep short-term interest rates exceptionally low for an extended period. According to the Expectations Theory of interest rates, this intent will bring down long-term interest rates. 4.Excess reserves interest rate is lowered to 0.25%. 5.Operation twist selling short-term debt (less than 3 year maturity) to fund the purchase of long-term debt (greater than 6 year maturity). This gives investors cash for long-term debt which should prompt them to invest more money in other assets. Fed announced in the fall of 2011 they would sell $400 billion, and in June 2012 they would sell an additional $267 billion. Operation twist ended in December 2012 when short-term bonds were gone. 5

6 Yr 5-Yr Inflation Expectations University of Michigan

7 Nominal Interest Rates, Real Interest Rates and Inflation Expectations Inflation Expectations 10-yr Treas TIPS (10-Yr)

8 DP/P 5.0% 2.5% 1.0% D A LRAS C AD B SRAS Shift AD Curve (due to D r ) Assume 1% DP/P The debt crisis => Fed s Financial Repression => r falls from 1 to -1. (autonomous easing of MP) => r falls from 1.5 to -0.5 => I, NX, => AD, at every given DP/P => AD > AS => DP/P => (DP/P) e t+1 => shift up SRAS => point D DP/P = (DP/P) e t+1 + g [Y Y P ] + r r % Y P Y r % MP Curve r = r + l (DP/P) e t+1 IS Curve 1.5 = (1) 1.5% 0.25% A D C 1.5% 0.25% A C D -0.5 = (1) -0.5% Y P B Y -0.5% 1% B 2.5% 5.0% DP/P

9 Price per barrel Oil Price per Barrel (West Texas Intermediate Crude) Recession Nominal Real Oil Economics P oil = 10 => P Gas = 0.25 => growth % 9

10 Annual Percentage Change Consumer Price Index to Present Headline Inflation 2.5% Fed CPI Target

11 (Percent) Labor Force Participation Rate Employment-to-Population Vs Debt-to-GDP Source: Department of Labor. Recession Employment Ratio Target = 62.5% Employment-to-Population (LHS) Labor Force Participation Rate (LHS) Debt-to-GDP (RHS) 25 The level of the employment ratio determines direction of debt ratio: Employment-to-Population > 63% => Debt-to-GDP Employment-to-Population = 62-63% => stable Debt-to-GDP Employment-to-Population < 62% => Debt-to-GDP

12 (Percent) Unemployment Rate Vs Budget Deficit-to-GDP Recession Deficit-to-GDP 5% Unemployment Target Unemployment Rate 3% Sustaintable Deficit Target In the short run, the deficit ratio is determined by the unemployment rate. When the unemployment rate exceeds 6%, the deficit ratio rises above the 3% sustainable target. If unemployment falls below 6% the deficit ratio falls below 3%. This will bring down the Debt-to-GDP ratio. In the long run, the unemployment rate is influenced be the nation s debt-to-gdp ratio. Automatic Stabilizers: government spending and tax rules that counteract the business cycle Low Unemployment Scenario => high tax revenues and low transfer payments => low deficit & contractionary fiscal policy. High Unemployment Scenario => low tax revenues and high transfer payments => high deficit & expansionary fiscal policy.

13 The Political Decision Short-Run Economic Growth versus Long-Run Fiscal Sustainability Two Goals: 1. Avoid a recession in the near term 2. Achieve fiscal sustainability in the long run Fiscal Sustainability Constant Debt-to-GDP ratio Achieved when the national debt grows in line with GDP Achieved when the employment-to-population ratio hits 62.5%. Keep the Debt-to-GDP ratio below 90% to avoid triggering a financial crisis. Keep deficits below 3% of GDP. Given the expected pace of GDP growth, that will stabilize the debt-to-gdp ratio. Unemployment must be below 6% to see the deficit-to-gdp ratio below 3% and therefore a stable and falling Debt-to-GDP ratio.

14 Econ 330 Chapter 24 Homework Due Friday, December 16 Chapter 24 Questions & Applied Problems 4, 8, 14, 16, 18, 22, 24