Macroeconomics: Policy, 31E23000 Lecture 1 Pertti Aalto University School of Business 22.02.2016
About this course 1 Current crisis: Role of policies in creating it? Role of policies in helping to get out of the crisis? New type of policies: Q(uantitative) E(asing), macroprudential policies, role of structural reforms. Government debt? Private debt? Role of financial markets? New type of crisis? Z(ero) L(ower) B(ound), secular stagnation? Main aim of the course: Amend and reinterpret the standard (New-) Keynesian model to be able to analyze what has happened and and understand the impacts of policies.
About this course 2 Alternative schools of thought? Hope to be able, in the time frame for the course to say something, and at least assign some readings, e.g. on expectations formation. In contrast to standard macro courses we begin with short and medium term analysis, in view of the recent crisis and the demands it has placed on economic analysis.
The Standard Model with Non-Standard Elements Quite unanimous agreement that events in financial markets lay behind the current (or just bygone?) crisis. How to incorporate financial markets in the model? How to interpret financial market shocks as shocks in the model? Go deeper e.g in the determination of monetary policies and public debt sustainability issues.
The Standard Model 1 Aggregate demand equation (IS-equation): relationship between the real interest rate and aggregate output Phillips-curve: relationship between the rate of inflation and aggregate output results from conflicting interests between the employers and employees: incentives, negotiation power(s), market power in goods markets basis for studying structural reforms Monetary policy reaction function: relationship between inflation and aggregate output for a inflation targeting central bank gives the policy trade-off between inflation and output, how large a drop the CB is willing to accept (or expecting to gain) to reach the target inflation
The Standard Model 2 The monetary policy reaction function (Taylor-rule) is the link between aggregate demand and aggregate supply. The central bank sets the policy interest rate which together with the structure and state of financial markets determines the real interest rate facing the agents and is the interest rate relevant for aggregate demand (the interest rate margin). Financial markets can have a direct effect on aggregate demand, e.g. through balance sheet effects and expectations.
Aggregate Demand 1 We know that at any point of time or during any period aggregate output (supply) by definition must ex post be equal to aggregate demand (including the change in inventories which we include in aggregate investment): Y = C + I + G (1) Here Y = GDP (output), C = private consumption, I = investment, and G = government consumption. This becomes a model when we specify the (aggregate) behavior of the agents. Then the observed entities must be such that the national income identities hold and the individual demand component must be consistent with the underlying behavior. Let us, for the moment, assume that government consumption is fixed.
Aggregate Demand 2, Consumption It is standard to assume that current private consumption depends on current net income Y T, T = income tax: C = a + c(y T ) (2) But why should it be so? Aren t people simultaneously making saving (lending) or borrowing decisions? And if so, should not consumption then also depend on consumers net wealth? And what about the distribution of income and wealth among the consumers, should it have an impact? And what is wealth? All this is saying that consumers are today also concerned about their future consumption and incomes: one borrows against future incomes to consume now, one saves to increase future consumption by having capital income in addition to income from labor and possible net transfers.
Aggregate Demand 3, Consumption How can one model the consumer decision making in this kind of framework? Standard approach: With relatively well-functioning capital markets there need not be any connection between current consumption and current income, people/conumers/households can borrow and save. But they have to pay back the loans and they earn capital income on their savings: they are not constrained by their current income but by?
Aggregate Demand 4, Consumption By wealth. Wealth? Wealth = expected present value of non-capital income (labor income + net transfers) flow + existing (net) assets. Note: Expectations play a crucial role. To see the claim, let us look at a consumer with 2 periods of life left. She faces two budget constraints c 1 + s = y 1 + A 0 (3) c 2 = y 2 + (1 + r)s (4)
Aggregate Demand 5, Consumption The net wealth (stock) at the beginning of period 1, A 1, is given by past decisions, consumption and labour income c i, y i are flows, as are the current savings s. What do we mean by perfect/functioning capital markets? The consumer is able to sell the assets without constraints (markets are liquid), investing s > 0 do not face any constraints, nor does borrowing s < 0 at the given (real) rate of interest r. With these and so s = y 1 + A 1 c 1 (5) c 2 = y 2 + (1 + r) [y 1 + A 1 c 1 ] (6)
Aggregate Demand 6, Consumption After reorganizing this gives the intertemporal budget constraint: c 1 + c 2 1 + r = y 1 + y 2 1 + r + A 1 Ψ (7) This fixes the type of budget constraint households are facing in normal times in advanced economies with developed capital markets. What else would we expect a good theory of aggregate consumption to contain? The next figure shows the development of aggregate household consumption and aggregate disposable income in Finland, both volumes (values deflated by consumer price index), both indexed with value 100 in the base year 2010:
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 SugarSync/Luennot/Macro2016/Household consumption and disp income.pdf 120 Household disposable income and consumption, volumes, 2010=100, StatFin 100 80 60 40 20 0 Yd C
Aggregate Demand 7, Consumption What do you see? Background: Finnish capital markets were liberalized during 1980 s, starting at the beginning of the decade, Finland had a (serious?) recession in the late 1970 s, serious economic crisis in the early 1990 s, and has been a member of the EMU since the beginning of 2002.
Aggregate Demand 8, Consumption The periods 1980-1990, 1996-2008: consumption smoother than disposable income. Contrast with the 1970 s. During the crises consumption and disposable fluctuated simultaneously. Before the crises household consumption grew faster than the disposable income: debt build-up. Consumption began to decline before the early 1990 s crises erupted, but not before the recent crisis.
Aggregate Demand 9, Consumption Smoothing: The traditional theory of intertemporal consumer choice can explain it In the static consumer theory we assume that consuming any good/service has declining marginal utility: an additional unit consumed will increase satisfaction less and less the more we already have consumed it. Analogously we can regard consumption at different points of time as distinct goods with declining marginal utility at the period when they are consumed. Let U (C t ) denote the welfare, in period t, generated by consumption C t during that period. Consider a small shift of consumption between periods t and t + 1, does it increase consumer welfare (as seen by the consumer now living in period t)?
Aggregate Demand 10, Consumption Smoothing, cont. Issue 1 to be handled: Does the consumer regard an addition to consumption now (in t) as valuable as an addition tomorrow (t + 1]? Standard assumption: No, people are assumed to be impatient, future addition to welfare as evaluated now is regarded smaller than the same addition now. Impatience is usually treated as a subjective discounting of future, analogously the usual discounting by interest rates: the level of welfare seen tomorrow as U (C t+1 ) is seen today as U(C t+1 ) 1+ρ, ρ > 0, where ρ is the subjective discount rate. Issue 2: But in evaluating shifts of consumption between periods we must also take into account the interest rate: by increasing consumption now we lose the future consumption because interest income tomorrow, which can be used then for consumption, is lost due to reduction in savings.
Aggregate Demand 11, Consumption Smoothing, cont. Consider now a small switch of consumption between the two periods and its implication for consumer welfare as seen today. The change in current consumption is dc t which implies that tomorrow consumption changes by (1 + r) dc t. The change in the current welfare is then U (C t ) dc t while the change in tomorrow s welfare as evaluated today is U (C t+1 )(1+r) 1+ρ dc t giving U (C t ) dc t - U (C t+1 )(1+r) 1+ρ dc t as the total change in welfare, U is the marginal utility. The consumer switches consumption between periods as long as welfare improves. At the optimum welfare improvements are not available and thus U (C t ) = U (C t+1 ) (1 + r) 1 + ρ (8)
Aggregate Demand 12, Consumption Since the marginal utility is declining, U < 0, when (8) holds, then no resuffling of consumption can improve welfare. In the special case where the real interest rate r equals the subjective discount rate ρ we see that the optimal choice currently is to have the same consumption in each period, C t+i = C t, i 0, i.e. perfect smoothing of consumption. This leads to the Permanent Income Hypothesis (PIH)-theory of consumption (by milton Friedman). To see closely what it implies let us generalize the intertemporal budget constraint from 2 to many periods: C t + C t+1 1 + r + C t+2 (1 + r) 2 +... = A t + Y t + Y t+1 1 + r + Y t+2 (1 + r) 2 +... (9)
Aggregate Demand 13, Consumption With C t+i = C t, i 0 the budget constrain can be rewritten as C t + C t 1 + r + C t (1 + r) 2 +... = A t + Y t + Y t+1 1 + r + Y t+2 (1 + r) 2 +... The left hand side can now be rewritten as [ C t 1 + 1 ] 1 + r + 1 (1 + r) 2 +... 1 = C t 1 1 1+r So C t = C t = (10) = C t 1 + r r (11) r [ A t + Y t + Y t+1 1 + r 1 + r + Y ] t+2 (1 + r) 2 +... = r 1 + r Ψ t (12)
Aggregate Demand 14, Consumption The theory is completed be recognizing the fact that people cannot know perfectly their income flows, not even for the current year until the end of the year, they have to form expectations of them, Yt+i e. This gives finally C t = r [ A t + Yt e + Y t+1 e 1 + r 1 + r + Y t+2 e ] (1 + r) 2 +... = r 1 + r Ψe t The PIH-theory implies that people consume the interest income on their wealth, which consists both of the human wealth (present value of expected labor incomes) and non-human wealth. (13) Expectations matter: If incomes are expected to increase, the consumer borrows now against future incomes to smooth the consumption. Life-cycle consumption?
Aggregate Demand 15, Consumption Expectations matter: An anticipated change in consumption has an effect already this period. If anticipations turn out to be correct, there should not be any change in consumption when the change takes place. Expectations matter: If the anticipations turn out to be incorrect, e.g. income turns out to be higher than anticipated, most of the surprise income will be saved, only the proportion r 1+r of will be consumed, if the change is temporary: a temporary change in income has only a minor impact on the wealth. Expectations matter: If a temporary change leads to a revision of future incomes, then the wealth increases. In the case the revision increases anticipated future incomes in the same proportion all of the increase in incomes will be consumed.
Aggregate Demand 16, Consumption The theory implies thus that if people are reasonably good in their anticipations of future incomes then the correlation between current changes in consumption and changes in income should be small, if capital markets are well-functioning. How has it been in Finland?
SugarSync/Luennot/Macro2016/Correlation c, yd.pdf Correlation between % changes in C and Yd period corr period corr period corr 76-14 0.645733 96-08 0.324833 76-80 0.879542 80-14 0.612397 96-09 0.383199 76-90 0.71063 80-90 0.495503 96-10 0.383953 76-95 0.676303 80-95 0.637142 96-11 0.364585 76-91 0.605774 96-14 0.55897 96-12 0.451733 76-92 0.694225 96-13 0.512929 76-93 0.741422 76-94 0.66185 Source: Statfin
Aggregate Demand 17, Consumption So? At the same time the theory tells that anticipated changes in future incomes should have an effect already today. How can we know what consumers are anticipating? One data in Finland: Consumer barometer (Kuluttajabarometri). It contains, among others, monthly data starting from October 1995 until 2016 on consumer confidence on their own economic situation (improves, stays the same deteriorates) over the next 12 months (A3), on their confidence on the Finnish economy (4), and an index combining these (A1).
Aggregate Demand 18, Consumption In the following diagram the changes in these confidence indices and the percentage change in household consumption expenditure are shown. I have taken an average of the confidence indices and calculated annual changes. Thus the change e.g. in 2001 reflects the change of confidence over 2001 to 2002.
SugarSync/Luennot/Macro2016/Household confidence and cons expenditure.pdf 25 Household confidence, saldo change, and %-change in hh consumption expenditure, Statfin 20 15 10 5 0-5 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014-10 -15-20 A1,c A3,c A4,c C, % ch
Aggregate Demand 19, Consumption One can also ask, how well consumer confidence indices, especially A3, correlates with future changes in households economic situation like change in disposable income. Next figure tells the story for the one year ahead change in confidence on own economy and realized change in household disposable income:
SugarSync/Luennot/Macro2016/Household confidence and disp inc.pdf 6 Household confidence on own situation, change, and next year's change in hh disposable income, Statfin 5 4 3 2 1 0-1 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013-2 -3 Yd, %c A3,c
Aggregate Demand 20, Consumption So? The correlation between the change in confidence in own economy, A3, and next year s change in disposable income is quite high, 0.56. The corresponding correlations with other confidence indicators are much lower A1 : 0.14, A4 : 0.05 Isolation from the rest of the economy?
Aggregate Demand 21, Consumption The theory can also highlight the role of household assets and debt on consumption and thereby on the role of capital markets in explaining swings in consumption. Look at (13). Clearly, large changes in A(t) can have large impacts on current consumption. This can happen e.g through changes in asset values (e.g. in changes in housing prices, especially if housing can be used as collateral, access to credit changes). This also implies that household heterogeneity matters as wealth is not equally distributed. By definition, the same holds for changes in the interest rate. Household debt and capital markets played a crucial role in igniting the Great Recession.
Aggregate Demand 22, Consumption The PIH-theory of consumption, as derived above, is based on the assumption that interest rate equals the time preference. Most of its insights hold even when this assumption is dropped. It is thus meaningful to study, how changes in the interest rate affect household consumption/savings. In the simple model, interest rate is a key determinant of the allocation of consumption between periods: higher interest rate is equivalent to a reduction of the price of future consumption. But: in addition to the substitution effect there is also the income effect: impact on savings unclear. Also the initial conditions matter: impacts depend on whether the consumer/household is a net creditor or net debtor. Thus, impacts of changes in interest rate in the aggregate can be small, though estimates vary, as do also estimates of the rates of intertemporal substitution.
Aggregate Demand 23, Consumption Most important effects of interest rate changes can come from channels other than intertemporal substitution (willingness to shift consumption between periods). Balance sheet effect: Changes in interest rates have an impact on asset values. Borrowing constraints can explain why current consumption seems to be relatively sensitive to current changes in income: Interest rate changes can have an impact on the borrowing constraints, e.g. through the balance sheet effect. All in all, changes in interest rate (and thereby impacts of monetary policies) can come through (wealth) redistribution channels (Sufi in the syllabus).
Aggregate Demand 24, Consumption All in all, we can conclude that private consumption depends on both current income and interest rate. Marginal propensity to consume is positive, but most likely below unity. Marginal propensity could be close to unity, if large share of consumers/households were credit constrained (i.e. were not able to get new credit). Thus c = c (y, r), 0 < c y < 1, c r =? (14)
Aggregate Demand 25, Consumption Notice that (??) looks exactly like the consumption equation we began with and criticized. The point here is that it is the interpretation that has changed, dependence on the current income comes e.g. through financial stress and/or through imperfections like credit rationing. To see the latter, look at the budget constraint (??), and assume that the household wants to borrow but cannot borrow as much it wants, s < 0 is fixed to it. In this case the budget constrain the family faces is c 1 = y 1 + A 1 + s (15) implying a marginal propensity to consume out of current income equal to unity, c 1 y 1 = 1.
Aggregate Demand 26, Private Investment The basic modern theory of private investment is based on an insight by Keynes: If somebody plans to invest in productive capital she has two options: Buy an existing firm (which already has made) an investment or buy the capital goods directly and establish a new firm. Obviously the first option is better if the share prices are low, relative to the price of new capital goods, the second, when the reverse holds. Think also of housing markets: you have the choice of buying an existing house or building a new one. If the housing prices are low then it pays to buy, and housing investments are low. To understand what kind of a basic theory we need let us look at how private investments (private gross capital formation) have developed in Finland.
Aggregate Demand 27, Private Investment The first figure displays the share of private non-residential investment in GDP. the second the share of gross fixed capital formation in housing.
SugarSync/Luennot/Macro2016/Priv Non-Res I, GDP.pdf 0.18 Priv non-res inv/gdp, OECD Ec. Outlook 0.16 0.14 0.12 0.1 0.08 Priv non-res I/GDP 0.06 0.04 0.02 0
1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 SugarSync/Luennot/Macro2016/Housing gross fixed I, GDP.pdf 0.12 H-Inv/GDP, OECD Economic Outlook 0.1 0.08 0.06 H-Inv/GDP 0.04 0.02 0
Aggregate Demand 28, Private Investment So? Long-term decline, how to explain? Investment is volatile.
Aggregate Demand 29, Private Investment Let us focus on the volatility. Keynes insight tying investment to stock market valuations (and to housing prices) can be helpful in explaining the volatility of investments, asset market prices are volatile. James Tobin, building on Keynes, built what is now known as the q-theory of investment. q denotes the additional value investment creates relative to the costs of that investment. If q > 1 new investments increase, if q < 1 investments shrink (no new investment, some replacement investment not made). When q = 1 there is no new investment, the economy is in the long-run equilibrium.
Aggregate Demand 30, Private Investment How can the situation ever be such that q = 1, should not optimal choice imply that marginal benefits equal marginal costs? The equality q = 1 determines the optimal long run capital stock. If this hel all the time the capital stock would change instantaneously for changes e.g. in marginal benefits and the investment rate would be infinite. One can rationalize the q-theory by assuming that it is costly to change the capital stock rapidly. So, what is q?
Aggregate Demand 31, Private Investment What is the marginal benefit from investment now? An additional unit of capital produces in the current period additional revenue which equals the value of marginal product of capital. Assume, here just for simplicity but, in general, for reality, it takes time to get the investment to become productive(e.g. time to build (Kydland-Prescott) or install, time to learn, etc.): assume gestation takes one period. Denote the production function by F (K, N) where K denotes the capital stock (assuming each unit of capital produces one unit of services) and N other inputs. Additional revenue from one unit of investment after gestation is thus PF K, F K P = the price of the good produced F (K, N) K (16)
Aggregate Demand 32, Private Investment But this is not all, the additional unit of capital will increase also future capital stocks, unless it depreciates completely in one period. Thus, one unit of capital increases tomorrow s capital stock by (1 δ), where 0 δ 1 denotes the rate of depreciation. The additional revenue obtained is, after two periods (1 δ) PF K. Continue like this, after three periods the revenue created by the unit investment is (1 δ) 2 PF K,.... But there are costs, other than depreciation: the money could have been invested elsewhere, denote the return then by r. Then the present value of the revenue created is PF K [ 1 1 + r ] (1 δ) (1 δ)2 + 2 + (1 + r) (1 + r) 3 +... (17)
Aggregate Demand 33, Private Investment Let P K be the price of a unit of new capital. The q is then q = PF [ ] K 1 (1 δ) (1 δ)2 + P K 1 + r 2 + (1 + r) (1 + r) 3 +... (18) giving as q = PF K P K (r + δ) (19) [ ] 1 (1 δ) (1 δ)2 + 1 + r 2 + (1 + r) (1 + r) 3 +... = (20) [ ( ) ( ) 1 1 δ 1 δ 2 1 + +...] = (21) 1 + r 1 + r 1 + r 1 1 1 + r 1 1 δ 1+r = 1 r + δ (22)
Aggregate Demand 34, Private Investment In (18) the numerator gives the flow benefit, the denominator the marginal cost (the interest cost and the cost of depreciation) of investment. Obviously, an increase in the interest rate reduces investments, while an increase in the (relative) price of the good produced increases investment. Also, in (18) both the numerator and denominator contain terms over which firms form expectations. This provides a link to the equity market: Equity prices are supposed to reflect firms expected future income flows and thus investment potential. The term PF K P K in the formula for q captures the potential income which can generated by new investment. Changes in share prices should then reflect expectations over these increases in income and signal markets willingness to fund new investments.
Aggregate Demand 35, Private Investment In practice, in empirical research the stock market valuation of a firm has been used as a proxy for PF K P K. In principle this is wrong as it is not a measure of the marginal increase in firm income due to investment. The q-teory is the standard theory of investment as the PIH-theory is for consumption, both rely on the assumption of (essentially) frictionless financial markets. But it turns out that credit constraints hit also firms: current cash flows have an effect on current investments: excess sensitivity of investment to external funds: aggregate investment depends also on current aggregate income. Collateral requirements. Sometimes it is hard to differentiate consumption and investment: SME s.
Other issues related to modelling consumption and investment Macro-micro: The role of household and firm heterogeneity, changes in distributions? Behavioral economics and macro? Intertemporal decision making: weakness of will (time-inconsistent preferences), habit formation, expectations formation, social interactions (networks). What is crucial?
Aggregate demand: IS-curve 1 We can now summarize, for modeling purposes summarize the discussion in the following three equations: C = c 0 + c 1 (1 t) y (23) I = a 0 a 1 r (24) y = C + I + G (25) (22) gives the consumption equation, (23) the investment equation and the last the equilibrium condition. Since in equilibrium demand must equal supply, the previous system of equations gives the income level consistent with prevailing demand. One can interpret c 0 to correspond to the PIH-level of consumption, affected by expectations.
Aggregate demand: IS-curve 2 Similarly, one can interpret a 0 as the marginal benefit part of the q, also very much affected by the expectations. t denotes the average marginal tax rate, G = public sector expenditure. By substituting (22) and (23) in (24) we ket the aggregate income consistent with demand: y = k (c 0 + a 0 + G) ka 1 r, k 1 1 (1 t) c 1 (26) k is the multiplier, it measures how strongly various demand shocks (like change in government demand) affect aggregate demand.
Aggregate demand: IS-curve 2 But the multiplier also matters for the effectiveness of monetary policies as monetary policies affect the economy through changes in the interest rate. (25) can be inverted to get r = (c 0 + a 0 + G) a 1 1 ka 1 y (27) This is the IS-curve, giving the interest rate which is consistent with the current aggregate demand, and eventually the aggregate supply. Graphically:
SugarSync/Luennot/Macro2016/IS-curve.pdf IS-curve r shifts in demand like G, expectations slope =1/ka 1 y