Two ways o we learn he model Graphical Inerface: Model Algebra: The equaion you used in your SPREADSHEET. Corresponding equaion in he MODEL.
There are four core relaionships in he model: you have already seen hree. EXT * RER = r + rp r + RER + 1 Exernal Risk premium Expeced (or rend) real ineres rae real exchange rae 1. An aggregae supply or Phillips Curve relaionship inflaion/oupu gap, ec. 2. A moneary policy relaionship or Taylor Rule, ha shows how he cenral bank ses ineres raes. 3. An ineres rae pariy equaion ha links he real exchange rae o foreign and domesic moneary policies.
The Fourh Core Relaionship Equilibrium in Goods/Services Marke IS (Invesmen/Savings) Relaionship Real Ineres rae in percen IS Curve (Oupu gap) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% 7.0% 9.0% Oupu gap in percen The IS curve summarizes equilibrium in he marke for goods and services. Downward slope in oupu/real ineres rae space; Two channels an increase in he ineres rae: Resrains domesic spending. Appreciaes he currency, discouraging expors, encouraging impors.
Deriving he IS Curve Naional Accouning Ideniy: Y = C+ I + G+ NX Wha we produce (Y) equals he sum of expendiures on consumpion, invesmen, governmen, and ne expors (expors minus impors). Nex segmen: will examine behavioral assumpions behind each of hese componens deriving he IS curve from he boom up.
Domesic Expendiure Elemens Y = C+ I + G+ NX
Domesic Expendiures - 1 Y = C+ I + G+ NX The equaion you used in your spreadshee. Δ % C = β * Δ% Y d YC Consumpion: Rises wih disposable income. Corresponding equaion in he model. C = a + a Y C0 CY Assumpion: Disposable income rises one-o-one wih oupu. acy = marginal propensiy o consume
Domesic Expendiures - 2 Y = C+ I + G+ NX The equaion you used in your spreadshee. Δ % I = β Δ % Y + β Δr IY Ir Invesmen: Decrease wih ineres raes (higher cos of funds for firms, fewer profiable projecs). Corresponding equaion in he model. I = ai0 + aiy * Y + air( r r) Increases wih oupu (acceleraor),
Domesic Expendiures Elemens Y = C+ I + G+ NX In he spreadshee, you obained your governmen spending projecion from deailed secor assumpions. Corresponding equaion in he model. Governmen: Deermined by policy makers (finance minisry). G = a + GP 0G Normal level plus spending expansion or conracion.
Exernal Secor Elemens Y = C+ I + G+ NX
Ne Expors in he Exernal Secor 1a Expors: Poenial oupu (insalled capaciy, produciviy) exogenous o he model. Y P Relaive price of expors. supply curves slope upward (higher prices encourage more producion). RPX = S * P P X
Ne Expors in he Exernal Secor 1b The equaion you used in your spreadshee. Δ % X =Δ % Y + ε Δ% RPX P X, RPX Corresponding equaion in he model. X a a rpx = 0X + 1 X * Real price of expors (deviaion from baseline)
Ne Expors in he Exernal Secor 1c Impors: Rise wih oupu (income effec) Y Decreases wih he relaive price of impors demand curves slope downward (higher prices discourage purchases). RPIM = S * P P IM
Ne Expors in he Exernal Secor 1d The equaion you used in your spreadshee. Δ % IM = ε Δ % Y + ε Δ% RPIM IM, Y IM, RPIM Corresponding equaion in he model. IM a a Y a rpim = 0IM + 1IM + 2 IM *
Ne Expors in he Exernal Secor 2a
Ne Expors in he Exernal Secor 2b
Ne Expors in he Exernal Secor 2c
The IS Curve and Ne Expors 12.0% IS Curve (Oupu gap) Y = C+ I + G+ NX Real Ineres rae in percen 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -5.0% -3.0% -1.0% 1.0% 3.0% Oupu gap in percen 5.0% 7.0% 9.0% All else equal, when ineres raes rise: Less domesic spending. Exernal secor: expors discouraged, impors simulaed.
The IS Curve and Oupu Gap - 1 If we have a change in governmen spending (or ax policy) he IS curve shifs. Real Ineres Rae- inpercen IS Curve 9.0% 7.0% 5.0% 3.0% 1.0% -1.0% -3.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% 7.0% 9.0% Oupu gap in percen
Adding in Moneary Policy 12.0% IS Curve (Oupu gap) Real Ineres rae in percen 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% The full equilibrium level of oupu will be a funcion of ineres rae. Cenral Bank Policy Acions -6.0% -5.0% -3.0% -1.0% 1.0% 3.0% Oupu gap in percen 5.0% 7.0% 9.0%
Moneary Policy and Real Ineres Rae - 1 A key goal of he cenral bank is o sabilize he price level. TAYLOR i f π π = [( ),...] *
Moneary Policy and Real Ineres Rae - 2 According o he Phillips curve, inflaion rises when higher demand pushes up he oupu gap. π = ggap (, π,...) e
Moneary Policy and Real Ineres Rae - 3 Thus, he Phillips Curve is a consrain for he cenral bank. TAYLOR i = f[( π π ),...] * π = ggap (, π,...) e
Nominal Ineres Rae - 1 π = e ggap (, π,...) i = f π π TAYLOR * [( ),...] i = f g gap π π TAYLOR e * [( (,,...) ),...] Since he PC is a consrain for he Cenral bank, we can subsiue i in o he Taylor Rule. Inuiion: Phillips curve is a consrain for cenral bank.
Nominal Ineres Rae - 2 Nominal ineres rae -- in percen Taylor Rule -- Nominal Ineres Rae 19.5% 17.5% 15.5% 13.5% 11.5% 9.5% 7.5% 5.5% 3.5% 1.5% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% Oupu gap in percen Resul upward sloping line in oupu gap and nominal ineres rae space. Inuiion The cenral bank ses he nominal rae of ineres; all else equal an increase in he oupu gap ha reflecs more aggregae demand will mean higher inflaion (Phillips Curve) -- so cenral bank raises ineres raes.
Real Ineres Rae The REAL ineres rae ha maers for economic decision-making. To obain real ineres rae Subrac inflaion (Phillips Curve) from nominal ineres rae (Taylor rule). r = i π TAYLOR Real ineres rae = nominal ineres rae minus inflaion.
Real Ineres Rae Real ineres Rae in percen Taylor-ype Rule 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -5.0% -3.0% -1.0% 1.0% 3.0% Oupu gap in percen 5.0% 7.0% 9.0% Resul upward sloping line in oupu gap and REAL ineres rae space. Inuiion: when inflaion rises, cenral bank has o increase nominal ineres rae vigorously enough o also raise he real ineres rae as well.
Macroeconomic Equilibrium Graphical Represenaion Core macro variables: Oupu gap Ineres rae Inflaion IS curve and Moneary Policy (Taylor-ype rule) Exernal secor: Real exchange rae (relaive o rend) Ne expors Pariy condiion and ne expor equaion.
IS and RR Real Ineres Rae- inpercen IS / RR Curve 9.0% 7.0% 5.0% 3.0% 1.0% -1.0% -3.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% Oupu gap in percen Thus we see an iniial macroeconomic equilibrium oupu gap and real ineres rae a inersecion of IS and RR.
IS, RR, and he Phillips Curve By adding he Phillips curve which slopes upward in oupu gap and inflaion rae space we ge he inflaion rae! Real Ineres Rae- inpercen IS / RR Curve 9.0% 7.0% 5.0% 3.0% 1.0% -1.0% -3.0% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% Oupu gap in percen Inflaion rae in percen PC -- Phillips Curve 13.5% 11.5% 9.5% 7.5% 5.5% 3.5% 1.5% -5.0% -3.0% -1.0% 1.0% 3.0% 5.0% Oupu gap in percen
Macroeconomic Equilibrium Graphical Represenaion Core macro variables: Oupu gap Ineres rae Inflaion IS curve and Moneary Policy (Taylor-ype rule) Exernal secor: Real exchange rae (relaive o rend) Ne expors Pariy condiion and ne expor equaion.
Ne Expors and Real Exchange Rae 1 Real Exchange Rae Gap 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Ne Expors and Real Exchange Rae More appreciaed currency, larger defici Price Effec: As he real exchange rae appreciaes, ne expors fall. -8.0% -12.0% -11.0% -10.0% -9.0% -8.0% -7.0% -6.0% -5.0% Ne Expors in percen of poenial
Ne Expors and Real Exchange Rae 2 Real Exchange Rae Gap 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Ne Expors and Real Exchange Rae Higher oupu gap, more impors, larger defici. Income Effec: Higher domesic income means more impors, larger defici on ne expors. -8.0% -12.0% -11.0% -10.0% -9.0% -8.0% -7.0% -6.0% -5.0% Ne Expors in percen of poenial
Ne Expors and Real Exchange Rae 3 Real Exchange Rae Gap Ne Expors and Real Exchange Rae 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -9.0% -8.5% -8.0% -7.5% -7.0% -6.5% -6.0% -5.5% -5.0% Ne Expors in percen of poenial Iniial Equilibrium: Wih zero oupu gap wih real ineres raes a heir long-run, real exchange rae a is long run value, ne expors are a heir long run normal value (raio o poenial oupu).
Macronia s Risk Assessmen Two risk assessmens: A deerioraion of Macronia s erms of rade a fall in exernal demand. Adverse exernal financial pressures ha forces Macronia o reduce is expendiure and improve is ne expors.
Macronia s Vulnerabiliies: A Risk Assessmen 2
Macronia s Exernal Financial Pressures 1 EXT * RER = r + rp r + RER + 1 Exernal Risk premium Expeced (or rend) real ineres rae real exchange rae Tigher money abroad This can happen wih lile warning. Example: The aper anrum of 2013
Macronia s Exernal Financial Pressures 2 EXT * RER = r + rp r + RER + 1 Exernal Risk premium Expeced (or rend) real ineres rae real exchange rae Invesors ge a wake up call Sensing ha he exernal siuaion may become unsusainable, hey abandon heir posiion in he counry ofen suddenly and abruply!
Macronia s Exernal Financial Pressures 3 EXT * RER = r + rp r + RER + 1 Exernal Risk premium Expeced (or rend) real ineres rae real exchange rae In eiher case, invesors now require even more compensaion o hold a counry s asses a higher ineres rae. Raising he ineres rae will help defend he currency. Bu, i will also squeeze ou expendiures a home lower oupu. Typically, we do see domesic ineres raes rise bu no enough o fully preven a depreciaion of he exchange rae.
Macronia s Exernal Financial Pressures 4 EXT * RER = r + rp r + RER + 1 Exernal Risk premium Expeced (or rend) real ineres rae real exchange rae Insead, we will boh some ineres rae increase and some exchange rae depreciaion. We ll see ha markes have forced he counry o boh rein in is domesic expendiures and o correc is exernal imbalances a forced improvemen in he ne expor balance. Again, such an adjusmen is no a happy scenario: i can happen suddenly and is adverse impacs can be severe.
Macronia s Exernal Financial Pressures 5