Session 16. Review Session The long run [Fundamentals] Output, saving, and investment Money and inflation Economic growth Labor markets The short run [Business cycles] What are the causes business cycles? How does the economy respond to shocks? How to stabilize business fluctuations? Extending the model [Policies, exchange rates, currency unions] Basic Definitions Output in the economy is distributed between consumption, investment, government purchases and net exports: GDP = C + I + G + NX Production leads to income and income gets allocated to For the world (closed economy) GDP+NFP = C+ S priv + T S gov + S priv = S = I This equation represents the balance between those who want to transfer current income to the future and those who want to bring future income into the present. The real interest rate is the price that equilibrates these two flows. 1
Saving and Investment: Loanable Funds r Investment Saving Saving increases if: 1. Current output increases 2. Expected future output decreases 3. Wealth decreases 4. Taxes increase 5. Government spending decreases Equilibrium Real interest rate Investment increases if: 1. Productivity increases 2. Taxes on capital decrease Saving, Investment Growth in the Long Run GDP Per Capita (US) New Economy 59900 11 22000 10 World War I 1981 monetary contraction World War II 8100 9 Industrialization Railroads Oil Shocks Constant growth (1.85%), but based on continuous effort to innovate, to improve processes, and bounce back after shocks The Depression of the The Great Depression 1890s 3000 8 1870 1876 1882 1888 1894 1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008 2
Long-run Growth: Catching up (or not) GDP Per Capita (PPP) 11 10.5 US 10 Singapore 9.5 Venezuela 9 8.5 8 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Long-run Growth: Investment Growth is about the ability to use current resources into building a productive stock of physical capital, human capital and knowledge. Growth GDP per capita (%) 10 8 6 4 2 Sierra Leone Investment and Growth USA Brazil France Chile India Botswana Mauritania Singapore 0 Venezuela 10 15 20 25 30 35 40 Niger -2 Investment in physical capital (% of GDP) Period: 1980-2010 Korea China 3
2 Institutions Matter Institutions are the main determinant of investment and growth. Oil Producing Countries Norway 1.5 Chile Poland Singapore 1 India USA Institutional Quality 0.5 0-0.5-1 Liberia Niger Indonesia Namibia Brazil Greece UAE Saudi Arabia Lebanon Russia China -1.5 Venezuela -2 250 680 1847 5021 13650 37103 GDP Per Capita (2010) Summary on Economic Growth: The Four I s Innovation Initial conditions Investment Institutions The incentives to innovate (e.g. respect of intellectual property rights) will shift the technology frontier. This is the main force behind growth in the developed countries. Provides the potential for catching up. Poor countries can grow faster when they set on a convergence path to the rich economies A key ingredient in the process of convergence is the building up of the capital stock. This requires high investment rates. Miracles are countries with investment of over 25% of GDP. In addition to physical investment, it is important to invest in human capital, efficiency, technology What drives investment: stability, institutions. The best way to ensure sound macroeconomic policies (i.e. stability) and political stability is to build institutions that create incentives for stability: Independent central bank, checks and balances, rule of law, transparency. US, Japan, France, Germany China today, Singapore in 80s High growth (Korea) 35%; Steady state (US, Germany) ~ 18% There is not a single country that has become rich with poorquality institutions 4
The Long-Run Dichotomy %ΔM + % Δ V = Inflation + Real growth Inflation rate (percent, logarithmic scale) 10,000 1,000 Georgia Democrati c Re publ Ni caragua of Congo Angola Brazil 100 Bulgaria 10 Kuwait Germany 1 USA Oman Japan Canada 0.1 0.1 1 10 100 1,000 10,000 Money supply growth (percent, logarithmic scale Percentage change in nominal exchange rate Inflation and the Nominal Exchange Rate Long-run Dichotomy % change in RER = % change in NER + Domestic inflation - Foreign inflation 10 9 8 7 6 5 4 3 2 1 Sweden Australia New Zealand Spain Ireland Canada South Africa France UK Belgium 0-1 Germany Netherlands - 2 Switzerland - 3 Japan - 4-3 - 2-1 0 1 2 3 4 5 6 7 8 Inflation differential Italy Depreciation relative to U.S. dollar Appreciation relative to U.S. dollar Source: Mankiw (Fig.5.13). Averages for 1972-2000. 5
The Long-Run Dichotomy Why did Italy have consistently higher nominal interest rates than Germany and a depreciating currency when they had their own monetary policy? Because inflation was higher in Italy (and inflation was the result of faster money growth) Germany Italy Nominal Interest Rate 7.2% 11.8% Money Growth 6.5% 10.1% Inflation 3.2% 7.7% Depreciation of Nominal Exchange Rate (average annual depreciation of the Italian Lira relative to the German Mark) 4.9% Average over 1960-1998. From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies 6
Global Imbalances Output in the economy is distributed between consumption, investment, government purchases and net exports: We can rewrite this equation as: Y = C + I + G + NX S - I = CA Trade and capital flows are recorded in the balance of payments Global Imbalances CA surplus Saving Saving World Real interest rate Investment CA deficit Investment Saving, Investment Saving, Investment 7
Global Imbalances Current Account as % of World GDP 3 2 1 0-1 -2-3 Income - Spending 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 US Europe Deficit OIL DEU+JPN CHN+EMA Others Europe Deficit: Bulgaria, Greece, Hungary, Ireland, Portugal, Spain, United Kingdom, From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies Increases in oil price: surplus in oil economies High saving rates Global Savings Glut Global imbalances Low Interest Rates Increase in borrowing and spending in some advanced economies (US) 8
Business Cycles: Definitions, Characteristics Business cycles are transitory deviations of output from its trend. Business cycles do NOT affect output trend Output and potential output UK 6 Output gaps 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 UK GDP Potential 3 0-3 -6-9 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Germany Japan United Kingdom United States The IS/LM 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 9
General Equilibrium Real interest rate Long-run aggregate supply LM Equilibrium Real interest rate IS Y LR Output Phillips Curve (Japan) 10
Changes in the Economic Environment 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) 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. Wealth increases 5. In the open economy demand for country s exports increases (or for imports decreases) 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) From the Great Moderation to the Perfect Storm Global Savings Glut Low Interest Rates Increase in borrowing and spending in some advanced economies (US) Increase in wealth Increase in asset prices 11
From the Great Moderation to the Perfect Storm Global Savings Glut Low Interest Rates Increase in borrowing and spending in some advanced economies (US) Financial innovation Search for Yield Central Bank faith in their model Increase in wealth Increase in leverage of financial institutions and investors Increase in asset prices Consumption and Wealth During those years, US wealth was increasing at a much faster rate than income (GDP). As a ratio to wealth, consumption decreased from 17% to 15% during 2002-2006. But the collapse of housing prices and stock prices in 2008 revealed a very different scenario. 480 460 440 420 400 380 360 340 320 Wealth (% of GDP) US 12
r The expansion years As the world interest rate decreases, consumption in the US increases. In addition, financial innovation provides access to credit to more individuals. The increase in asset prices (wealth) increases consumption further. The central bank accommodates the increase in output as (CPI) inflation was never a problem. But this growth was unsustainable and ultimately leads to a recession when asset prices collapse. LM Interest rate World interest rate r* r* new IS Y Output Aggregate Demand Management Business cycle fluctuations might be an inevitable companion to economic progress but they do impose costs on the society: Output grows too fast Output grows slowly Inflation* Unemployment * But not in 2000 or 2007! Tools to stabilize business cycles Monetary policy: Fiscal policy: lower interest rates in recessions increase interest rates in expansions increase spending or cut taxes in recessions decrease spending or increase taxes in expansions 13
How Is Monetary Policy Conducted? The Taylor Rule. Interest rate target = Inflation + r N + 0.5 *(Inflation π T ) + 0.5*(GDP gap) 40 Monetary Policy: UK 30 20 10 0 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 Central Bank Interest Rate Taylor Rule The Great Moderation: New Zealand Volatilit y 10 9 8 7 6 5 4 3 2 1 0-2 1965 1970 1974 1978 1982 1987 1991 1995 1999 2004 2008 Inflation Volatility Growth Volatility Inflation 20 18 16 14 12 10 8 6 4 2 0 Inflation 14
From the Great Moderation to the Perfect Storm Low Inflation Low Interest Rates Low inflation expectations Financial innovation Central Bank faith in their model Great Moderation Increase in leverage of financial institutions and investors The IS/LM Model for a Small Open Economy There are two modifications relative to the closed economy: (1) The IS curve depends on Net Exports, and thus on the real exchange rate and on foreign income. (2) There is capital mobility: Domestic interest rates cannot be independent of world interest rates. Perfect capital mobility (driven by arbitrage) makes domestic and foreign interest rates equal: r = r* r World interest rate r* LM IS Y Appreciation Depreciation 15
The Open-Economy IS/LM Model The key mechanism in the open economy model is the following: 1. The change in the economic environment implies a change in the interest rate. 2. The new interest rate induces capital outflows (if it is below the world interest rate) or inflows (if it is above). 3. Capital inflows lead to appreciation of the currency (foreigners want to buy the currency to invest in the country), while capital outflows lead to depreciation. 4. In an economy with a floating exchange rate the appreciation will lead to decline in (net) exports and lower demand (while depreciation will have the opposite effect). 5. In an economy with a fixed exchange rate regime appreciation or depreciation is not allowed, hence monetary policy must intervene. The Impossible Trinity Key lesson: In a world with high capital mobility a country cannot fix the exchange rate of its currency and run at the same time independent monetary policy unless they restrict capital mobility. Independent monetary policy Fixed exchange rate Capital mobility A country can select only two of these options. 16
From the Great Moderation to the Perfect Storm Preference for liquid (US) assets Attempt to control exchange rates (China) Accumulation of foreign reserves (China, Japan) Global imbalances Low Interest Rates From the Great Moderation to the Perfect Storm Fast Growth in China and other emerging economies Increases in oil price: surplus in oil economies Preference for liquid (US) assets Attempt to control exchange rates (China) Increase in World productive capacity High saving rates Global Savings Glut Low Interest Rates Low Inflation Accumulation of foreign reserves (China, Japan) Global imbalances Increase in borrowing and spending in some advanced economies (US) Low inflation expectations Financial innovation Search for Yield Central Bank faith in their model Increase in wealth Great Moderation Increase in leverage of financial institutions and investors Increase in asset prices 17
The confidence in financial markets Frederic Mishkin (Federal Reserve Board of Governors Member, 2006-2008) in August 31, 2007: The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions. Policy response Policy in advanced economies had to focus on: - Avoiding an even deeper financial crisis (liquidity!) - Bringing the economy close to potential as soon as possible: Expansionary monetary and fiscal policies. Ideally we also want to improve potential growth (pro-growth reforms). 18
When a recession meets the risk of deflation (real) Interest Rate Investment Saving The lack of spending relative to income (the excess of saving relative to investment) might require a negative (real) interest rate. With deflation this becomes impossible! Central banks had to ensure that they did not get into a deflation/ liquidity trap. Need to raise inflation expectations. The End of the Euro Bubble 19
Before the crisis Low and stable inflation is the best policy (great moderation) Limited role for fiscal policy (lags, implementation) Financial regulation should be independent of monetary policy What we have learned Stabilizing inflation is not enough We might need more room to deal with major crisis (higher inflation target?) Financial sector is key to propagation of business cycles We need tools to deal with bubbles Fiscal policy is an important tool, but if we start with high debt levels, we are in trouble! Sovereign default crisis are possible in advanced economies Scenarios for the World Economy If we insist on austerity for everyone 1. Growth will remain weak. 2. Countries will be unable to stick to deleveraging plans. 3. Financial markets will have no confidence in governments. 4. Elections will be won by populist parties. 5. Bank runs will make some national financial markets unstable and lead some Euro countries to leave the Euro area. 6. The World Economy will go into a deep recession. 20
Scenarios for the World Economy If we understand that the long-run recipe is different from the short one 1. We stop co-ordinated austerity and we allow growth to come back. 2. Countries will be able to stick to (realistic) plans even if adjustment is slow. 3. Financial markets will stabilize and improve. 4. And if emerging countries get it right, the World economy will grow. 5. The Euro area will remain stable and return to growth. 21