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Money, Inflation and the Business Cycle

Money, Inflation and the Business Cycle. The Taylor Rule Reverse Causation Segmented Markets Misperceptions Model Commitment & Monetary Policy. Readings: * Williamson, Ch 11 * Williamson, Ch 17. Recall that money in the CE model is either

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Money, Inflation and the Business Cycle

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  1. Money, Inflation and the Business Cycle The Taylor Rule Reverse Causation Segmented Markets Misperceptions Model Commitment & Monetary Policy

  2. Readings: * Williamson, Ch 11 * Williamson, Ch 17

  3. Recall that money in the CE model is either (i) Neutral & Superneutral in the ad-hoc or CIA model w/ exogenous income (Classical Dichotomy). (ii) Neutral but not Superneutral in CIA model w/ production. • CIA model w/ production  money growth leads to lower employment and output (countercyclical). • BC fact is money is procyclical and leading.

  4. Figure 3.13 Money Supply (black line) and Real GDP (colored line) for the Period 1959–2003

  5. Three CE explanations of procyclical money: (i) Reverse Causation procyclical & neutral. (ii) Segmented Markets procyclical & non- neutral. (iii) Misperceptions (Lucas-Friedman) Theory  procyclical & non-neutral.

  6. The Taylor Rule • Movements in money supply are often endogenous and react to economic events. • Traditionally, FED has two primary objectives: (i) Price Stability (ii) Output Stability • The Taylor Rule (J. Taylor – Stanford) quantifies the observed decisions of the FOMC as depending upon deviations of (i) inflation from a target level (p*) (ii) GDP from “potential” or target y*

  7. FOMC Statement – May 2000 • The Federal Open Market Committee voted today to raise its target for the federal funds rate by 50 basis points to 6-1/2 percent. • Increases in demand have remained in excess of even the rapid pace of productivity-driven gains in potential supply … The Committee is concerned that this disparity will continue, which could foster inflationary imbalances. • … The Committee believes the risks are weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.

  8. FOMC Statement – March 18, 2008 • The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent. • Recent information indicates that the outlook for economic activity has weakened further … Financial markets remain under considerable stress …Inflation has been elevated, and some indicators of inflation expectations have risen.  Uuncertainty about the inflation outlook has increased. • Downside risks to growth remain.  The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

  9. Taylor Rule expressed in terms of a nominal interest rate rule: * 1% increase in p > p* 1.5% increase in R * 1% decrease in y < y*  0.5% decrease in R • Taylor Rule expressed in terms of a money supply rule: where a1 ,a2 > 0.

  10. RBC View: Endogenous Money(“Reverse Causation” View) • If money is neutral in a CE model, can it explain why the nominal money supply is procyclical and leading the business cycle? • Yes. Focus on Fed’s price stability objective. • Combine the Taylor Rule with RBC model: Let y* be the CE value of output and set yt = yt*: where a1 > 0.

  11. Example: Productivity Shocks and Fed Reaction Today (t): Fed forecasts negative productivity shock ( )  future prices (Pt+1)  p > p*  Mts Future (t+1): Productivity shock  Yt+1 and p = p*. Conclusion: Mtstoday and Yt+1tomorrow.  money is procyclical and leading but neutral

  12. Figure 3.13 Money Supply (black line) and Real GDP (colored line) for the Period 1959–2003

  13. Non-Neutral Money • There is evidence that monetary policy is non-neutral: (i) Reverse causation cannot completely explain procyclical money supply. (ii) Statistical Evidence: Money  Output (iii) The Taylor Rule implies FED operates as if it can affect real output: • Can this explained in CE models w/o assuming fixed prices (e.g. IS-LM)?

  14. Segmented Markets Theory • Motivates by the “Bank Lending Channel” of monetary policy emphasized by B. Bernanke and A. Blinder. • Originates with works of Robert Lucas (1990) and Timothy Fuerst (1992). • Sometimes called “Limited Participation” models: • Inventory Models of Money (Baumol/Tobin) • Costly Portfolio Adjustment

  15. The traditional view of effect of monetary policy: Short-Run  Liquidity Effect Long-Run  Anticipated Inflation Effect or Fisher Effect: R = r + pe • Assumptions (i) Segments goods and financial market. (ii) Monetary policy works through financial markets. (iii) Firms must use borrowed cash from financial market to pay their wage bill (and/or investment).

  16. Money Supply: where Xt = mtMts = transfer of money to financial market and mt = money growth rate: = “average” money growth rate, e = random money growth shock.

  17. M1 Money Supply, 2000-2010Growth Rate

  18. Flow Chart • Timing in Period t: (i) Households begin with Mt money, Firms have Kt capital stock. (ii) Portfolio decision - Household deposits Dt into financial market based on rational expectation of Xt. Deposits pay interest rate Rt (iii) Fed injects money Xt into financial market. (iv) Firms borrow Qt from financial market to pay wages, produces output from labor and capital, buys investment goods. Loans are charged Rt. (v) Households consume with cash Mt - Dt. (vi) All loans and interest on deposits are paid. Ends period with Mt+1, Kt+1.

  19. Key: Portfolio decision (ii) happens before (iii)! • Modified Cash-in-Advance constraints. Households: Firms:

  20. Household Deposits/Portfolio FOC: expected marginal cost of deposits = expected marginal benefit or expected marginal value expected marginal of cash in goods market = value of cash in financial market • Let L = (Actual Marginal Value of Cash in Goods Mkt) - (Actual Marginal Value of Cash in Financial Mkt) L < 0 More than expected cash in goods market L > 0 More than expected cash in financial market

  21. Labor Supply FOC: • Firm FOC: Investment: Labor Demand: • Market-Clearing Conditions. Goods: Money: Labor: Financial:

  22. Household portfolio decision, i.e. money demand, based upon expected nominal interest rate ( ): Net-of-Deposits Money Demand = • The expected nominal interest rate obeys Fisher Effect: • The actual nominal interest rate follows

  23. Unexpected positive money shock  Excess cash in financial market  R < Re. • Unexpected negative money shock  Excess cash in goods market  R > Re . • Recall Labor Demand will be inversely related to R:

  24. Expected Money Shock • Purely temporary (r=0) and expected money shocks are neutral. • An expected and persistent (r > 0) positive money supply shock (e)  Similar to CIA model w/ production: * Increases expected inflation rate * Increases nominal interest rates (R) * Decreases ND and NS * Decreases N*, c*, y* * Money growth is countercyclical!

  25. Simulation: Expected Monetary Shock in Period 5 Nominal Interest Rate (R) Money Growth Rate (m)

  26. Simulation: Monetary Shock in Period 5 Output (Y) Labor (N)

  27. US DATA: Unexpected Negative Monetary Shock (Bernanke & Gertler, 1995)

  28. Unexpected Money Shock • An unexpected positive money supply shock (e): Current Period: (1) Excess cash in financial market  R < Re • Lower R  Firms borrow more to increase labor demand.  Increases w* and N* (3) Higher N*  Shifts Output Supply right  Increases y* and decreases r* (secondary effect on NS) • This is often called the LIQUIDITY EFFECT

  29. Simulation: Unexpected Monetary Shock in Period 5 Segmented Markets Model Nominal Interest Rate (R) Money Growth Rate (m)

  30. Simulation: Unexpected Monetary Shock in Period 5, Segmented Markets Model Output (Y) Labor (N)

  31. Future Period: (1) Excess cash is pulled out of financial market by households  R = Re (2) Persistence of money shock  increase expected future money growth and inflation  increase in R. The ANTICIPATED INFLATION EFFECT • N*,y*, c* will be temporarily lower than their long-run steady state values but eventually converge. • Money is procyclical and non-neutral in the “short-run”. • Shortcoming: No persistence effect of monetary policy on nominal interest rates and real GDP.

  32. Table 11.2 Data Versus Predictions of the Segmented Markets Model with Monetary Shocks

  33. Non-neutrality of money is caused by imperfect (unexpected) information about monetary policy. • Remarks about optimal policy: (i) Generally inefficient to create unexpected monetary shocks to boost output (lowers utility). (ii) If the Fed can react faster to productivity shocks then a procyclical money supply may be welfare improving:  Optimal ND greater than expected but limited cash in financial market. FED adds liquidity to support ND and increase Y to its “efficient level”

  34. Misperceptions Theory(Money Surprise Model – Williamson Ch 17) Origins: M. Friedman (1968) – “The Role of Monetary Policy” The Worker “Surprise” Model Formalized: R. Lucas (1973) – “Some International Evidence on Output-Inflation Trade-Offs” The Producer “Island” Model

  35. Worker Surprise Model • What should matter to workers are real wages w = W/P. • Labor Market with Nominal Wages. • Workers confuse W and w. • Recall W = wP. It can increase because (i) positive productivity shocks  increases w (ii) an increase in Ms increases P. • An unexpected increase in P  increases N* and Y*.

  36. Lucas Island Model • Supply of individual firms depends positively on local price relative to aggregate price level. • Time-Line of Information: (i) Period t-1: Form Et-1Pt (expected value of Pt given information up to time t-1). (ii) Period t: Observe local price NOT Pt. • Let 0 < q < 1 represent the correlation between local price and aggregate price Pt: q = 0  No Correlation q = 1  100% Positive Correlation 0 < q < 1  Some Correlation

  37. The AS Curve: • where y* = CE value for output (w/ perfect info) • If q = 1 y = y* • If q < 1 then Et-1Pt = Pt y = y* Et-1Pt < Pt y > y* Et-1Pt > Pt y < y*

  38. The Lucas Critique: Expectations about (monetary) policy affects the impact of the policy. • Value of q is based on rational expectations High inflation countries  q = 1  AS steep Low inflation countries  q = 0  AS flat

  39. Application: Rational Expectations and Monetary Policy • T. Sargent and N. Wallace (U. of Minnesota) • Consider the following “reduced form” macro model (let a = 1-q). (AS Curve) (AD Curve) (Monetary Policy) Variables are in logs. y* is the CE value of output w/ complete info. • Tools of Fed: e surprise shock to money supply. r  anticipated (systematic) policy rule.

  40. Results: • Anticipated or systematic changes in monetary policy (r) have no effect on real output (y). • Unexpected shocks matter for real output:

  41. In this situation (exogenous) changes in money supply is procyclical (& non-neutral). • Note that unlike CIA model w/ production, money is also superneutral (no anticipated inflation effects) • Policy Evaluation: a matters for the effect of monetary policy: q = 1  a = 0  dy/dm = 0

  42. Result became know as the Policy Ineffectiveness Proposition: Anticipated changes in monetary policy are neutral and unexpected changes are non-neutral. • Information regarding monetary policy and the Fed matters for the effect of money on real output. • If goal is to minimize output fluctuations (yt – y*), ala the Taylor Rule, it is optimal for FED to set et= 0. (monetarist “constant growth rate rule”)

  43. Phillips Curve • The Phillips Curve is a statistical (i) Positive relationship between inflation and real GDP. (ii) Negative relationship between inflation and unemployment rate.

  44. Figure 17.2 The Phillips Curve, 1947–1959

  45. Figure 17.3 The Phillips Curve, 1960–1969

  46. Figure 12.1The Phillips curve and the U.S. economy during the 1960s

  47. PC in Keynesian Model • If nominal wages (W) are slow to adjust there will be a (i) Positive relation between p and Y (ii) Negative relation between p and unemployment rate u. where u* is the “natural unemployment rate” • Trade-off can be permanent • Fed can exploit this trade-off and control UR by choosing p.

  48. Some Historical Facts about US Inflation • Stable and low inflation in 1950s and 60s • High inflation and unemployment in 1970s • Low inflation and unemployment in 1990s • PC “broke down” since 1970s. • Failure of Keynesian models to account for PC break down (see Mankiw article).

  49. Figure 17.3 The Phillips Curve, 1960–1969

  50. Figure 17.4 The Phillips Curve, 1970–1979

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