Macroeconomic problems

Macroeconomic problems • In this lecture we will use our economic models to study two persistent economic problems- depression and hyperinflation. • An economic depression is an extended period of output below the natural rate and unemployment above the natural rate. • Hyperinflation (or just high inflation) is an extended period of very high levels of inflation, where price levels may be doubling monthly or even weekly.

What is supposed to happen? • When we have output below the natural rate, the economic models that we have used so far in the class have always had equilibrating forces driving the economy back to the natural rate. • In most of our stories, there is a shock to the economy in the short-run, but the economy moves back to its natural levels in the medium-run. • But in a depression, the economy is “stuck” in the short-run equilibrium. What happens to the equilibrating force?

Equilibrating force • If we have a shock to the economy, we wind up at point A, where output is below the natural rate and unemployment is above the natural rate. • High unemployment causes workers’ wages to be bid down, which causes firms to drop prices. • AS shifts so we move towards point B.

Equilibrating force • As prices falls, the AS curve shifts down, and the real stock of money rises. • As the real stock of money rises, interest rates are bid down, and investment rises. • As the LM curves shifts down we move towards equilibrium.

Open economy model • Assume we have a negative terms of trade shock in an open economy with fixed exchange rates. Domestic prices have risen, so the real exchange rate increases and the domestic AD curve shifts to the left. • Higher unemployment causes domestic wages and also prices to fall.

Open economy model • As prices fall, we can not have interest rates falling, as uncovered interest parity must hold, so monetary policy must maintain the real stock of money. • But the real exchange rate will fall as domestic P falls, so NX will rise assuming the Marshall-Lerner condition holds. The IS curve shifts to the right, so we move down the AD curve towards B. • What about the floating exchange rate case?

Open economy model • However if the exchange rate is floating, a fall in domestic terms of trade and high domestic P leads to trade deficit. The trade deficit will lead to a drop in the price of the A$, so E rises. • A rise in E leads to a shift rightward of the AD curve, assuming M-L, back to equilibrium.

Depression • In an economic depression, this equilibrating force is not working. There is no tendency for the economy to move back to equilibrium, so we are “stuck” at point A. • So a depression requires that this equilibrating mechanism has been blocked. That’s the only way a depression can persist. • The key point then is to concentrate on the factor blocking the equilibrating mechanism in these models.

Liquidity trap • The equilibrating mechanism we saw was the falling prices pushed down the interest rate. • Currency earns a nominal interest rate of zero, so bonds can not offer a lower rate than zero. So there is a minimum rate to which nominal interest can be pushed. • Equilibrium in the money market was given by: Supply = (M/P)s = Demand = YL(i) • We used this relationship to map out our LM curve for (Y and i).

Liquidity trap • As Y drops, we see the money demand curve shifting left. • However if Y falls below Y’’, the equilibrium interest rate drops to zero, and bonds and money become equivalent. • LM is flat at i=0.

Liquidity trap • Our short-run equilibrium is at point A, where Y < Yn. • Falling prices and wages push the LM curve down, but after we reach point B, interest rates are zero. Further falls in the LM curve (to LM’’) do not shift the equilibrium from B. • Our equilibrating mechanism fails.

Deflation • Deflation is the opposite of inflation. Under deflation, average prices in an economy fall. • In a deflation, real interest rates will be higher than nominal interest rates, as inflation is negative. • So even if the nominal interest rate has been driven down to zero, the interest rate facing investors is still positive under deflation.

The Great Depression (1929-1939) • The Great Depression which lasted about 10 years was a combination of the above two effects. • The stock market crash was not the cause of the Great Depression. Far more important were the bank crises that followed. • Many firms failed and went into bankruptcy which meant that banks’ incomes went down. • At the same time, there was a run on cash at banks with many people withdrawing their cash- to hide it under their beds etc.

The Great Depression • An enormous number of banks simply failed. They could not honour the cash withdrawals people were requesting. At this point, there was no government-regulated banking insurance system. • As the banks failed and as people stuffed cash under their mattresses, the money multiplier in the economy fell (money velocity dropped). • So the nominal money supply shrank, which led to deflation.

The Great Depression • The RBA in Australia responded to the banking crisis in precisely the wrong manner. The RBA talked of “belt-tightening” and cut the money supply. • This raised nominal interest rates and reduced output further, but it also meant that combined with deflation, real interest rates were very high. • With high real interest rates, investments ceased, and demand fell still further. • The economy did not start to recover until starting in 1933 when money supply was increased.

The Great Depression- that wasn’t • In October 19, 1987, on “Black Monday”, the US Dow Jones experienced its worst-ever day, losing 22% of value in one day. This was almost twice the percentage drop on October 28, 1929. • However, no Great Depression followed Black Monday. Why? • Banking insurance (most governments now have systems under which depositors at banks have their deposits insured), so no bank runs • US Federal Reserve increased M in response to the drop in the DJIA, so no deflation

How to get out of a depression? • Monetary policy becomes ineffective if we are stuck in a liquidity trap. • Note that the Great Depression was probably NOT a liquidity trap, but rather was a result of completely misjudged monetary policy- tightening money when it should have been loosened. • Note also that monetary policy is still used to control deflation, so the correct response is to loosen money even if nominal interest rates are zero. • Government spending can still be effective, even if in a liquidity trap.

The Japanese slump • The Japanese economy has been in an extended depression since the early 1990s. • Nominal interest rates have been driven to zero. Deflation has occurred, so real interest rates are positive. • Government spending should be used now, right?

The Japanese slump • But Japan has dramatically increased government spending, yet has not come out of its depression. • Problems/solutions: • Deflation, so need to pump money supply even though interest rates are zero. • Banks, Japanese banks still have billions in bad loans

Hyperinflation • The root cause of high inflation is always a government budget deficit. Government spending exceeds government tax revenues. • The sources of government funds are: • Taxes (politically unpopular) • Debt (after a while, people will not buy any more of the government debt) • Printing money (called “seignorage”) • So facing a choice of cutting spending or raising taxes (both politically painful) or printing money, some government have chosen to print money.

Printing money • When the government prints money, it adds ΔM to the money supply. The RBA turns the new money over to the government, which uses the money to pay for spending. • This is different from simply replacing existing worn-out money. The government is adding to the money supply. • Resources gained by the government are ΔM/P. But raising the money supply will lead to a rise in the price level, so ΔM has to be higher next time to get the same real resources.

Printing money • Printing money is a cheap way of financing a deficit as money costs only cents to print. Budget deficit = BD = ΔM/P • Or if we think as a proportion of GDP: BD/Y = ΔM/(PY) BD/Y = (ΔM/M) (M/PY) • Where M/PY is the ratio is money supply to yearly output, let’s say this is 0.25. (ΔM/M) = 4 (BD/Y) • So the money supply must increase at a percentage rate 4 times the budget deficit as a percent of output.

Printing money • From the Quantity Theory of Money: vM = PY • If v and Y are assumed fixed in the short-run, then: Inflation = π = (ΔP/P) = (ΔM/M) • So the rate of inflation must be 4 times the budget deficit rate. • Seignorage is a tax on holding money. It is also called the “inflation tax”, since Seignorage = (ΔM/M) (M/P) = π (M/P)

Seignorage • In some cases, printing money can be a sensible way of raising taxes, ie. if the government is so inefficient that income or sales tax will not work. • But high levels of seignorage typically are unsustainable. What happens? • The required level of inflation for a budget deficit BD is: π = (BD/Y) / (M/PY) • But as π rises, i rises, so people restrict their holding on real balances, so M/PY falls.

Hyperinflation • As M/PY falls, so π must rise further. • How do people economize on M/PY? • Reduce the cash they carry around. • Hold other currencies, such as US$. • Resort to barter instead of using cash for transactions. • So π rises, which causes M/PY to drop further, and the economy enters a spiral of higher and higher inflation- hyperinflation. • Money is driven to worthlessness, and the government passes silly laws banning holding foreign currency etc.

Costs of hyperinflation • Typically economists assume away prices in models and look only at “real values”. • If prices do not matter, and hyperinflation is simply rapidly rising prices, why should we worry about hyperinflation? • Costs of hyperinflation: • Minimizing cash balances has costs • Impoverishes people on fixed incomes • Requires constant rewriting of prices in contracts and on menus etc • Using foreign currency is giving away the inflation tax to other governments

Curing hyperinflation • The root cause of the hyperinflation is the unwillingness of the government to cut spending or raise taxes to reduce its budget deficit. • The hyperinflation will only end when the government credibly commits to cutting spending or raising taxes. Typically this does not work, as the government was too weak to do this in the first place, such as occurred in Brazil. • But note that we have the problem of credibility of the stabilization.

Curing hyperinflation • People write contracts in advance. If the government is not believed, all the contracts will be written assuming the hyperinflation continues. • If the government is not believed, but it does reduce inflation, all the prices in all the contracts will be “wrong”. We will have a severe recession, as all the contracts are “too expensive”. • If the government is believed, and does reduce inflation, then all the prices are right, and we will have no inflation.

Curing hyperinflation • But it was the weakness of the government that caused the problem in the first place. What makes this government believable now? This was the principle problem faced by the Brazilian government. • One option has been to adopt a new currency, such as abandoning your own currency and using the US$. • Another option has been to “fix” the value of your currency to another currency, such as the US$. But how do you make this promise credible?

Macroeconomic problems