Macro Final

The importance of a stable exchange rate: Finance and Industry agree on

While industrialists look forward to a in the exchange rate, and need one in order to compete and survive, this last reason gives financiers an added incentive to fight tooth and nail against such a depreciation even when the economic tide has turned against them. But industrialists often have to plan years ahead for supplies of raw materials, or for imported goods, even light manufacturing like shoes, things aren’t just supplied when you want, it takes time. Therefore they make 2-3 year contracts to guarantee delivery dates, prices, and protect themselves against exchange-rate fluctuations. However, if the exchange rate does , they may find themselves competing with companies that are in a much more profitable situation, simply because the US e has risen. So, industry likes the exchange rate to be and low.

If the e is or stable, perceived as not very likely to fall, this will attract foreign financial investment to a “safe haven.” This is a kind of liquidity preference, where there is less risk or uncertainty with $-denominated assets than, for instance, peso-denominated assets for Mexicans in the early 1990s or early 1980s. So again, financial interests love to keep stable currencies, even if they are high, because this ensures even greater demand for their financial products.

The financial sector does like an appreciating or rising currency, but does not like volatility and . So they do favor Fed to keep the currency stable, or to make it rise.

Therefore Fed plays a role in keeping the exchange rate , even under the “floating” exchange rates since 1970 (i.e., exchange rate subject to market forces). We get “dirty” floats, or managed flexibility in foreign currency markets.

Fed currency swaps during financial crisis

The Fed made 6-month deals with trading partners, primarily (80%) with Eurozone.
To lend the $ at a fixed agreed-upon exchange rate, and have it be paid back at a fixed agreed-upon exchange rate

This was 1/3 of the total spending by the Fed between 2008-2010

is very important in the macroeconomy – reducing uncertainty
The currency swaps succeeded in avoiding speculative runs against, for instance, the Euro. The Fed wasn’t shoring up the euro, it was helping assure predictability in its exchange rate. Everyone benefited, except the speculators.

Fed stabilization of currency markets

Fed targets e* based on historic exchange rates chosen by the Treasury, and on the state of the economy and other macro policy goals. So even “floating” exchange rates are characterized by “dirty floats”, governments intervene to help assure exchange-rate stability.

It is in business’s and financial-sector interest to have e-stability, as long as e is viable.
Importers and exporters like to know e is pretty set for several years, since they have to plan 18 mos-2years ahead to get products delivered to stores (sent by slow boat)

Fed Policy: The Fed can only enter the market, can cause the D$ or S$ to shift out. (it can’t tell people to the market, go away).

Suppose the Treasury/Fed target is below the market exchange rate.
So if the exchange rate is temporarily overvalued, above the e^ targeted by the Fed, the Fed will shift the S$. Fed will use $’s to foreign currencies, “sell the $”, really buy
government issues (short-term debts) denominated in foreign currencies, e.g., British consoles

Suppose the Fed target is above the market exchange rate.
So, if the e is temporarily undervalued, below the e^ targeted by the Fed, Fed has to raise q$ (only thing it can do) and raise e, therefore the Fed will Shift D$. By using its foreign currency holdings to buy dollars (sell foreign government bonds, convert yen to $, buy US T-bills or just hold the $’s)

Is this a viable proposition? If it’s short-term stabilization, yes.
Notice what the Fed’s doing, it’s buying the $ when it’s , and it sells the $ when the $ is expensive (the e is too high). Therefore the Fed makes money on this stabilization activity.

What if the exchange rate is always too low? Can the Fed keep using foreign currencies to “prop up” the dollar (to buy more dollars and keep e high)?
No. It will run out of foreign currency.

This is when we hear about pressure on the currency to depreciate, or in a fixed exchange-rate system, to devalue, to come down. Pressure on the Fed to “let the dollar fall”, let the exchange rate drop to what the market says it should be.

1993 Mexican currency crisis
Before talking to the US Treasury, the Fed spent $9 B to prop up the Mexican peso
Clinton Treasury Dept and Congress said ok to $20 B for “stabilization”
Since the US government had sufficiently deep pockets, they could finance the Central Bank’s (Fed’s) continued efforts to prop up the Mexican .

2008 Financial Crisis

Fed created Central Bank Swap Lines (CBLS), permitting primarily Europe to borrow dollars at a fixed exchange-rate to use to buy their own currencies and support their exchange rate. This helped eliminate speculation that those currencies would fall, and speculative pressure on those countries.

The Hong Kong dollar had fallen 40% in 1997 after the government tried to shore up its currency, and ran out of foreign-currency holdings. Arguably the 40% overshot the mark because of all the speculation. The Fed’s CBLS prevented the same from happening to Europe.

Neoclassical Synthesis of Keynes and Classics:

Neoclassical Keynesian range of AS: [No more Strategic Competition]
Keynes said supply was , we have said nothing about the P level so far in the Keynesian-Cross model.
So if supply is passive, how do we show that in a P-y diagram?
P must be , since we don’t know what it is.
AS must be at that given P level, since companies respond passively to customer demand. Demand ends up determining y, supply is passive.
This is called the Keynesian range of the AS diagram
Note, GDP is relatively low, there is tremendous capacity in the economy, adjusting ys by adding shifts and overtime is feasible

Classical Range of AS:

SIDEBAR:
1) Equation of Exchange: Ms v P y velocity a residual

2) Transactions demand for money:
MDT = 1/v P y velocity assumed to be a constant, gives a theory of Md, causation
runs from right to left, changes in v or P or y will change Mdt

3) Classical Quantity Theory of Money
_ _
Ms v = P ys
>
Where v is assumed to be constant and given, and ys is assumed to be determined on the real side of the economy, ys is (PC, economy is on its PPF). Ricardo (circa 1817) did this first (he was classical, labor theory of value not perfect competition).

Here Money is a veil thrown over real relations, any change in the Ms has no real-world effect since Ys is of the amount of (credit-) money. Demand plays no role in determining output, supply is .

Note that in the Classical Quantity Theory, ys is a .

Implication is that any change in Ms will only change P level, it will only cause .

4) Modern Quantity Theory of Money (Monetarists)

Ms v = P YD

Given constant v, given P level, any change in Ms can change Ys.

However, ONLY a change in Ms can permit a change in Y (demanded). Money is powerful, and it is all-powerful. They conclude that the Fed’s hands should be tied, it should have no discretion and should have to follow a money-growth rule such as that the money supply is allowed to grow 3%/year to allow for real growth plus mild inflation.

END SIDEBAR

From the sidebar, in the Classical approach ys is a constant. That is, potential GDP is actual GDP, markets clear, there is no market failure, and we are at output.

Why is AS upward sloping in the Neoclassical Synthesis Range?: Diminishing Returns

Diminishing returns: higher Ys requires higher costs as companies the factory, so price level rises

if the economy is below full employment, why isn’t there excess capacity, why need to the factory? [SC – constant costs]

if price level is going up, wouldn’t their input costs also be rising, so wouldn’t they just supply their original quantities they chose given real input costs?

Then you’re on the Classical AS schedule. Or, if your prices are rising and your input prices are also rising, then you would only increase output if prices are accelerating upward, there is accelerating inflation. This is not a new (P, Y) point on an upward-sloping AS schedule. It’s the vertical AS Classicals draw.

- This story does not work as a theory of upward-sloping AS, it’s consistent with AS. Real GDP is determined by the intersection of DL = MPL and SL determined by the Labor-Leisure trade-off.

Why is AS upward sloping in the Neoclassical Synthesis Range?: Bottlenecks

Bottlenecks: As the economy expands and Ys rises, some sectors hit employment (or shortages of crucial scarce resources) before others, so their costs rise and P

OK, but not an alternative theory of Ys. This is more a real-world description than a theory of supply, it’s a description of short-term price changes.

Keynes knew any bottlenecks would be , and as supplies were able to increase, he said, P would fall back to where it was before. This rise in relative P indicates need to reallocate resources to the sectors facing shortages and bottlenecks, once that happens P should drop back down

Besides, the cause of higher Y is not the , it’s vice versa: the rising demand causes output and also causes some price increase, not because of costs but because of inelastic demand (price-gouging, charging more for limited stuff

This does not explain Y supplied, it explains .
What about sectors left behind in the expansion, e.g., excess supply of steelworkers. Wouldn’t they have lower wages and bring prices down?

Why is AS upward sloping in the Neoclassical Synthesis Range?: Input Contracts

Input Contracts:
a) Input prices are by contract while output prices are flexible.
b) And in order for companies to expand Ys, they require a higher profit margin (profits/$ sales).
c) So output prices rise, giving them the higher profit margin, as Ys .

Suggests there are only materials and final products, what about intermediate goods (capital goods): one company’s output price is another company’s input price.

Plus, why suddenly do companies need rising profit margins to expand? Under profit maximization, any positive profit is inducement to expand (so MC = MB in equilibrium). Now suddenly the same profits for the next unit of output is no good, you have to earn continually increasing profits as you expand or you’ll refuse to supply output (MB-MC keeps increasing). This is an extortion or accelerating-greed theory of profits.)

Why is AS upward sloping in the Neoclassical Synthesis Range?

Monetarist: Money Illusion, Really Money(-of-account) Illusion
ASSUME: 1)Almost PC, 2) As the economy changes, on average prices change faster than . (almost PC: some institutional rigidities prevent W’s from changing as fast as prices can).
(PC Labor market assumptions about DL and SL, real W/P on axis.)
3) In an expansion: ASSUME: rising demand causes rising prices and therefore some rise in to a lesser extent
4) Monetarists envision labor market as initially at employment before the expansion.
5) Imperfect information for workers: they’re fooled by , focus on nominal variables and interpret them as if they were real changes. Companies however have perfect information.

STORY: So in an economic expansion, prices rise:
Firms: See real wage fall so willing to earn lower MPL(=W/P) so hire more workers and their factories
Workers: [Fooled by wage .] See rising nominal W and think it will mean more purchasing power (higher real wage) and increase Ls and give up leisure. Don’t immediately notice that prices have also risen, and even faster than the wage. Workers choose to increase their hours at work
Combined: higher LD, LS, Ys increases

Notice: If we were talking about an economic contraction for Monetarists, and prices fell more than wages, workers would quit their jobs because they’d see wages being cut and they’d choose leisure. The recession is voluntary choices to leave work. This is not a theory of involuntary unemployment.

Notice, we have to assume the rising prices, which is what we’re trying to prove. What happened to initial SC argument that dropping inventories leads to increased Ys without a price effect? Typically taught at beginning of intro macro, then switched for this assumption, without motivation. This is assuming what we’re trying to prove.

Why asymmetry? Are workers stupid and companies smart? “Fooling” hypothesis.
Response – companies have better ways of estimating inflation, so they have (again, almost PC, not quite perfect information).
? How long will it take workers to catch on?
Response – at low inflation rates, the real-income effects are so it could take a while.
? But these are obsessive workers who calculate how many labor-hours vs. leisure are worth it given small changes in the wage rate. Suddenly they don’t obsess? Inconsistent.

The BLS reports on inflation every month, wouldn’t they notice? Wouldn’t it take at most a few months to figure this out? Yet this is a story designed to explain business-cycle expansions which last 1½ –10 years. Doesn’t make sense unless there is accelerating inflation and workers are continually fooled. Wouldn’t workers notice even this pattern and demand accelerating wage increases?
Analysis rests on irrational workers or uninformed workers. Especially since as consumers they continue to be rational, yet it’s the same people.

Why is AS upward sloping in the Neoclassical Synthesis Range?: Rational Expectations

Rational Expectations [New Classical]:
Workers are not fooled by any more than companies are
Then AS is not upward sloping in the short run, it is . The short run picture is the old Classical long run.

This is a return to the Classical macro model Keynes criticized.

Why is AS upward sloping in the Neoclassical Synthesis Range?: Neoclassical Keynesians

Neoclassical Keynesian: Labor Contracts

ASSUME: 1) Almost PC
2) Wages are by contract (unions, administered wages in large companies). Think of this in terms of workers returning from layoff, where the fixed W had forced companies to lay people off during the last downturn when lower demand caused the price level to fall.
3) In an expansion: rising demand causes rising prices (what happened to unplanned changes in inventories causing output to adjust in response?)

So we start out with a PC labor market where the real W is above the equilibrium level and the economy is already in recession. As the economy expands, price rises, W fixed.

STORY: 4) Starting from recession, as AD rises, P rises.
Firms: see declining real wage and hire more , move along MPL
Workers: return from layoff, get their jobs back. Had had excess supply of labor at initial high real wage. With declining real wage some workers choose more (and quit their jobs), others return from layoff.

Note that implicitly you do get involuntary unemployment at the initial too-high real wage. Also, we approach what would be equilibrium employment as the economy expands. This makes this story an improvement over the Monetarist.

What causes the unemployment is institutional factors that prevent the nominal wage from being cut by , e.g., administered wages (like salary contracts set W for a full year or two until it gets adjusted.)

Like what, unions? Unions were 1/3 of LF in 1950s, only maybe 8% today. Yet recessions in last 40 years are worse than previous 40 years. The K’n story suggests that if only there were fewer institutional rigidities and more W cuts, there would be no . Inconsistent with recent history.

Like what, the minimum wage? In recent years the national minimum wage has slipped dramatically. Are workers really because their MPL < $8.45/hr?

Also, we’ve had recessions since the early 1800s, but widespread only since the 1950s.

Does anyone believe that W cuts would cure recessions? Wouldn’t there be spending consequences by workers? Also, Keynes had argued that employers would delay hiring to get the benefit of lower wages. He also argued that any (price and wage cuts) would make debt harder to repay (so corporate bonds would be worthless), causing defaults and bank and business failures and making the recession worse.

What about postwar recessions where the P level never fell during recessions. [before 2008] This story would require fixed nominal wage growth where price-level growth was at a lower rate so the real wage rose.

Does the real wage rise in recessions? The evidence is it does not. In fact, logically, since last hired first fired translates to low-W workers being laid off first, the average real W should rise in recessions even if every employed worker’s real W is unchanged. The fact is that the average W appears not to change, suggesting that employed workers’ real wages in recessions, the opposite of what this theory predicts.

Is this really a theory of involuntary U? Workers voluntarily choose institutions like unions and the minimum wage which prevent the nominal wage from falling. Does anyone really think that recessions will be cured by the minimum wage being reduced? It still sounds like socially chosen voluntary choices give us this unemployment, even if it is involuntary for the individual.

This implies a wage cut will bring us back to full employment. That conclusion rests on the fact that we assume diminishing returns, and that wage cuts do not hurt AE or AD. If there are in fact constant returns, and wages are cut, all that happens is wages are cut, employment will not .

Why is AS upward sloping in the Neoclassical Synthesis Range?: Long Run

Need to link change in P level with change in output supplied (ys )

M’t: workers no longer fooled by , insist on higher real wage if going to work more hours. Companies can’t afford to pay higher real wage. Equilibrium returns to original position

K’n: labor contracts are renegotiated to increase N to level. Return to equilibrium real wage and L-services hired.

So in the long run we’re back in the Classical world. How is this a synthesis of Keynes and the Classics? Where is the possibility of long-run depression, like the 1930s, on the supply side? Absent.

NOTE: where there is a shift in AS, y changes more in the lr, P changes more in lr

Short run vs. Long run AS

What we’ve been discussing is AS representing business-cycle movements (expansion, recession). This is called the short run

Micro - Short Run means K stock is , L varies (1-10 years)
Long Run means K can , plant size can change, and there may be decreasing returns to scale due to coordination failure (company too big to manage effectively) (longer than 1-10 years)

Macro - Short Run means over the course of a business cycle (2-9 years)
Or really, over the expansion phase (1 ½ -8 years). Long run means , from one business-cycle to the next (e.g., one peak to the next peak or one trough to the next trough. (more than 2-9 years, 18-20 years): Trend

Long run, what happens to shape of AS?

M’t,: Workers are no longer fooled, they quit their jobs, we return to in PC labor market
K’n: Wage contracts are renegotiated to reflect realistic levels, we to PC labor market equilibrium
So it’s a Classical Macro world, AS is , return of PC, in particular, the PC labor market with L-Leisure trade-off and diminishing returns due to factory crowding

Why is AS upward sloping in the Short Run?

Monetarists: Workers are fooled by
Keynesian: Wages are by labor contract

Why AS is Vertical in the Long Run?

Monetarists: Workers catch on to the , require that real wages rise if they are to stay in new jobs, leave LF when employers say no. So in the cyclical expansion, workers had increased Ls beyond the “natural” rate, beyond what we have been calling full employment. The recession level of U is the natural rate of U. Workers being fooled effectively pushes the economy beyond its potential.

Keynesian: Labor contracts can be . Since the cause of involuntary U was real wages being too high, employers can negotiate for nominal wage cuts, and this restores full employment. Note that the boom level of U is the long-run rate of U or “natural” rate, the recession is below potential.

Aggregate Demand:

Keynes: Keynesian-Cross/SC, Post-Keynesians - Demand is determinant of GDP [ AD]

Neoclassical Synthesis/Almost PC, IC: Neoclassical Keynesian, Monetarist, Neoclassical short run - Need both Supply and in the short run or over the business cycle to find GDP (in long run or for trend growth rate, supply is determinant)

Classical/PC: Supply-Side, Rational Expectations, Neoclassical long run - Supply is determinant of GDP [ AD, or slope irrelevant]

Keynes said determines Y, Classicals said determines Y, the Neoclassical Synthesis says you need AS and AD to determine Y, it comes out of their interaction, and is mediated by the price level.

Derive AD: Why does rise in P level cause a drop in YD?

1) *Transaction demand for money:  P,  MDT so  i (given fixed MB by Fed), lower I along I(i), lower AE, lower YDemanded.
Note that we reinterpret equilibrium Y on the AE diagram as YDemanded, not actual GDP since we have a separate theory of supply (AS).

2) International:
Assume 1) fixed e,
2) any  US price level is faster than abroad, then  PUS  gets
passed abroad. [PUS rises faster than PROW [rest of the world]]
Implications:  EX to other countries (our stuff is more expensive) and IM look more attractive (since our stuff is more expensive) so IM, so  NX, and AE, and YDemanded .

3) Real-wealth effect or real-balances effect or Pigou effect:
increase P level so
decreases real monetary balances—M/P, that is, the money households have in checking & savings accounts
decrease real wealth of households
decrease Ca, AE, YDemanded

Criticisms from Keynesian-Cross/Strategic Competition perspective

1. Transactions demand for money: higher P, higher MDT so higher i (given fixed MB by Fed), lower I along I(i), lower AE, lower YD.

Criticism: Only get downward-sloping AD because of “fixed MB by Fed”.
This is a heroic assumption, Keynesian-Cross model recognizes that the Fed accommodates mild inflation, higher price level, by expanding the MB.
If the Fed , there is no downward-sloping AD. AD is , and AD determines equilibrium GDP.

This is why the Keynesian-Cross model uses the Keynesian-Cross diagram to find equilibrium, AD-AS analysis adds nothing.

2. International: given fixed e, rise US price level = down EX abroad and IM look more attractive so up IM , so down NX, and downAE, and downYD .
[really need our P level to rise faster than the rest of the world]

Criticism: “given fixed e” since when? Bretton Woods 1944- 1970. We’ve had dirty floats since then, but not exchange-rates. If our P level rises faster than the rest of the world (ROW), our exchange rate will depreciate, reflecting the lower purchasing power of the $.

This would neutralize the P-level change, and imports would cost the same in real terms as before (a lower e requires more $’s to buy the same Yen-denominated imports).

So AD is only -sloping if the international currency market cannot work, if there are fixed exchange rates, which has not been the case for 47+ years.

3) Real-wealth effect or, better, real-money-balances effect or Pigou effect

Criticisms: Very interesting—since when does money affect Ca, didn’t money affect i and I?

Isn’t the wealth effect on Ca relatively weak compared with effect of Y, so then the question is when there’s inflation, what happens to your earnings on your money. You get higher nominal i because banks start having to pay higher nominal i due to the inflation. You may or may not be fully protected, but there is some nominal interest-rate response.

If you want to look at effect of inflation on wealth, why pick money in banks? Most household wealth is in the form of their house and car. Houses go up in nominal value, fixed nominal mortgages, so households’ real wealth rises during inflation. Oops, then AD would be upward sloping if the logic of this models holds. Also, we know borrowers benefit from inflation, their real debt is reduced, so their real wealth increases. The only sector demonstrably hurt is the financial sector, not the macroeconomy as a whole.
Problematic, the model ignores it, just keep going.

For the wealthy, financiers, what about bonds? Hurt by . What about stocks? Companies’ prices are of course rising with inflation, that’s what inflation is, rising prices. And industry is a net borrower, so benefits from inflation.

Conclusion: Inflation is a mixed-bag in terms of its effect on wealth: corporations are charging the prices, so their nominal stock values rise, real stock values is an open question.

Shifts in AD

Anything that causes AE to shift up causes AD to shift
[shift in AD is new equilibrium in AE]

Only exception: a change in P level is already on the graph, so changes in P, while causing a shift in AE, will not shift AD, they will move us along AD

What causes shifts in AS?
shifts

Helpful Hint – If shift SM
Also note, shifts in the supply of money can be handled intuitively by thinking about the consequent changes in Ms and therefore AE (same direction), because higher Ms means lower i.

Empirical Phillips Study:

A. W. Phillips 1958, empirical study of US 20th century, plotted W growth against U and found that nominal wages tended to more steeply as U fell. But the relationship was like a hyperbola. And he asked, what is the macroeconomic theory behind this?

The Neoclassical Synthesis developed an answer:

Wage growth tends to echo growth, since both workers and companies are concerned with real wages (W/P) over the long haul.

So they derived a -sloping Analytical Phillips Curve from shifting AD and moping along AS, which then moves the economy along the Phillips Curve.

The short run or business-cycle AS shape explains the downward-sloping and curved shape of the Phillips relationship—it is a business-cycle description

So as AD shifts out and we move to the right and up along AS
The Phillips Curve mirrors AS and we move back and up along the Phillips Curve

The Phillips Curve is just another way of drawing , to put U on the horizontal axis instead of Y

Colander finesses the problem by saying that in the expansion, there are constant outwards shifts in AD. So there is demand-pull inflation. He knows that the Neoclassical Synthesis jump from AS to Ph Curve is analytically flawed, so he makes the case that way.

Is this involuntary U on the analytical Phillips Curve?

Monetarist – it is voluntary leaving of the labor force as P and W falls, and workers quit to choose at the lower nominal W

Keynesian – it is for the individual, caused by the fixed nominal W set by union contract.

However, the union itself was chosen by these individuals, fought for against opposition, the union wage increase was demanded by these workers. Are they stupid collectively? Wouldn’t they notice that this caused recessions and rethink? Historically recessions were before widespread unionization, and have been worse since unions have been increasingly decertified.

The Phillips Curve, like the AS schedule, implies that there will be no involuntary unemployment above the natural rate of U if only wages can be flexible downward. Because for Keynesians this would mean that the labor contract is renegotiated, and AS is vertical, so Phillips would be vertical.

Long Run

AS is , Phillips is mirror of AS, so Phillips Schedule is .
We are back in a Classical world, there is no , the only possible U is structural+frictional = natural, the natural rate of U

[Some economists speak of the NAIRU (non-accelerating-inflation rate of unemployment).]

Notice, in the long run, what is the Keynesian explanation for the vertical Phillips Schedule? Wages are . If there’s a recession, and AD falls, this will mean lowers prices and over time wages will be cut through renegotiations and we will return to full employment.

Colander on cost-push vs. demand-pull inflation (Neoclassical vein, letting AS shift (cost-push) or AD shift (demand-pull)

Cost-push inflation (ongoing prevalence of inward shifts in AS)

Cost-push inflation involves any upward pressure on caused by a change in supply-side conditions, or by initiatives from the supply side

Examples of cost-push inflation
Anything that causes PPF or AS to shift

Notice that when there is a in the real aggregate income being negotiated over (a decline in the size of the pie), if everyone tries to defend their habitual real income levels (W, profits) by passing on the higher cost, we will just have an ongoing wage-price spiral, perhaps even accelerating inflation as recent inflation rates get built into the process, and everyone demands more than last year’s inflation rate just to cover their real income.

At issue is a conflict over the distribution of income.

Notice, then the real issue with accelerating inflation is the underlying in real national income and everyone trying to recoup lost income. The only way to stop the inflation without hurting GDP is to address the income redistribution issues directly through an INCOMES POLICY (more below) or through targeted programs to help those hardest hit by the lost income.

Modern efforts to fight deterioration in PPF or AS is Governmental investment in infrastructure

Demand-pull inflation (caused by chronic outward shifts in AD)
Anything that causes AD to shift causes higher prices

Standard efforts to counteract such inflation is to AD (e.g., tight M policy or higher T or lower G) would end up reducing the inflation rate.

These are called austerity policies when invoked by the IMF in developing countries facing exchange-rate problems.