e) Permanent changes in monetary and fiscal policies (assume now long run price flexibility)

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1 Topic I.4 concluded: Goods and Assets Markets in the Short Run a) Aggregate demand and equilibrium b) Money and asset markets equilibrium c) Short run equilibrium of Y and E d) Temporary monetary and fiscal policies e) Permanent monetary and fiscal policies f) Macroeconomic policies and current account dynamics e) Permanent changes in monetary and fiscal policies (assume now long run price flexibility) We begin with Y = Y F and in the long run prices adjust and Y = Y F. Monetary policy. Suppose M S permanently: AA shifts to the right but E e and E overshoots because of interest parity and short run price rigidity 1

2 2 That is R = R US + (E e E )/E E DD E 2 E 1 Y F AA Y So in the short run AA shifts to the right, but in the long run P increases so AA shifts back to the left and DD also shifts left and we end up at E = E 3 > E 1 < E 2 ( E = M S = P) Remark: a permanent shift in M S change long run E and have a stronger short term effect on E and Y than a temporary shift.

3 3 Note: here a permanent increase in M D will cause a temporary decline in Y and could potentially be offset by an increase in M S. Still, the best action could be to do nothing since it is very difficult in practice to diagnose the origin/persistence of any shock. Fiscal policy: suppose G permanently: What happens to DD and AA? We assume that long run equilibrium q and E as in the case of higher global demand for domestic output E DD E 1 Y F AA Y

4 4 Thus DD shifts to the right but the higher AD equilibrium E now pushes AA to the left and there is little room for a higher Y Money market equilibrium: M s /P = L(R, Y F ) If we assume that P and R are unchanged, then since M s = 0 then Y cannot be > Y F because M D would be higher R would be higher and (E e E)/E > 0. So fiscal policy is ineffective with a permanent fiscal expansion, here E adjusts to keep Y = Y F f) Macroeconomic policies and current account dynamics Recall: Assume: CA = f (EP *, Y-T) P CA = X (desired rate of accumulation of foreign assets

5 5 We can plot combinations of E and Y such that CA = X (higher Y will need higher E) E Y Remark: XX is flatter than DD because as we move along DD, CA (i.e. as Y domestic demand (absorption) by less and the remainder is the CA improvement) We saw two examples: Expansionary monetary policy: in the short run E, q, CA. In long run we go back to Y F

6 6 Expansionary fiscal policy: E, q, CA both in the short and the long run Note: so far we assumed that a real depreciation CA = Q X ((EP * /P) x Q M ) (see appendix III to textbook chapter on Marshall-Lerner condition). Since as q we expect Q X and Q M. In many cases, however, it is observed that CA initially worsens as Q X and Q M could be fixed (import and export contracts made in advance) or increase (speculation) after q CA T 1 T 2 Time

7 This is called the J-curve; the initial CA deterioration could last 6-12 months. Note that this effect will also delay any potential increase in Y. Note: the J-curve effect coupled with incomplete pass-through means that CA will adjust slowly and that the effects of monetary and fiscal policies will be much smaller than implied by the DD-AA model. 7

8 Summary: macro policies under flexible exchange rates, short-term price rigidity, and perfect asset substitutability Monetary policy: (i) Transitory change in money supply Effect on E, q P R Y CA Short run Long run (ii) Permanent change in money supply Effect on E, q P R Y CA Short run Long run

9 9 Expansionary fiscal policy (i) Transitory Effect on E, q P R Y CA Short run Long run (ii) Permanent?? Effect on E, q P R Y CA Short run Long run 0 0 0

10 10 Remarks: Undesirable effects of monetary policy. Monetary policy changes E but since the economy may return to Y F on its own the real depreciation may create excess demand for goods and inflation pressures. Also, if monetary policy tends to be expansionary, even if Y < Y F, people may start anticipating inflation and adjust P and W upwards. Fiscal policies may not work either. Fiscal expansion normally causes the currency to appreciate which dampens the policy effect on Y. In addition, fiscal expansion could (i) increase interest rates (see Mundell-Flemming IS- LM model in Appendix I of textbook chapter, which includes interest rate effects on I and AD) and (ii) result in higher savings and lower consumption if Ricardian equivalence holds.

11 Better focus on inflation. Lags and difficulties in assessing economic conditions suggest that in most cases it is better for a central bank to focus on controlling inflation rather than manipulating output. 11