ECON2004 Term 2 Problem Set 3 PDF

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Detailed work for Problem Set 3 for ECON2004 Term 2, taught by Wendy Carlin...

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ECON2004 Problem Set 3 Merle Radow Problem Set 3. The 3-equation model – supply shocks; overshooting 3.1 Modelling a supply-side reform in the open economy. [Essay / explore] Simulator problem - work in pairs; submit separately. a) Decide on a supply side reform – try to find an example of a supply-side reform that is being implemented in a country that has a flexible exchange rate. Look at the bottom of the appendix to the IMF Annual Report for a listing of exchange rate arrangements in every country (choose a country with a ‘Free floating’ arrangement): http://www.imf.org/external/pubs/ft/ar/2012/eng/pdf/a2.pdf „Strangely, these people also tend to say ‘we should be more like Germany.’ They admire Germany’s more robust employment performance since 2008. But what they seem to conveniently forget is that Germany undertook significant supply-side reforms through the 2000s to both make themselves more competitive and their economy more flexible. [...] Germany’s large industrial unions in the export sectors decided to protect existing jobs through wage restraint – a supply-side strategy that allowed employers to capture most of the productivity gains in the hope of stabilizing employment by improving the profitability of domestic production and the competitiveness of German industries in international markets. Between 2000 and 2005, the Government managed to reduce taxes on company profits and capital incomes, to lower the level of employment protection, primarily by deregulating temporary and part-time employment, and to drastically cut benefits to the long-term unemployed in order to reduce the reservation wage of job seekers. In fact, the downturn after 2001 paved the way for a paradigm shift in labour market and social policies as well as new deregulatory reforms. The Hartz reform packages together with the controversial ‘Agenda 2010’ meant a transition from human capital oriented labour market policies to a stronger emphasis on, for example, reinforcing jobseekers willingness to take up even low paid jobs. This meant stricter job search monitoring, harsher provisions in unemployment benefits and a shift from long-term training and direct job creation measures to shorter programs aiming at an accelerated reintegration into the labour market. Unemployment insurance benefit duration for older workers was shortened from 32 to 18 months, which effectively removed a de facto early retirement tool. Even more important was the merger of earnings-related, but means-tested unemployment assistance and social assistance into ‘Arbeitslosengeld II’, a general minimum income support scheme with strong activation requirements as part of the ‘Hartz IV’ reforms.“ Source: https://www.cps.org.uk/blog/q/date/2012/05/11/the-importance-of-the-supply-side/ I will model the fall in the level of unemployment benefits and their duration (implemented in Germany in various ways as mentioned above – using cuts in benefits to the long-term unemployment as well as a shortage of the duration of the payment of unemployment benefits from 32 to 18 months) as a downward shift of the WS curve which reduces equilibrium unemployment / increases equilibrium output. The fall in the level of unemployment benefits and their duraton raises the cost of job loss.

b) Using the simulator:  Start by opening the simulator and choosing the open economy (flexible exchange rates) version. Then reset all shocks by clicking the appropriate button on the left hand side of the main page. Click on ‘Go to saved data’ on the left hand side. Click reset.  Decide on a supply-side reform and describe briefly how it is modelled. (i.e. does it affect the WS or PS? What effect does this have on the ERU curve?)  Apply shock: Permanent 4% positive supply shock (Note that a positive supply shock is one that reduces equilibrium unemployment; raises equilibrium employment). The downward shift of the WS curve leads to a new intersection of WS’ and the PS curve. At this new equilibrium level, unemployment is lower/output is higher. The vertical ERU curve is defined by the intersection of the WS and PS curves and shows the combinations of the real exchange rate and output at which there is supply side equilibrium (i.e. constant inflation). The downward shift of the WS curve hence leads to a rightward shift of the vertical ERU curve, indicating the higher supply-side equilibrium (with constant inflation). c) Use the impulse response functions from the simulator or from your sketches to help explain the path of the economy following the above shock.

Explain the path of the economy following the positive supply shock Period 0 The economy is initially at point A – the CB’s bliss point with inflation at target, output at equilibrium output level, the real interest rate at the world interest rate and the real exchange rate as the constant level of exchange rate in equilibrium, q. The economy is then hit by a positive supply shock. Due to the fall and shortage of duration of unemployment benefits, the WS shifts down. Hence, there will be a new intersection of the WS’ and PS curves which gives a new level of equilbrium output – the downward shift of the WS curve leads to a higher level of equilibrium output / a lower level of equilibrium unemployment. Since the ERU curve shows combinations of the RER and output at which there is constant inflation and hence supply-slide equilibrium, it is defined at the intersection of the WS and PS curves. Due to the shift of the WS curve and hence the new supply-side equilibrium, the vertical ERU curve shifts to the right. Therefore, there will be a new intersection of the AD (r=r*) and the new ERU’ curve, an equilibrium with a depreciated real exchange rate, point Z – this is where the adjustment process of the economy to the shock will end. We can see from the WS-PS diagramme, that at point A there is now downward pressure on inflation since the new WS curve is below the PS curve (which has not changed). There is a negative bargaining power gap since output is currently below the new equilibrium output, ye’– workers will have lower bargaining power and will bargain for lower nominal wages to reflect this – they will increase their wages by less than expected inflation, by π0 = πT – x where x represents the lower bargaining power. The gap πT - π0 is a measure of the lower bargaining power of workers. Firms will follow and increase their prices by less, hence actual inflation in the economy will fall to π0. The PC will shift therefore shift down, reflecting the change in the equilibrium level of output. The economy moves to point B. The CB analyses the nature of the supply shock and predicts that it is a permanent shock. As there will now be a new bliss point at πT and ye’, the CB will shift the MR curve to ensure that the bliss point is where output is at ye’ and inflation at πT. At point B, output is still unchanged but inflation has fallen to π0. Point B is not on the CB’s new MR curve. The CB will forecast the PC in the next period, based on adaptive

expectations; actual inflation today is π0, hence expected inflation in the next period will be π0 – the PC will shift, and will go through the intersection of π0 and the new equilibrium level of output. Faced with this new PC, the CB will want to locate at point C, on their new MR curve, MR’. At point C, output is above equilibrium, so the CB needs to create a positive output gap. The forex market knows this and foresees that the CB will keep the interest rate below the world interest rate for a number of periods in order to stimulate the interest sensitive components of aggregate demand and increase output. This will lead to an immediate depreciation of home’s currency, so that it can appreciate back over the period where the interest rate is below the world interest rate. The depreciation of the exchange rate will increase net exports and hence increase output – therefore, the CB has to change (reduce) the interest rate by less than in the closed economy. It sets interest rates at r0 (lower than r*), taking into account the reaction of the forex market and the immediate depreciation of the exchange rate. The lower interest rates and appreciated exchange rate only affect economic output with a one period lag. Hence, the economy ends the first period with output at ye (old level of equilibrium output), inflation at π0, interest rates at r0 and exchange rate at q0.

Period 1 The change in interest rate and depreciation of the exchange rate have had time to affect output and have filtered through to the economy. The lower interest rate r0 has stimulated investment and the depreciated exchange rate has increased net exports, so output has risen and is now at y1, above the new level of equilibrium output, ye’. The IS curve has shifted to the right to IS(A,q0) due to the depreciation of the exchange rate which increases net exports. Through the labour market and the model of bargaining power and efficiency wages (at C there is now a positive bargaining power gap since output is above equilibrium output), workers bargain for higher nominal wages than expected inflation to reflect their additional bargaining power and negotiate for an increase in nominal wages of π1 > π0. Firms immediately set prices as markup over wages and inflation in the economy hence rises to π1 and the economy moves to point C). Point C is off the AD curve, since we know that on the AD curve r=r* but at point C interest rates are at r0 which is lower than r*. The lower interest rates r0 stimulate investment and lead to higher output, hence output at C is higher than on the AD curve. The depreciation from A to C is the initial depreciation of the real exchange rate. However, we know that the adjustment process of the economy in response to the shock will end at Z, so the equilibrium change is from A to Z. Hence, the additional depreciation (the level between the exchange rates at C and Z) is referred to as exchange rate overshooting. The adjustment process from C to Z follows the standard procedure: the CB will gradually increase interest rates from r0 back to r* and the exchange rate will appreciate to q. The economy will move from C to Z along the RX and MR curves. Due to the appreciation of the exchange rate back to the new constant exchange rate in equlilbrium, q , the IS curve will shift to the left, to IS(A,q ). Along the RX curve, the UIP condition always holds – i.e. it shows the CB the interest rate to set to achieve a given output gap, taking into account the reaction of the forex market. The adjustment from C to Z will take a number of periods. At Z, the economy will be back on the AD curve where r=r*.

Sketch of impulse response functions (simulator doesn’t work)

d) Draw the IS-RX and PC-MR diagrams for this scenario. Draw the AD-ERU diagram for this scenario. (Hint: the path of the key variables (output, inflation, real interest rate, real exchange rate) will have to match the impulse response functions from the simulator or from your sketches. Remember that whenever the CB sets the interest rate different from r* to get the economy on to the MR, the economy will be OFF the AD curve. Once the economy is back at a MRE, then r = r* and the economy is, once more, ON the AD curve.)

e) In the light of the reform you have chosen, briefly discuss one aspect of this way of modelling the adjustment of the economy to a supply-side reform that seems to you to be unrealistic. Express your concern in terms of the assumptions of the model. In our model, we assume that the CB and forex market can exactly work out where the economy will be in the next period – for example, we assume and model that CB calculates the output gap it needs to create and works out where it wants to locate in the next period, and then uses its instruments and then definitely achieves that desired level. This makes the world, the economy and policy responses look very simple. We use these simplifying assumptions to deal with the high complexity in macroeconomics and policy analysis, however, we need to be aware that this is not an exact representation of the practice in the real world. There is a high level of uncertainty underlying every part of the model. We shouldn’t assume that the CB can work out exactly where the economy is located at the moment. We also assume that the interest rate change the a new real exchange rate affect the economy with a one period lag. However, the effect might take longer than calculcated in the real world, between 1-2 years so we largely simplify our model by splitting up the economy into strict seperate time periods and say that from period 1 to 2 the change in the interest rate and real exchange rate has had its full effect. Similarly, we assume that the interest rates changes always have the desired effect – but interest rates are an instrument that can be blunt and don’t always achieve what is calculated in reality. We assume that the CB changes the nominal interest rates to change the real interest rates in the economy. We assume that the banking markup relates the policy rate the CB sets and the real interest rates that affect aggregate demand. For this to work, we need a high correlation between nominal and real interest rates which is usually reasonable assumption. However, we should be aware that the banking markup can change dramatically and that the correlation between the nominal and real interest rates might break down during crises which leads to the CB losing control of its interest rate instrument to affect aggregate demand. In addition, there is constant structural change in the economy which makes it even harder to predict the response of the real economy in the future. Furthermore, we have modelled a supply-side shock and the following adjustment of the economy to that shock, without anything else happening during the adjustment process that might disturb the adjustment. However, in the real world, the economy is hit by shocks all the time, so during there adjustment process to the supply shock there might be a new shock that hits the economy which then requires a different response by the CB. Lastly, we only model the reducation and shortage of duration of unemployment benefits as a reduction in equilibrium unemployment. We ignore socialeconomic issues such as the individuals who are unemployed now having a lower income and hence reduce demand. This might be a valid argument as people on low incomes tend to have a lower marginal propensity to save / a higher marginal propensity to consume as they generally spend all of their income on consumption. This might be a reduction in demand (even if only on a small scale compared to the overall size of the economy) which we have ignored in our modelling.

3.2 Exchange rate overshooting in the 3-equation model [Analytical] Use the 3-equation open economy model a) Explain what the following statement means: ‘After a demand shock in a small open economy, the exchange rate overshoots.’ Use an AD-ERU diagram to help explain your answer. Exchange rate overshoting refer to the phenomenon of the nominal and real exchange rate jumping by more than the equilibrium adjustment in response to a shock Take the example of a positive aggregate demand shock

Period 0           

The economy starts at point A – the CB’s bliss point. The economy is hit by a positive permanent demand shock which shifts the IS curve to the right to IS(A’, q ) Output falls to y0 and inflation falls to π0 The economy moves from point A to B Point B is not on the CB’s MR curve – the CB forecasts the PC in the next period, given adaptive expectations; actual inflation today is π1 hence expected inflation in the next period is π1, so the PC will shift down Faced with this new PC, the CB will want to locate at point C At point C, output is below equilibrium, so in order to reach this point the CB will need to increase interest rates to depress investment (or interest sensitive components of demand) and reduce output The forex market foresees that the CB will keep interest rates above the world interest rates for a number of periods in order to reduce demand and bring inflation back to target The UIP condition implies this will cause an immediate appreciation of home’s currency, so that it can depreciate for the whole period where home’s interest rates are above world interest rates The CB therefore sets the interest rate r0, taking into account the immediate appreciation of the exchange rate that will occur, to get the economy back on the MR curve in the next period The interest rate and the exchange rate can only affect output with a one period lag, hence the economy ends period 0 with output at y0, inflation at π0, interest rates at r0 and exhange rate at q0

Period 1      

The change in interest rates and exchange rate have had time to filter through to the economy and affect output The higher interest rate depresses investment and the appreciated real exchange rate reduces net exports The economy moves to point C, with output y1 below equilibrium and π1< π0 The IS curve has shifted to the left due to the appreciation of the real exchange rate – this is further to the left than the original IS curve The adjustment process from C to Z will take a number of periods – the CB will gradually reduce the interest rates from r0 to r* and the exchange rate depreciates from q0 to q So the IS curve will gradually shift to the right and the economy will move down the RX and MR curves

Look at the exchange rate movements From A to B – no change in the real exchange rate From B to C – initial appreciation of the exchange rate From C to Z – depreciates to new constant MRE real exchange rate From A to Z – equilibrium change/equilbrium appreciation After the shock, the forex market knows that the CB will have to increase home interest rates to produce a negative output gap and reduce output and inflation to bring inflation back to target Therefore, the exchange rate will immediately appreciate – however, it appreciates more than the equilbrium adjustment in response to the shock and then gradually depreciates back until the new MRE is reached at point Z with an appreciated real exchange rate (but less depreciated than the initial appreciation of the exchange rate). We can define the equilibrium change as the difference in the real exchange rate between the

initial equilibrium and the new MRE equilibrium (difference between points A and Z). Hence, the initial jump in the exchange rate equals the equilibrium change plus the exchange rate overshooting.

b) What causes exchange rate overshooting? Overshooting is integral to the 3-equation model of inflation targeting. It exists because of the combination of: 1. an internationally integrated financial market 2. rational expectations in the forex market, which leads to jumps in the exchange rate 3. sluggish adjustment of wages and prices, which requires the CB to keep interest rates above (or below) the world interest rate until inflation returns to target The idea of overshooting centers on the fact that the exchange rate is a variable that can jump easily, implied by the UIP condition. After the shock, the forex market knows that the CB will have to increase home interest rates to produce a negative output gap and reduce output and inflation to bring inflation back to target. Their rational expectations will hence lead to an immediate appreciation of the real exchange rate within seconds, hence the exchange rate will jump. By contrast, the prices of most goods and services and labour – wages – do not jump. It is because prices and wages do not adjust immediately to bring about the new equilibrium exchange rate (here an appreciated real exchange rate in MRE) to wipe out a demand shock, that overshooting occurs. Because wages and prices in the economy only adjust sluggisly, the CB has to keep interest rates above (or below) the world interest rate until inflation returns to target. If prices and wages just adjusted instantly, we could have the new MRE with an appreciated real exchange rate in the MRE after the demand shock without the need to change interest rates which lead to the jump in exchange rates.

c) What problems, if any, woul...