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Patrick Kelly
Professor Maloy
ECON 1110 SEC1040
28 April 2021
1. The Open Economy and Mundell-Fleming Model
a. Since monetary policies directly impact the money supply, the values of an
economy's interest rate and inflation rate are in turn directly influenced. With this
being said, the changes in interest rates result in changes to exchange rates, which
in turn create changes in the total net exports. A currency war is the result of a
country’s central bank using expansionary monetary policies to purposely devalue
its national currency. The intent behind these “wars'', is to achieve a comparative
advantage in international trade through stimulating their own economy through
depreciating the value of their domestic currency. To do so, a country will have to
increase supply of their currency, and when this supply is greater than demand,
the value of currency will in turn have decreased. With a weak domestic currency,
a nation will experience an increase in foreign demand in the currency war. A
depreciation of the nation’s domestic currency will reduce their imports, however,
this will in turn increase net exports, as an increase in the exchange rate implies
that the domestic currency has depreciated relative to the foreign currency. Such
depreciation will raise the value of the foreign currency and in turn the world
commodity prices will rise. This is significant because some world commodities
like oil and iron are primary exports of these foreign countries, and as the prices
rise for these commodities rise, demand will slow down and cause a slowdown in
the economies for the exporting countries. That being said, a country may retaliate
against intentional currency movements either through political intervention or
through further devaluation of their own currency, i.e., beggar-thy-neighbor
policies. This suggests that a nation who follows a policy of competitive
(intentional) devaluation is actively pursuing for economic success for their own
self-interest. Thus, a country may retaliate in a currency war by manipulating their
own currency value.
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b. Through competing the Mundell-Fleming framework with the assumptions of a
small open economy and perfect capital mobility, one can analyze the short-run
effects of a fiscal contraction under flexible exchange rates. Since this model is in
perfect capital mobility, the domestic interest rates must equal world interest rates
in equilibrium; seen on diagram as (BP). Due to the fiscal policy contraction, the
model will undergo a shift in the IS curve to the left. This can be seen on the
diagram through the shift from IS0 to IS1, which in turn leads to a decrease in
values of output and interest rate. Further, since the shift to IS1, the domestic
interest rate is lower than the international one, which would result in an outflow
of capital, BP shortage, and a depreciation of the domestic currency. This in turn
would establish a shortened supply of foreign exchange, and the exchange rate
would rise. As the exchange rate rises, domestic goods and services become less
expensive for foreigners and foreign goods become more expensive for the
domestic country in question. The decrease in imports and increase in exports will
cause the net exports to increase, which would be a rightward shift of the IS
curve, as IS1 shifts back to IS0. The shift back from IS1 to IS0 moves the values
of output and interest rate back to the equilibrium. Therefore, Fiscal policy
contraction under flexible exchange rates and perfect capital mobility in a small
open economy in the short run is ineffective in changing the output.
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c. The Bretton Woods system was a fixed exchange rate peg system that hoped to
provide exchange rate stability to boost trade and investment among foreign
countries and the US. This system implemented fixed exchange rates; thus, this
new situation requires the Mundell Fleming model from part b to change. This
change would follow a leftward shift of IS0 to IS1, which in turn leads to a
decrease in the values of interest rate and output. A new point is reached below
the BP curve, thus domestic interest rates would be higher than world interest
rates. This in turn would result in capital outflow, placing upward pressure on the
exchange rate, and resulting in a balance of payment deficit. This would mean
that there is a shortened supply of foreign currency at the fixed exchange rate.
Since the Bretton Woods system is a fixed rate system, it requires the central bank
to intervene and maintain the exchange rate at a fixed level. To stay aligned with
the Bretton Woods fixed exchange rate system, the central bank would exchange
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some of domestic currency reserves for a foreign currency. To keep the exchange
rate fixed there would be pressure applied towards depreciation of the currency,
thus the central bank would decrease the money supply. This would shift LM0 to
the left of LM1, which results in a further decrease of the output value. Therefore,
fiscal policy with a fixed exchange rate and perfect capital mobility is effective at
moving the output in the short run, as the output values decreased significantly as
seen in the diagram.
2. Traditional Keynesian Analysis
a. The memo from the San Francisco Fed. introduces two significant instances of oil
price shocks in the 1970’s. These shocks were extremely disruptive to the U.S
economy and proved to be very challenging to overcome. The oil shocks were an
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unexpected event that manipulated the supply of oil, resulting in a sudden change
in price. Supply shocks are created by any unexpected event that limits output or
disruptions to the management of the supply chain, much like that of a natural
disaster. The significance of the oil shocks can be analyzed through aggregate
supply, as changes in aggregate supply push inflation and unemployment at the
same time. Since oil consumption dramatically decreased, the oil shocks had a
negative effect, shifting aggregate supply to the left as both inflation and
unemployment continued to rise. An oil price shock, or upward spike in oil prices,
implies an increase in the cost of production for a country. As firms experienced
rising input costs they will in turn have to produce less output for any given price
level for oil. At the original price level, aggregate demand is greater than
aggregate supply. As price levels rise, then consumers experience a reduction in
their real wealth resulting in a general decrease of consumption. This adds to the
reduction in the aggregate quantity demanded as the price level rises, a movement
along the aggregate demand curve to the new equilibrium point with a higher
price level and a smaller aggregate output. The first oil shock of 1973 was
associated with the utilization of price controls to attack against the severe
inflation of the time, along with the oil embargo at the end of 1973. The imposed
price controls were able to combat the inflation, but as a result, the controls
allowed economic policy to become highly expansionary by hiding the effect of
policy on prices (Oil Shock). Also, within the Oil Shocks essay, there is a mention
of the fiscal/monetary policies made in the intent of lessening the damages of the
oil shock”, used by the Fed in the first oil shock where they tried to keep output
constant in the face of an adverse supply shock. However, the Fed didn’t
comprehend the extent at which inflation had increased, and soon after abandoned
this policy for the implementation of a contractionary policy to disperse the rising
inflation (Oil Shock). In the abandonment of an accommodative policy, the Fed’s
attempts to fix the problems stemming from the oil shock by stimulating
aggregate demand through monetary or fiscal policy will raise output to a degree,
but in a more likely scenario these policies would lock the economy of
accelerating inflation.
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b. In implementing a contractionary monetary policy to reduce inflation, the Fed
would be aiming to decrease the money supply within an economy by increasing
interest rates and decreasing bond prices. Since the Philips curve diagram used in
part (i) is experiencing high inflation, a contractionary policy would completely
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restructure the Philips curve in place. The Phillips curve depicts a negative
relationship between inflation and unemployment. Thus, from principle, if the Fed
was to decrease inflation, the result would be a growth in unemployment. It’s
imperative to recall the short-run tradeoff between unemployment and inflation,
as lower unemployment leads to higher inflation and higher unemployment leads
to lower inflation. Within the short run, this policy affects both unemployment
and inflation through manipulating the money supply. There is a short-run trade-
off between unemployment and inflation, as lower unemployment leads to higher
inflation and higher unemployment leads to lower inflation. Moreover,
expectations about inflation rates are significant, as the expectations about future
inflation directly affect the present inflation rate. Since this economy is engaging
in a contractionary monetary policy to reduce inflation, the money supply will be
directly manipulated by the Fed. Changes in the expected rate of inflation affect
the short-run trade-off between unemployment and inflation, and ultimately shift
the SRPC. When the expected inflation rate increases, the actual inflation rate at
any given unemployment rate will increase by the same amount. Moreover, in the
diagram analysis of the SR/LR Phillips curve the role of expectations was heavily
emphasized in the shifts of the SRPC. Policies designed to reduce inflation will
move the economy from point B to point A, a transition when inflation is
temporarily lowered at the expense of higher rates of unemployment. Despite this,
eventually the economy will transition back to the natural rate of unemployment,
point C, which produces a net effect of only increasing the unemployment rate.
The unemployment rate cannot fall below the natural rate without increasing
inflation in the long run for an economy. If consumers are considered rational
like in expectations theory, the transition point at B doesn’t exist because workers
are anticipating decreased inflation and will adjust their demanded wages to
account for this transition.
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3. The Austrian Model
a. The Austrian time preferences theory suggests that “time preferences” determine
the ratio of current consumption to savings and investment for the future. These
preferences give rise to the pure interest rate, which is the rate at which people are
willing to forego current consumption to save for the future. Thus, Austrian time
preference theory details interest rates in terms of the person’s preference to spend
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in the present rather than the future. Further, this contends that interest rates will
always be positive as people prefer to spend today and save for later. Since this is
a low-saving nation who prefers consumption today over consumption tomorrow,
they would experience a higher interest rate. This is true due the fact market
interest rates are a function of these time preferences, thus there would be higher
interest rates as the preference of consumption today is greater than consumption
tomorrow. However, this resulting interest rate can be influenced by fractional
reserve lending, where only a fraction of bank deposits is backed by actual funds
on hand, with the purpose to expand the economy by freeing up capital to use for
lending. Austrian economics argues that in a pure free market, there is no general
business cycle, rather the business cycle boom is prompted by monetary
distortions to the economy through credit expansion, typically caused by rational
reserve lending from central banks. Additionally, Austrian economists contend
that with a fixed money supply market forces will ensure that the proper amount
of consumption, investment, and savings occur, given society’s preferences. The
instability associated with fractional reserve lending can be observed through
credit expansion, as the increase in money supply distorts the market, and in turn
causes market interest rates to decrease. This credit expansion would lead firms to
observe lower market rates and make them believe the amount of saved funds
available for investment have increased. The increase in investment would
theoretically create jobs and increase income but, with a higher savings rate
relative to income, people would continue to save and permit firms to invest in
capital goods to build for the future. Despite the increase in investment, the fall in
interest rates was due to credit expansion. For this reason, when income created
but this investment in capital goods is spent, people will spend it in the same
proportion relative to savings before. With that, there is a renewed demand for
consumer goods not capital goods. This Austrian model thus explains the
volatility of investment during the business cycle as fractional reserve lending
through credit expansion distorts the interest rate, which results in mass
investment in capital goods, which in turn have to be liquidated following this
period.
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b. The Austrian theory of economics is highly critical of federal Reserve monetary
policy being a key factor in the credit bubble. Understanding the policies placed
forward is imperative in analyzing the impact these approaches shared in the
creation of the credit housing bubble. Artificially low interest rates from the
Greenspan Fed, accompanied with incessant fractional reserve lending, frequent
government protection of the banks and mortgage market via federal deposit
insurance corporations, combined with policies that encouraged people to buy
houses, led to malinvestment in houses. Further, from the reading there are three
main assertions against the Fed’s expansionary monetary policy. Firstly, the
implementation of the Hayek’s Monetary Rule where the Fed should have
maintained constant nominal income allowing prices to fall as productivity
increased throughout the late 1990’s (Sub-prime). The next rule of policy
mentioned is Freidman’s rule, which suggested the Fed should have instead
increased the quantity of money at a constant low rate to avoid dramatic
fluctuations in inflation. And finally, the last rule was Taylor’s rule, which
focused on the “factual versus counterfactual” developments of central banks in
setting short-term interest rates compared to those actually set by the Fed prior.
Under the backdrop of these policy rules in consideration, I will now focus more
so on the resulting developments these policies had. Because of artificially low
interest rates, so firms could take in investment projects that wouldn't have been
available otherwise. This led to mal-investment, and in consequence the housing
sector received most of these investments taking place through the easy-money
policy (Sub-prime). The Federal Housing Administration (FHA) contributed to
this boost in investment observed in 2004 when the most demanded FHA product
carried a requirement of only 3% down (Subprime). This was disastrous because
it increased the rate of default because it gave individuals with poor credit and
financial means to enter into a mortgage that they couldn't sustain. Further, The
Community Reinvestment Act (CRA), was a sanction expanded upon during the
late 2oth century that ultimately distributed millions in mortgages to low-income
customers, who were previously eligible for credit (Subprime). This policy further
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disturbed the housing market with an influx of newly accredited homeowners who
were at great risk of default on the mortgage. The combined effort of these
policies dramatically increased the demand for housing, as housing construction
rose to more than 4.6 million homes during 2003 to 2006 and resulted in
significant increases on the prices of existing houses (subprime). This idea is
further supported in figure 4 of the article which displays the boom-bust results
from the consequences of reducing interest rates. The chart dictates that the boom
that took place in 2002 and 2006 would have just been a little hill according to the
counterfactual data, if the Fed would have followed the implications of Taylor’s
rule. The confusion and inconsistency brought upon by the disproportionate
number of unstable investments in the housing sector was unsustainable, and was
well on track to end in a crisis under the control of the Fed.
4. New Classical and New Keynesian Theory
a. The situations described in the question reflect anticipated and unanticipated
fiscal policies depicted under the new classical position. These assertions are
proved in rational expectations theory, where workers will use all available
information in forming expectations, and thus have no reason why workers would
ignore current information to intentionally form incorrect price expectations. This
relates to the anticipated and unanticipated policies of an economy as rational
expectations suggest participants in the economy are assumed to understand the
economic relationships that control the variable they are trying to predict. The
first scenario where there is a planned and announced new policy is considered to
be anticipated because people were given notice of this change and are expected
to act accordingly under rational expectations theory. The second scenario is
unanticipated because the increase in military spending was a result of an
unannounced surprise attack by an enemy, so people must respond rationally as to
what they expect will happen. New classical economists contend that participants
in the economy are rational, and don’t intentionally make bad decisions or ignore
significant information. Further, the workers do not have perfect information, but
if a change is anticipated, they do have enough information and economic
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understanding to make the best decision. Within scenario 1, since the increase in
government spending was announced prior to its implementation, this would be
an example of anticipated change. The anticipated decline in investment and AD
will cause everyone to expect a decrease in prices. If the general public has
comprehensive knowledge on how policy was conducted and if firms have
adjusted to this policy, then the growth of the money supply will have no effect on
output or employment. The nominal wages in the particular case of scenario 2,
since the increase in military spending was from a surprise attack from an enemy
nation, this would be an example of an unanticipated change. The monetary
policy will shift AD, and because workers are unaware that expansion has
occurred, their expectations are faulty, and labor supply and AS will not shift in
the short run.
b. The endogenous money model observed in topic 13 displayed the concept that the
market decides how much money that want, which the central bank then provides
at the chosen interest rate. Reserves in the banking system come in the form of
liabilities of the central bank, with currency holdings plus deposit at the central
bank. Central banks are therefore considered to have a monopoly on the supply of
reserves in the banking system, which then in turn grants them control over
setting the price on those reserves. In order to make a profit, banks lend at a
higher rate than the cost of funds and the banks then subject loans at this higher
rate. This model argues that banks lend first and will find the deposits to back
these loans later, as the quantity of loans depends on how much is demanded at
this rate. Further, this model is similar to that of a bank balance sheet, where
assets must equal liabilities, and is simplified to be loans must equal deposits. If
these two aspects must be equal, the bank must acquire deposits to match the
loans it has extended.
c. The Taylor rule is a forecasting model of the interest rate, which implies how
central banks should change interest rates to account for inflation and other
economic conditions. The Taylor rule mainly operates with the inception that the
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Fed should increase rates when inflation is higher than desired or when GDP
growth is too high above potential. Due to the business expansion introduced in
part b, this would most likely result in the Central bank raising interest rates as
inflation would be increased during an expansion in the business cycle. Taylor’s
rule would call for an increase in the interest rate of 1.5% for each percentage
increase in the inflation rate, under the assumption there is no output gap. The
central bank would impose an interest rate that is not cost-effective, in order to
account for inflation, as interest rates on bank loans would rise. With higher rates
on the bank loans, there will be a decreased demand for investment as investors
would rather purchase loans when the rate is lower. This would result in a
decreased quantity in banks loans, as there is less motivation to acquire one with a
higher rate.
