1. EC120 Spring 2014 Week 24, topic 19, slide 0 EC120: The World Economy in Historical Perspective Topics Week 24: The Great Moderation: declining inflation, falling interest rates, and booming credit, 1981 - 2007 1. Prelude: the final end of Bretton Woods (March 1973) and the oil price shock of 1973-74. 2. Oil price shocks and inflation. 3. Policy responses: the international trilemma makes life difficult for policy makers, especially in tightly integrated Europe. 4. International monetary arrangements in a floating world. 5. Implications.

2. EC120 Spring 2014 Week 24, topic 19, slide 1 EC 120 Week 24: The Great Moderation, 1981 – 2007 1.Prelude: the oil price shock of 1973 Conventional wisdom holds that the ‘oil shock’ of 1973-74 heralded the end of the ‘Golden Age’ and the follow-up shock of 1979- 1981 buried it. –Recall from last week, Barsky & Kilian (2001), Fig.6, for nominal price indices for industrial commodities, 1948-2000; Fig.9 for real price indices, 1948-2000. –For data on inflation and unemployment, see Baldwin & Wyplosz, (2004), Figs.12-1 and 17-1 and Mankiw (2003). –For long-term growth rate data, review Maddison (2001), Table3- 1a.

3. EC120 Spring 2014 Week 24, topic 19, slide 2 EC 120 Week 24: The Great Moderation, 1981 - 2007 1.The oil price shock of 1973 [cont.] Given the pervasive use of oil throughout advanced economies for both transportation and electrical power generation, it is clear that a sharp increase in oil prices, ceteris paribus, will lower aggregate output. The inflationary impact is much harder to determine a priori, for it depends heavily upon the policy response to the decline in output and rise in unemployment (see Diagram 1). It took time to adjust the capital stock to the new reality.

4. EC120 Spring 2014 Week 24, topic 19, slide 3 EC 120 Week 24: The Great Moderation, 1981 – 2007 2.Oil price shocks and inflation, 1 As Diagram 1 indicates, it is not hard to imagine a situation where an adverse oil price shock reduces the level of both output and prices for an oil-importing country. However, the actual experience of the oil shocks of the 1970s on the economy-wide price levels of OECD countries was unambiguously highly inflationary. This suggests that both the economic environment in which the oil shocks occurred and the subsequent policy responses deserve closer attention. –For European inflation rates 1960-2000, see Baldwin & Wyplosz (2004), Table 10-1. –For real growth, inflation and nominal growth across U.S. business cycles 1960-2000, see Barsky & Kilian (2001), Table 1. –For U.S. quarterly inflation rates 1960-2000, see Barsky & Kilian (2001), Fig.8. –For nominal and real price indices of industrial commodities 1948-2000, see again Barsky & Kilian (2001), Figs.6 & 9 respectively.

5. EC120 Spring 2014 Week 24, topic 19, slide 4 EC 120 Week 24: The Great Moderation, 1981 - 2007 2.Oil price shocks and inflation, 2 The increasingly inflationary environment of the late 1960s raises the possibility that conventional accounts of the end of the ‘Golden Age’ have causation at least partially reversed: that increasingly inflationary policies helped induce the oil shock rather than that the oil price shock induced higher inflation. Evidence: –in the early 1970s, for the first time since the early 1950s, all the major market-based economies were expanding rapidly together, putting increased pressure on commodity markets. –flagging productivity from the late 1960s onwards increased inflationary tendencies correspondingly for any given degree of demand pressure, making policy errors more likely (for data on output/capital ratios and profit rates for selected developed countries, see Marglin, et. al. (1990), Figs. 2.2 & 2.4 respectively). –OPEC needs high demand pressure to make price increases ‘stick’. –the beginnings of the final breakdown of the Bretton Woods international monetary regime in August 1971, accompanied by dollar devaluation against gold, markedly increased global inflationary pressures.

6. EC120 Spring 2014 Week 24, topic 19, slide 5 EC 120 Week 24: The Great Moderation, 1981 - 2007 3. Policy responses: constrained by the international trilemma limiting choices among fixed exchange rates, control over domestic interest rates, and full capital mobility. To the extent Barsky-Kilian’s reverse causation argument is correct, it adds another important justification for anti- inflationary policies (and the related subordination of interest rates to other policy objectives – notably in Europe, fixed exchange rates). The long struggle to suppress inflation – an overview: ̶ In Europe, steps towards closer economic integration and monetary union were only possible with converging (or at least stable) rates of inflation, a task not easily accomplished (for an indication of the consequences of differential inflation in foreign exchange markets, see Baldwin & Wyplosz (2004), Fig. 10-4). ̶ In the U.S., the “Volcker squeeze”, starting in late 1979, brought inflation down to 3% by 1983, albeit at the cost of two sharp but brief recessions (see again Barsky & Kilian (2001), Table 1). ̶ Eventually interest rates, both real and nominal, also came down (see Blanchard (2003), Figs. 1 & 2).

7. EC 120 Week 24: The Great Moderation, 1981 - 2007 The Long Struggle to Suppress Inflation, con’t.: Collateral Damage in Latin America (shared with American banks that had exercised poor credit screening, forgetting the lessons of the 1920s). Background − The end of Bretton Woods, in a context of still-rapid economic growth and accompanied by rapidly increasing international liquidity (and, not coincidentally, rising inflation) encouraged international bank lending (re-cycling petro-dollars). − In these circumstances, awash with cheap petro-dollar deposits American banks lent freely (but often not wisely), especially to Mexico and other Latin American countries. − As interest rates (both nominal and real) rose in the early 1980s, many Latin American borrowers, facing repayment of short-term loans, defaulted, threatening the solvency of the American banking system while compromising the borrowers’ continued access to foreign credit markets. The sovereign debt of advanced economies (as a percentage of GDP), which had been falling since the end of the Second World War, began to rise in the 1970s (and is still rising) as countries struggled to cope with less favourable circumstances. See Jordà et. al. (2013), Fig. 1. EC120 2014 Week 24, topic 19, slide 6

8. EC120 Spring 2014 Week 24, topic 19, slide 7 EC 120 Week 24: The Great Moderation, 1981 - 2007 3. Policy responses in the developed world were constrained by the international trilemma limiting choices among fixed exchange rates, domestic interest rates, and full capital mobility [cont.]. The particular problems of differential inflation rates for European economic integration in the context of generalized floating: –either the country with a higher rate of inflation accepts the loss of export market share that pegged exchange rates imply and the loss of reserves that follow; –or it devalues and thereby perhaps gains a temporary cost advantage in export markets; –in either case, unequal rates of inflation tend to disrupt trade.

9. EC120 Spring 2014 Week 24, topic 19, slide 8 EC 120 Week 24: The Great Moderation, 1981 - 2007 4.International Monetary Arrangements after Bretton Woods, 1 European solutions: ̶ as discussed in Week 22, the first arrangement, the ‘Snake’ (1971-1979), was unsatisfactory due to lack of monetary policy co-ordination (review Eichengreen (1996), Table 5.1, in the Extras of Week 22). ̶ the move to a stronger, more formalized regime in 1979 - the European Monetary System (EMS) with an Exchange Rate Mechanism (ERM) - characterized by mutual support and joint management of exchange rate realignments. EMS, Version 1, the System without a leader, 1979-1986 – each country set its own monetary policy; realignments were frequent. EMS, Version 2, the System aligns on Germany, 1987-1992 – the Bundesbank dictates policy and the rest follow. For a tabulation of revaluations of the DM against other EMS currencies in the period 1979-1990, see Eichengreen (1996), Table 5.2 and Baldwin & Wyplosz (2004), Table 12-1.

10. EC120 Spring 2014 Week 24, topic 19, slide 9 EC 120 Week 24: The Great Moderation, 1981 - 2007 4.International Monetary Arrangements after Bretton Woods, 2 The shock of German reunification led to atypical German inflation (for differential inflation rates 1985Q1-1992Q4, see Baldwin & Wyplosz (2004), Figs. 12-3 & 12-4), to which the Bundesbank responded by raising interest rates, creating serious problems for countries facing weaker domestic demand, flagging exports, and higher unemployment. The Berlin Wall, c.10 November 1989

11. EC 120 Week 24: The Great Moderation, 1981 – 2007 EC120 2014 Week 24, topic 19, slide 10 Crisis in the EMS: Britain and Italy were forced out of the ERM in September 1992, unable to hold the peg to the DM without unacceptable costs. Pressure continued, and in August 1993, the normal ERM bands were widened from 2.25% to 15%, greater than they had ever been during Bretton Woods, the ‘Snake’, or the EMS previously. The policy choices after 1992: monetary union vs. wide-band floating. See Baldwin & Wyplosz (2004), Fig. 11-8 for a selective illustration of the consequences of exchange rate regime choice. Norman Lamont, British Chancellor of the Exchequer George Soros, c. 1992 and aide, September 1992

12. EC120 Spring 2014 Week 24, topic 19, slide 11 EC 120 Week 24: The Great Moderation, 1981 - 2007 5.Implications The prize: has economic volatility really been reduced, and, if so, why ? (For plots of GDP volatility over various time intervals, 1948-2001, see Stock & Watson (2003), Figs. 1, 2, & 3). Is inflation targeting by central banks the new Gold Standard? –But what inflation measures are to be targeted? Should indices of financial assts and house prices be included in the inflation target?