Lecture 6: Macromodel Exercises Given to the EMBA 8400 Class Buckhead Center April 17, 2009 Dr. Rajeev Dhawan Director

1B: Monetary-Stimulus (Inflation) Experiment When Money Growth Stops Slowly by 2017 Rate of growth of the money supply is increased from 0% to 5% in 2009, and then kept at 5% until 2013, and then decreased slowly to 0% by 2017 (stays at 0% afterwards)

Inflation follows the money growth path, lagging behind at first but then over- shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

The real interest rate becomes cyclic. At first it drops which helps investment and then when it rises it hurts investment.

Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP Unemployment Drops Unemployment Rises

1C: Monetary-Stimulus (Inflation) Experiment When Money Growth Never Stops! Rate of growth of the money supply is increased from 0% to 5%. This is done forever (till the end of simulation period in 2034!)

Money Supply Growth Rate is a constant 5% forever starting in year 2007

Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run

Comparison of Real and Nominal Interest Rates

Real GDP shoots above the base case values, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to the potential GDP

Lessons From the Three Monetary (Inflation) Experiments 1a 1c 1b

Inflation Response Depends on How Long Monetary Stimulus Lasts 1b 1a 1c

Interest Rate Overshooting Depends on How QUICKLY Monetary Growth Returns to Normal 1a 1b 1c

Depth of the Recession Depends Upon How Quickly the Monetary Stimulus is Withdrawn! 1b 1c 1a

2a. Fiscal-Stimulus Policy Experiment

 In this experiment real government spending is increased in steps of $100 billion higher from 2009 to 2012, and then spending stays elevated at that level forever.  NO INCREASE IN TAX RATE: A deficit-financed war provides the historical context for large increases in government spending.

Government Spending and Tax Rate

Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state Unemployment Drops Unemployment Rises

Inflation follows the a cyclic path. Why? Because GDP has risen. So initially it shoots up and then drops, but eventually settles to the steady state values

 The booming economy raises the demand for money and forces the real interest rate higher.

Rise in interest rate hurts investment

Real Exchange Rate

 Higher real interest rates also raise the exchange rate relative to the domestic price level and the rest- of-the-world price level. That is, the real exchange rate rises. This lowers real exports.

 The imports rise as exchange rate rises.

 Higher imports and lower exports cause net exports (trade deficit) to drop.

 Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values

Comparison of Government Spending and Consumption

 Even though the tax rate is constant, higher GDP levels result in increased tax revenues

Government Deficit/Surplus and the Real Interest Rate

 As Government Spending goes up (G↑), GDP goes up (GDP↑) which causes price level to go up too (P↑).  Real Interest Rate rises (R↑) which depresses Investment (I↓).  Also as Real Interest Rate rises the Real Exchange Rate rises (EXCH↑) which hurts Exports (EX↓) but boosts Imports (IM↑) causing the Trade Deficit to rise (NETEX ↑).  As GDP goes up the tax collections rise but not by as much as the increase in government spending causing the Government deficit to increases. A Somewhat “Sequential” Working of the Model (Fiscal Policy)

 In this experiment real government spending is increased in steps of $100 billion higher from 2007 to 2010, and then spending stays elevated at that level forever.  Inflation follows the a cyclic path. Initially shoots and then drops, but eventually settles to the steady state values  Higher government spending adds directly to real GDP, by the national income accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillations but in the long run GDP comes back to steady state  The booming economy raises the demand for money and forces the real interest rate higher.  Higher real interest rates also raise the exchange rate relative to the domestic price level and the rest-of-the-world price level. That is, the real exchange rate rises. This lowers real exports and raises real Imports, causing net exports (trade deficit) to drop for both the reasons.  Higher real GDP and constant tax rates, raises the real disposable income and thus also increases consumption in the short-run, but in the long-run it settles back to steady state values  Even though the tax rate is constant, higher GDP levels result in increased tax revenues Summary of Reactions

Data Table 2 (a): Govt. Spending

2b: When…Govt. Spending is Reduced to its Original Spending Value by 2016 Government Spending increases for four years and then gradually reduced back to the original spending by 2016

Government Spending increases for four years and then gradually reduced back to the original spending in 2012 whereas the tax rats remain constant

Because the government spending is reduced and brought back to the original level in 2012, the real interest rates are forced to come back to the original as the stimulus is taken away.

Inflation Behavior

As inflation wears off and the real interest rate returns to normal implies that the nominal interest rate will drop

Comparison of Government Spending and Consumption

Higher government spending adds directly to real GDP from the national accounting identity. Since prices do not adjust completely in the first year, the full adjustment is delayed and the economy goes into a damped oscillation toward the long run steady state

3. Neutral-Budget Policy Experiment –In this experiment real government spending is increased by the same one-step increase imposed in the fiscal-stimulus experiment. –Instead of running a deficit, the government raises the tax rate high enough to crowd out the exact amount of increase in government spending by reducing consumption. Billions(in %)

Higher taxes via higher tax rate leads to drop in consumption

Government Spending vs. Consumption

No Change in Interest Rate!

Increased G and Decreased C => Constant GDP

Second half of the data Neutral Experiment Table