Models of Stagflation

EC6012 Lecture 9Models of Stagflation

Stephen Kinsella

March 23, 2008

Today

IntroductionData

A Simple Macrodynamic ModelIntroductionThe ModelThe Output MarketEquilibrium in the product and money markets

Examples

Aggregate supply

The Phillips curve

Dynamics of asset accumulationExpectations

Bernanke-Blinder Model

An SFC Inside-Outside Model

Stagflation

A stagflationary economy experiences a slowing of growthcombined with rising inflation. Episodes of stagflation occurred inthe world economy in the late 1970’s and early 1980’s.

Data

Sept 18! CPI (consumer price index) 2.3%! PPI (producer price index) 2.3%! PCE (personal consumption expenditure)

deflator 2.5%! Gold $714

Oct 31! CPI 3.5%! PPI 6.1%! PCE deflator 3.0%! Gold $790

Dec 11! CPI 4.1%! PPI 6.3%! PCE deflator 3.6%! Gold $811

Jan 22! CPI 4.3%! PPI 7.4%! PCE deflator 3.7%! Gold $893

Jan 30! CPI 4.3%! PPI 7.4%! PCE deflator 3.7%! Gold $921

Mar 18! CPI 4.0%! PPI 6.4%! PCE deflator 3.7%! Gold $1004

Real GDP Growth for the US Economy, current andforecasted

Figure: Real GDP Growth for the US Economy, current and forecasted.

Industrial Production for the US Economy, current andforecasted.

Figure: Industrial Production for the US Economy, current andforecasted.

Historical CPI, trends to date.

Figure: Historical CPI, trends to date.

Recent US CPI data, current and forecasted.

Figure: Recent US CPI data, current and forecasted.

Recent US Unemployment.

Figure: Recent US Unemployment.

Definitions

Macrodynamics

Macrodynamics studies the evolution of the macroeconomy overtime. The macroeconomy is assumed to evolve from an initialstate towards a steady state, encountering exogenous shocks as itdoes so. These shocks can be studied using comparative staticsand dynamics to come up with policy proposals to help theeconomy deal with these shocks in the future.

A Macro Model with Four Sectors

! The product market,

! The money market,

! The bond market,

! The labour market.

Setup

GDP = C + I + G , (1)

GNP = C + I + G + (X !M). (2)

GDP = C + S + T . (3)

The Output Market

Y = C + I + G (4)

(Caution)C = C (Y ). (5)

Y = C (Y ) + I + G . (6)

Derivation

C = C (YD). (7)

C = C (YD,A, r). (8)

A =M + PkB + PkK

P. (9)

The Investment Function

I ! I (r ! !). (10)

Put it all together

Y = C

!T ! T , r ! !,

M + B + PkK

P

"+ I (r ! !) + G . (11)

The IS Curve

Figure: The IS curve.

Shifts in IS Curve

1. an increase the expected rate of inflation, or

2. a fall in the price of output, or

3. a rise in the stock of assets, or

4. an increase in the price of capital, or

5. a reduction in the level of taxes.

Money Markets

MD

P= L

!Y ,!!, r ! !, rk ,

M + B + PkK

P

"(12)

BD

P= J

!Y ,!!, r ! !, rk ,

M + B + PkK

P

"(13)

PkK

P= N

!Y ,!!, r ! !, rk ,

M + B + PkK

P

"(14)

MD + BD + PkKD

P=

M + B + PkK

P= A (15)

rk =P " R

#YK

$

Pk(16)

Put this all together

M

P= L

%Y ,!!, r ! !, rk ,

M + B

P+

RK

rk

&(17)

B

PJ

%Y ,!!, r ! !, rk ,

M + B

P+

RK

rk

&(18)

Edging towards LM

rk = r ! !. (19)

M

P= L(Y , r ,A) (20)

LM Curve

Figure: The LM Curve.

Slot IS into LM to get

Y = Y (P;M,B,K ,!, G ,T ). (21)

Which looks like

Figure: Equilibrium in the IS-LM model

[Bush’s fiscal stimulus]

C

onsider a standard IS-LM model in equilibrium. Graphically analysethe e!ects of a large increase in government expenditure financedthrough taxation on output/income and the interest rate, andbriefly explain your reasoning.

[Numerical example]

I

magine a closed economy with equilibrium output given byY = C + I + G . Total supply is given by Y = 5, 000.Consumption is determined by C = 250 + 0.75(Y ! T ).Investment is given by I = 1000! 50r . Initially, fix G and T atG = 1, 000,T = 1, 000. Suppose the government pursues anexpansionary policy, driving G from 1000 to 1250. What happensto national savings? Is there a deficit? How much of one? Will theinterest rate decrease or increase? By how much?

Aggregate Supply

This aggregate production function relates the labour input L andthe level of the capital stock employed to the level of output in theeconomy.

Y = F (K , L). (22)

Labour/Leisure Tradeo!

" = Pf (LD)! wL. (23)

W

P= "LD , (24)

Household utility maximisers

max(Y , Le) (25)

subject toLe = Tot ! LS , (26)

Y =W

PLS . (27)

LS = LD = L. (28)

Household utility maximisers

W

P= "(L) = #(L). (29)

The Phillips Curve

The Phillips curve relates changes in inflation to changes inunemployment.

p =P

P= $(Y ! (Y )) + ! (30)

Govt. Budget Constraint; Growth theory

M + B = P[G ! T ] + rB. (31)

K = I . (32)

Expectations

! = %(p ! !). (33)

! = p. (34)

Setup

LD = L(&, i , y). (35)

L(&, i , y) = '(&, i)D(i ! (), (36)

D(i , y) = m(i)R (37)

Setup

y = Y (i , &) (38)

& = "(i , y ,R) (39)

y = Y (i , "(i , y ,R)). (40)

Solution

Figure: Bernanke-Blinder Model Equilibrium.

E!ects of Shocks on Observable Variables. (Bernanke andBlinder, 1988, pg. 438.)

Rise in Income Money Credit Interest RateBank Reserves + + + -Money Demand - + - +Credit Supply + + + +

Credit Demand - - + -Commodity Demand + + + +

Table: E!ects of Shocks on Observable Variables. (Bernanke andBlinder, 1988, pg. 438.)

SFC

Godley and Lavoie (2006, Chapter 10) build a model capable ofsimulating the e!ects of a stagflation on a growing economy. Thesetup of model INSOUT is complicated, and the handout from thebook will show the setup. All we need here is the steady statecondition:

y! = (G + rbB! + BL!)" 1 + (

&((41)

References

B. Bernanke and A. Blinder. Credit money and aggregate demand.American Economic Review, 78(2):435–439, May 1988.

Wynne Godley and Marc Lavoie. Monetary Economics AnIntegrated Approach to Credit, Money, Income, Production andWealth. Palgrave-Macmillan, 2006. URL http://www.palgrave.com/products/Catalogue.aspx?is=0230500552.