1

International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.1 The Classical Theory of Inflation

4.2 Inflation and Unemployment
4.3 The IS-LM-PC-Model
4.4 Price Levels, Inflation and Productivity Growth
4.5 Fiscal Policy and the Sustainability of Government Debt

Literature: Blanchard et al. Chap. 8, 9, 10.1, 22.2, 22.4, 23.2

The classical theory of inflation
2
Three key assumptions

(1) In the long run, real GDP Y is determined by the endowment of an economy with labor,
capital, natural resources, and by the technology used in production.
(2) In the long run, perfectly flexible prices guarantee that the economy is in a state of full
employment.
(3) Money demand is a stable function if income (quantity equation): 𝑀𝑀𝐷𝐷 � 𝑣𝑣 = 𝑃𝑃 � 𝑌𝑌

 Consequence: “Inflation is always and everywhere a monetary phenomenon, in

the sense that it is and can be produced only by a more rapid increase in the
quantity of money than in output.“ (Milton Friedman, 1956)

 Proof:
�𝑆𝑆 : growth rate of money supply
𝑀𝑀
• Equilibrium condition: 𝑀𝑀 𝑆𝑆 = 𝑀𝑀𝐷𝐷
� inflation rate
𝜋𝜋 ≡ 𝑃𝑃:
𝑆𝑆
• Insert into the quantity equation: 𝑀𝑀 � 𝑣𝑣 = 𝑃𝑃 � 𝑌𝑌
�
𝑌𝑌: growth rate of real GDP
�𝑆𝑆 + 𝑣𝑣� = 𝜋𝜋 + 𝑌𝑌�
• Expressed in growth rates: 𝑀𝑀 𝑣𝑣:
� change in velocity
�𝑆𝑆 − 𝑌𝑌�
• With constant v (i.e. 𝑣𝑣� = 0): π = 𝑀𝑀

If the growth rate of money supply exceeds the growth rate of real GDP, inflation will result.

2
 From money targeting to inflation targeting
3
Monetary policy – money supply targeting

 Targeting money supply: Dominant strategy of central banks in the 70’s and 80’s,
followed by the Bundesbank until 1998, initially part of ECB’s strategy.
• Aim: Control inflation by a target growth rate for money supply
� 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 = 𝜋𝜋 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 + 𝑌𝑌� 𝑒𝑒 − 𝑣𝑣� 𝑒𝑒
𝑀𝑀
� 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 = 4,5%
• Example: ECB’s reference value for growth rate 𝑀𝑀3 was 𝑀𝑀

• Reasoning: 𝜋𝜋 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 = 2% , 𝑌𝑌� 𝑒𝑒 = 2%, 𝑣𝑣� 𝑒𝑒 = −0.5%

 Conditions for successful money supply targeting

• In the short run, tight relationship between interest rate (= instrument) and money supply.
• In the medium run, tight relationship between money supply and inflation.
• Both conditions require a stable money demand.

3
Money targeting
4
The European experience

 Eurozone: Stable money demand

• Velocity follows a stable trend. • The relationship between money supply
• Annual decline 0.5% - 1%. growth and inflation was stable.
• Since 2000: relationship has become
weaker due to credit booms and busts.

Figure: Velocity of M3 in the Eurozone Figure: M3 growth and inflation

blue: velocity of M3
black: linearized trend
dotted line: trend since 1999

Source: Görgens, Ruckriegel & Seitz (2013)

Slide 4
Money targeting
5
The US experience

 US: Instable money demand

• Large shifts in the demand for money in • Relationship between M1 growth and
the 80’s and 90’s due to financial inflation was not very tight.
innovations.
• Shift to inflation targeting in the 90’s.

Figure: Velocity of M2 in the US Figure: M1 growth and inflation

10 year averages

Slide 5
From money targeting to inflation targeting
6
Inflation targeting and interest rate rules

 Due to problems with money supply targeting, many central banks switched to
inflation targeting (e.g. UK 1992, Sweden 1993)
• Problem: Time-lag of monetary policy – current inflation rate cannot be targeted
• Flexible inflation targeting: Central banks adjust the interest rate to return to the target
inflation rate over time, rather than right away. The inflation target is compared with the
inflation forecast.
- If expected inflation is higher / lower than target, interest rate is adjusted.
- Further variables that affect interest rates: output gap, unemployment rate.
 Interest rate rules: Taylor rule
• Aim: Simple rule to determine the policy rate which allows to achieve the inflation target

𝑖𝑖𝑡𝑡 = 𝑖𝑖 𝑇𝑇 + 𝑎𝑎 𝜋𝜋𝑡𝑡 − 𝜋𝜋 𝑇𝑇 − 𝑏𝑏 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑁𝑁

- 𝑖𝑖 𝑇𝑇 = 𝑟𝑟𝑁𝑁 + 𝜋𝜋 𝑇𝑇 : target nominal rate
- 𝑟𝑟𝑁𝑁 :
neutral (or natural) real interest rate - compatible with stable prices and output at the potential /
natural level
- 𝜋𝜋 𝑇𝑇 , 𝜋𝜋 𝑒𝑒 : target inflation and expected inflation
- 𝑢𝑢𝑡𝑡 and 𝑢𝑢𝑁𝑁 : unemployment rate and natural unemployment rate
- 𝑎𝑎, 𝑏𝑏: positive coefficients, weights given to deviations from targets (inflation, unemployment)

6
Inflation targeting with interest rate rules
7
The Taylor rule

 Rule for policy makers: 𝑖𝑖𝑡𝑡 = 𝑖𝑖 𝑇𝑇 + 𝑎𝑎 𝜋𝜋𝑡𝑡 − 𝜋𝜋 𝑇𝑇 − 𝑏𝑏 𝑢𝑢𝑡𝑡 − 𝑢𝑢𝑁𝑁

• If 𝜋𝜋𝑡𝑡 = 𝜋𝜋 𝑇𝑇 and 𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑁𝑁 , the central bank should set 𝑖𝑖𝑡𝑡 = 𝑖𝑖 𝑇𝑇 .
• If 𝜋𝜋𝑡𝑡 > 𝜋𝜋 𝑇𝑇 , the central bank should increase 𝑖𝑖𝑡𝑡 above 𝑖𝑖 𝑇𝑇 .
This increases the unemployment rate and decreases the inflation rate.
The coefficient a reflects how much the central bank cares about inflation.
• If 𝑢𝑢𝑡𝑡 > 𝑢𝑢𝑁𝑁 , the central bank should decrease the nominal interest rate.
The coefficient b reflects how much the central bank cares about unemployment.

 Problem: The Taylor rule should not be applied blindly

• Empirical problems
- Estimate potential output / natural unemployment (change over time).
- Estimate the natural interest rate (declined over the last three decades).
• Other reasons could justify changes in the policy rate (e.g. exchange rate crisis,
debt policies).

7
Empirical evidence on money supply and prices
8
Implications of the classical theory of inflation

 The classical theory of inflation is based on classical assumptions

• Competition and flexible prices are sufficient to guarantee full-employment.

• Monetary neutrality: Money supply does not affect real variables (like GDP, income,
employment), it only determines the price level.

 Core: Quantity equation - Md is a stable function of variables like income and

interest rates
 Criticism: Assumptions are empirically questionable
• Money demand can be highly unstable (e.g. USA).

• Full employment assumption neglects business cycles - with unemployment,

monetary neutrality does not hold in the short-run, monetary policy affects income and
prices.

 Conclusions should be interpreted in a long run sense

8
Empirical evidence on money supply and price levels
Money growth and inflation – 3 insights 99

Money Supply Growth and Inflation Money Supply Growth and Inflation
79 countries, 1950-1990 in Low Inflation Countries, 1970-2005

1. There seems to be a close long-run relationship between average monetary growth and
average inflation.
2. For countries with low inflation rates, the raw relationship between average inflation and the
growth rate of money supply is tenuous at best.
Source: Teles, Uhlig & Azevedo 2016, Economic Journal
Empirical evidence: Money supply growth and inflation show almost vno
10
correlation in economies with low inflation and a strategy of inflation targeting

3. Role of central banks’ strategy: The sub-

sample after the adoption of inflation
targeting (IT) shows a worsening of the
fit of a one‐for‐one relationship between
money growth and inflation.

Source: Teles, Uhlig & Azevedo 2016, Economic Journal 10

 11

International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.1 The Classical Theory of Inflation

4.2 Inflation and Unemployment
4.3 The IS-LM-PC-Model
4.4 Price Levels, Inflation and Productivity Growth
4.5 Fiscal Policy and the Sustainability of Government Debt

Literature: Blanchard et al. Chap 8

The trade-off between inflation and unemployment 12
The Phillips curve and the role of expectations

 Question: Why did the Philipps curve vanish in the 70’s? Two answers:
1. Wage setters changed the way they form expectations – expectations became de-anchored due
to high inflation.
2. There is no trade-off between inflation and unemployment in general, only in cases when
expectations are not correct. (Friedman / Phelps)

 The Phillips curve equation: (8.2) 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 + (𝑚𝑚 + 𝑧𝑧) − 𝑎𝑎𝑎𝑎
 Anchored expectations: 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋� and the PC is 𝜋𝜋𝑡𝑡 = 𝜋𝜋� + (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡
• Interpretation: Assume that inflation is low, non-persistent and varies around 𝜋𝜋� (e.g. an average of
the last years). Then it makes sense to expect that inflation is not related to recent inflation, 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋.
�
• Consequence: Trade-off between inflation and unemployment
 De-anchored expectations: 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1 and the PC is 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡
• Interpretation: Assume that inflation rates become higher and more persistent. Then it makes
sense that the recent inflation rate 𝜋𝜋𝑡𝑡−1 affects expectations

• Either 𝜋𝜋𝑡𝑡𝑒𝑒 = 1 − 𝜃𝜃 � 𝜋𝜋� + 𝜃𝜃 � 𝜋𝜋𝑡𝑡−1 or 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1

• Consequence: The PC no longer describes a relationship between inflation and unemployment,

but between the change in the inflation rate and unemployment

❓ What is the problem with de-anchored expectations?

Slide 12
The de-anchoring of expectations in high inflation times
Figure: Change in inflation versus unemployment in the United States, 1970-1995 13

From 1970 to 1995,

there was a negative
relation between the
unemployment rate and
the change in the
inflation rate in the
United States.

• The line that best fits the scatter of points is 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = 7.4% − 1.2𝑢𝑢𝑡𝑡 .

Slide 13
The re-anchoring of expectations in low inflation times
Figure: Inflation versus unemployment in the United States, 1996-2018 14

 By the mid-1990s the Fed had largely achieved its goal of keeping inflation around 2%.
 Stable inflation changed the way people formed expectations yet again: Expectations of
inflation that became de-anchored during the 1970s and 1980s became re-anchored in
the mid-1990s.

Since the mid-1990s,

the Phillips curve has
taken the form of a
relation between the
inflation rate and the
unemployment rate.

 The line that best fits the scatter of points is 𝜋𝜋𝑡𝑡 = 2.8% − 0.16𝑢𝑢𝑡𝑡 .

Slide 14
The Phillips Curve and the natural rate of unemployment
8.2 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 + (𝑚𝑚 + 𝑧𝑧) − 𝑎𝑎𝑢𝑢𝑡𝑡 15

 Critique of Friedman and Phelps (1968)

1. Unemployment cannot be sustained under a certain level, the natural rate of
unemployment. At the natural rate of unemployment, a trade-off does not exist.
2. A trade-off only exists if expectations were wrong and wage setters under-predicted
inflation (surprise inflation).
3. If the government tries to sustain lower unemployment than the natural rate, it has to
accept higher inflation rates.

 Definition: The natural rate of unemployment is the unemployment rate that

results if the actual inflation rate is equal to the expected inflation rate (i.e.
expectations are correct)
(𝑚𝑚+𝑧𝑧)
• Setting 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 in equation (8.2): 𝑢𝑢𝑁𝑁 =
𝛼𝛼
𝑚𝑚+𝑧𝑧
• Equation (8.2) can be rewritten as 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡𝑒𝑒 = (𝑚𝑚 + 𝑧𝑧) − 𝛼𝛼𝑢𝑢𝑡𝑡 = 𝛼𝛼 − 𝑢𝑢𝑡𝑡
𝛼𝛼

• Inserting the definition of uN, the PC now shows a relation between inflation,
expectations, unemployment and its natural rate:
𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡𝑒𝑒 = 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡

Slide 15
Inflation and the natural rate of unemployment
16
𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡𝑒𝑒 = 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡

 Effect of expectations:
1. If expectations are correct, 𝜋𝜋𝑡𝑡 = 𝜋𝜋𝑡𝑡𝑒𝑒 , unemployment is at its natural level, 𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑁𝑁
- Interpretation: With correct expectations, unemployment is at its natural level, and
there is no trade-off between inflation and unemployment
2. If there is surprise inflation, 𝜋𝜋𝑡𝑡 > 𝜋𝜋𝑡𝑡𝑒𝑒 , unemployment falls below its natural level, 𝑢𝑢𝑡𝑡 < 𝑢𝑢𝑁𝑁
- Interpretation: Unexpected inflation / surprise inflation allows to reduce unemployment
below its natural level
 Effect of the unemployment rate:
• If unemployment is lower than the natural level, 𝑢𝑢t < 𝑢𝑢N , inflation will be higher than
expected.
• If unemployment is higher than the natural level, 𝑢𝑢t > 𝑢𝑢N , inflation will be lower than
expected.
 The dynamics depend upon expectation formation
• Suppose a high-inflation environment, de-anchored expectations: 𝜋𝜋𝑡𝑡𝑒𝑒 = 𝜋𝜋𝑡𝑡−1
• Then the PC relationship becomes 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡
• If the inflation rate is high and should decrease, 𝜋𝜋𝑡𝑡 < 𝜋𝜋𝑡𝑡−1 , unemployment must be
pushed above its natural level: 𝑢𝑢𝑡𝑡 > 𝑢𝑢𝑁𝑁

Slide 16
 17
The Phillips Curve and the political economy of inflation

 Role of expectations
• If expectations are correct, π = 𝜋𝜋 𝑒𝑒 , unemployment is at
its natural level, 𝑢𝑢𝑡𝑡 = 𝑢𝑢𝑁𝑁 : Long-run relationship
𝜋𝜋
- Interpretation: no trade-off
• If there is surprise inflation,π > 𝜋𝜋 𝑒𝑒 , unemployment falls
below its natural level, 𝑢𝑢𝑡𝑡 < 𝑢𝑢𝑁𝑁 : Short-run relationship 𝜋𝜋3
- Interpretation: Unexpected inflation / surprise inflation
allows to reduce u below its natural level
𝜋𝜋2
 Game between government and wage setters
• The government has targets both for inflation and
unemployment – it wants to reduce unemployment below 𝜋𝜋1
𝜋𝜋 𝑒𝑒 = 𝜋𝜋2
the natural level to 𝑢𝑢1
• The government announces an inflation target of 0 – if
households expect 0 inflation, the government has an 𝜋𝜋 𝑒𝑒 = 𝜋𝜋1
incentive to create surprise inflation 𝜋𝜋1 by a monetary 𝑢𝑢
expansion – unemployment is reduced to 𝑢𝑢1 𝑢𝑢1 𝑢𝑢𝑁𝑁
𝜋𝜋 𝑒𝑒 = 0
• Over time, households adjust inflation expectations to
𝜋𝜋1 - this defines the new short-run PC with expected
inflation 𝜋𝜋1  Consequence: There is a short-term trade-off
between inflation and unemployment for every level
• If the government wants to sustain 𝑢𝑢1 , it again has to of expected inflation
create a surprise inflation 𝜋𝜋2 - over time, households
adjust expectations to 𝜋𝜋2
 If the government wants to sustain a lower
unemployment rate than 𝑢𝑢𝑁𝑁 , it has to create
• If the government wants to sustain 𝑢𝑢1 it has to create accelerating surprise inflation
surprise inflation 𝜋𝜋3 - …
 Solution: Delegate monetary policy to an
independent institution
17
Estimations of the natural rate of unemployment
18
𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡𝑒𝑒 = 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡

 De-anchored expectations: 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡 ,

• Line of best fit 𝜋𝜋𝑡𝑡 −𝜋𝜋𝑡𝑡−1 = 7.4% − 1.2𝑢𝑢𝑡𝑡
• Setting the LHS to 0 implies: 𝑢𝑢𝑁𝑁 = 6.2%

 Re-anchored expectations: 𝜋𝜋𝑡𝑡 = 𝜋𝜋� + 𝛼𝛼 𝑢𝑢𝑁𝑁 − 𝑢𝑢𝑡𝑡

• Line of best fit 𝜋𝜋𝑡𝑡 = 2.8% − 0.16𝑢𝑢𝑡𝑡
• Assume that anchored expected inflation is close to Fed target of 2%, 𝑢𝑢𝑁𝑁 is then the
unemployment rate at which inflation was equal to 2%
• Inserting: 2% = 2.8% − 0.16𝑢𝑢𝑁𝑁 : 𝑢𝑢𝑁𝑁 = 5%
 Caveat: Rough estimates, since fit of the regression line is not very good.

Slide 18
The natural rate of unemployment in Europe 1919

Unemployment rates in 15 European countries,

2006

• The natural rate of unemployment

differs across countries due to
labor-market institutions and
rigidities, and it also changes over
time.
• Factors affecting labor-market
rigidities:
 System of unemployment insurance:
More versus less generous
 Degree of employment protection:
High versus low
 Minimum wages
 Wage negotiation rules (e.g.
extension agreements).
The Phillips Curve and the natural rate of unemployment
20
Puzzles

 After the financial crisis and the Eurozone crisis, the Phillips Curve relationship
implied two puzzles.
1. Given the strong increase in unemployment after 2009 in many countries, the inflation
rate remained surprisingly high in 2010-2012.
2. Given the low unemployment rates in many countries after 2016, the inflation rate
remained surprisingly low.
 Possible explanations:
• The Phillips curve relation breaks down in phases of low inflation.
- In a high inflation environment, workers are willing to accept a cut in real wages by accepting
nominal wage growth lower than the inflation rate.
- In a low inflation environment, real wages can only fall by a decrease in nominal wages – this
seems unacceptable for workers.
• Growth in insecure forms of employment (part-time work, temporary work, casual
work) eroded bargaining power of workers/unions
• Inflation expectations adjust very slowly.
• Measures of unemployment 𝑢𝑢𝑡𝑡 are biased – “true” unemployment is higher
• The PC is a non-linear relation - inflation surges as soon as 𝑢𝑢𝑡𝑡 falls below a certain
threshold

Slide 20
 21

International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.1 The Classical Theory of Inflation

4.2 Inflation and Unemployment
4.3 The IS-LM-PC-Model
4.4 Price Levels, Inflation and Productivity Growth
4.4 Fiscal Policy and the Sustainability of Government Debt

Literature: Blanchard et al. Chap 9

The IS-LM-PC-Model allows to analyse the effects of inflation 22

 New assumptions
- The central bank follows a policy of interest rate r
targeting (vertical LM) IS
- The central bank is able to steer the nominal policy
rate in a way as to control the real interest rate r
- Inflation expectations are anchored at the target rate 𝜋𝜋�
LM
rN
 The equations:
• IS-relation: 𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑟𝑟 + 𝐺𝐺
• LM-relation: 𝑟𝑟 = 𝑟𝑟̅ Y
𝛼𝛼 YN
• PC-relation: 𝜋𝜋 − 𝜋𝜋� = (𝑌𝑌 − 𝑌𝑌𝑁𝑁 )
𝐿𝐿

𝜋𝜋 − 𝜋𝜋�
• Medium-run equilibrium: 𝑌𝑌 = 𝑌𝑌𝑁𝑁 , 𝑟𝑟 = 𝑟𝑟𝑁𝑁 , 𝜋𝜋 = 𝜋𝜋�

0 Y

22
Supply shocks: A permanent increase in the price of oil 23

 Analogy: An increase in the price of oil

is equivalent to an increase in the
markup.
 It leads to lower real wages and a
higher natural rate of unemployment

 Adjustment:
• Firms have to pay more for oil – if they want
to pass-through their higher costs, they
must increase their mark-up
• The wage they can pay is lower – getting
workers to accept lower wages requires an
increase in unemployment

23
Supply shocks: An permanent increase in the price of oil implies a period of
24
stagflation
 Initial equilibrium: 𝑌𝑌 = 𝑌𝑌𝑁𝑁 , 𝑟𝑟 = 𝑟𝑟𝑁𝑁 , 𝜋𝜋 = 𝜋𝜋� (point A)
r
IS
 Short-run adjustment:
• Permanent increase in price of oil – firms increase mark-up A‘‘
r'N
• The PC-curve shifts up – natural rate of unemployment
increases, natural rate of output decreases A LM
rN
• If IS does not change, and if the central bank does not
intervene – output does not change, but inflation is above
target (A’)
Y
 Medium-run adjustment: YN
• Risk: Without central bank intervention, output exceeds
the new natural level – if expectations become de- 𝜋𝜋 − 𝜋𝜋�
anchored, wage setters would expect higher inflation, and PC
inflation would keep increasing
A‘
• Central bank increases real interest rate to return inflation 𝜋𝜋 − 𝜋𝜋�
to target (LM shifts up) – decline in investment, lower
A
aggregate demand, lower employment, lower income, A‘‘
0 Y
multiplier effects (income-dependcnt C and I) Y‘N YN
• As output decreases, inflation decreases to target
• Final equilibrium: 𝑌𝑌𝑁𝑁′ < 𝑌𝑌𝑁𝑁 , 𝑟𝑟𝑁𝑁′ > 𝑟𝑟𝑁𝑁 , 𝜋𝜋 = 𝜋𝜋� (point
A’’)
24
Issues of the analysis 25

 What are short-run demand effects?

• Assumption: IS does not change in the short-run
• Firms may react to higher oil prices: change investments plans, cancel some projects, more
energy-efficiency investments
• Internationally, income is redistributed from oil buyers to oil producers – if producers have a
lower propensity to consume, decline in consumption demand (especially if producers are
foreigners)
• Demand may be reduced, even in short-run output declines
 How persistent is rise in oil prices?
• Here: permanent increase in price of oil – permanent decrease in output
• If increase is temporary – central bank may accept a temporary higher inflation, anticipating that
inflation will fall again if prices of oil decline
• Risk: If adjustment period is too long, expectations might become de-anchored

25
Oil price increases – the 2000s are different from the 1970s 26

Fig.: Effect of a 100% permanent increase in the price of oil on the CPI and on GDP

 In both periods, the increase in the price of oil led to an increase in CPI and a decrease
in GDP
 The effects on both GDP and CPI have become smaller

26
 27

International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.1 The Classical Theory of Inflation

4.2 Inflation and Unemployment
4.3 The IS-LM-PC-Model
4.4 Price Levels, Inflation and Productivity Growth
4.5 Fiscal Policy and the Sustainability of Government Debt

Literature: Blanchard et al. Chap 10.1

Differences in national inflation rates in the Eurozone
28
Inflation is not always and everywhere a monetary phenomenon

 Due to economic catch-up, some peripheral countries (e.g. Ireland, Spain) had
higher productivity growth in the traded goods sector than the core countries.
⇒ higher wage increases in traded goods sector relative to core countries.
⇒ spillover to the non-traded goods sector: relatively higher wage increases for non-
traded goods, too.
⇒ higher price increases for non-traded goods, higher inflation rate in the catch-up
countries.
⇒ loss of competitiveness, “internal real appreciation”.
28
 29

International Macroeconomics

Chapter 4: The Long Run Effects of Economic Policy

4.1 The Classical Theory of Inflation

4.2 Inflation and Unemployment
4.3 The IS-LM-PC-Model
4.4 Price Levels, Inflation and Productivity Growth
4.5 Fiscal Policy and the Sustainability of Government Debt

Literature: Blanchard et al. 2017, Chap 22.2.& 22.4

Fiscal policy and debts 30
The problem

 In most advanced economies, the financial crisis and the Corona pandemic have
led to large budget deficits and increases in debt-to-GDP ratios.
 This calls for governments to reduce deficits, stabilize the debt, and reassure
investors.
 Economic problem: How can a sustainable debt level be achieved? E.g. how is it
possible to stabilize a certain debt-GDP-ratio?

 The budget deficit Dt equals spending minus tax revenues, (Gt – Tt), plus interest
payments on outstanding debts (𝑖𝑖 �Bt-1):
𝐷𝐷𝑡𝑡 = 𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡 + 𝑖𝑖 � 𝐵𝐵𝑡𝑡−1
 Government budget constraint:
• Assumption: The deficit is financed by issuing new debt.
• The change in the government debt level during year t equals the deficit in t

𝐷𝐷𝑡𝑡 = 𝐵𝐵𝑡𝑡 − 𝐵𝐵 𝑡𝑡−1

❓ Are there alternatives to finance a budget deficit?

30
Stabilizing the debt-GDP-ratio
31
Sustainable debt requires stabilizing the debt-GDP-ratio

𝐺𝐺𝑡𝑡 − 𝑇𝑇𝑡𝑡
∆𝑏𝑏𝑡𝑡 = + 𝑏𝑏𝑡𝑡−1 � 𝑖𝑖 − 𝑔𝑔
𝑌𝑌𝑡𝑡
 Several aims are possible
• Stabilize the debt-to-GDP ratio at a constant value (∆𝑏𝑏𝑡𝑡 = 0)
• Decrease the debt-to-GDP ratio (∆𝑏𝑏𝑡𝑡 < 0)
• Run balanced primary budget (∆𝑏𝑏𝑡𝑡 = (𝑖𝑖 − 𝑔𝑔)𝑏𝑏𝑡𝑡−1 )
• The necessary primary surpluses depend on the relationship between the interest rate
on government debt and the growth rate of GDP: 𝑖𝑖 − 𝑔𝑔

 Conclusion
• If a country has accumulated large deficits, it will have to run primary budget
surpluses in order to prevent the debt-to-GDP-ratio from increasing automatically.

31
Case study: How countries decreased their debt ratios after World War II 32

 The debt ratios of many countries declined in the decades after World War II.
 The declines in debt were not mainly the result of primary surplus, but the
result of high growth and sustained negative real interest rates.

Table: Changes in Debt Ratios Following World War II

32
The relationship between interest rates and growth
33
Long-term interest rates and growth in the US

Fig: Nominal GDP Growth Rate and 10-Year Bond Rate,

1950-2018

• Nominal rates vary substantially from year to year. The 10-year rate has averaged
5.6%, while nominal GDP growth has averaged 6.3%.
• The 10-year rate has been lower than the growth rate for 4 out of 7 decades.
• Consequence: If on average, 𝑖𝑖 < 𝑔𝑔 , a debt rollover decreases the debt-GDP ratio

Sources: Blanchard (2019), Public debts and low interest rates, American Economic Review,
Wyplosz (2019), Olivier in Wonderland, VoxEU 33
 The relationship between interest rates and growth
34
Do higher debts harm future generations?

 Problem: Even if debt rollovers are feasible – are they desirable?

• In a dynamic model with uncertainty, a debt rollover has two effects: It reduces capital accumulation,
and it changes returns to labor and capital
• The welfare effect through lower capital accumulation depends on the safe rate, i.
• The welfare effect through the changes in factor returns depends on the average (risky) marginal
product of capital, FK
• If 𝑖𝑖 < 𝑔𝑔 < 𝐹𝐹𝐾𝐾 , the effect on welfare is ambiguous.
• But: Welfare costs of deficits and debts are smaller than commonly thought

 Critique (Wyplosz 2019)

• The relationship 𝑖𝑖 < 𝑔𝑔 is not the norm – in a sample of OECD countries, it occurs for 49.7% of observations
• The differential is very volatile – impossible to make inferences about the future.
• Deficit is important, too. “Deficit bias hypothesis” - due to political reasons, governments often fail to reduce debt if
interest rates are low.
- If 𝑖𝑖 − 𝑔𝑔 is negative: biased governments see an opportunity to raise the deficit (second column – no significant
difference between share of increasing and decreasing debts)
- If 𝑖𝑖 − 𝑔𝑔 becomes positive: biased governments may fail to react soon enough to stem the debt increase (in 60% of
observations, debts increase)

i-g>0 i-g<0
𝐵𝐵𝑡𝑡+1 − 𝐵𝐵𝑡𝑡 > 0 0.605 0.497
𝐵𝐵𝑡𝑡+1 − 𝐵𝐵𝑡𝑡 < 0 0.395 0.503
34
The dangers of high debt 35

 Public debt vortex

• Suppose that a country runs a primary surplus sufficient to stabilize debts
(Example: debt ratio 100%, interest rate 3%, growth rate 2%, primary surplus 1%).
• If investors begin to fear that the country’s debt may not be sustainable, they demand
higher interest rates
(Example: if interest rates rises to 8%, the primary surplus necessary to stabilize debt
must rise to 6%).
• But to increase the primary surplus, the country must follow a policy of fiscal contraction
(spending cuts, tax increases) – this is likely to lead to a recession – higher interest rate
and lower growth require even higher primary surplus
• In the end, the country is in a situation where it has to borrow more - the rise in the debt-
to-GDP ratio can lead markets to push borrowing costs even higher.

 When a government finds itself unable to repay the outstanding debt, it may
decide to default
• Haircut: The percentage that creditors will not receive compared to what they were
owed.
• Default comes under different names: debt restructuring, debt rescheduling, private
sector involvement.

35
The dangers of high debt
The Eurozone debt crisis in 2012 36

Fig.: Italian and Spanish spreads* during 2012

 The spreads on Italian and
Spanish two-year
government bonds over
German two-year bonds
increased sharply between
March and July 2012.
 At the end of July, when
the President of the ECB,
Mario Draghi, “the ECB is
willing to do whatever it
takes to preserve the
Euro”, spreads declined.

*: The spread is the difference between two interest yields, measured in basis points (a 100th of a percent).

36
The dangers of high debt - debt monetization
The government can finance the deficit by “printing money” 37

 Debt monetisation: The government issues bonds and then forces the central
bank to buy its bonds in exchange for money.
 Seigniorage: The revenue, in real terms, that the government generates with
increasing central bank money (= monetary base 𝑀𝑀0 ).
∆𝑀𝑀𝑜𝑜
Seigniorage =
𝑃𝑃
∆𝑀𝑀𝑜𝑜 ∆𝑀𝑀0 𝑀𝑀0
 Role of money supply growth: Define = �
𝑃𝑃 𝑀𝑀0 𝑃𝑃
(READ: real seigniorage revenues equal rate of nominal money supply growth • real money stock)
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 ∆𝑀𝑀0 𝑀𝑀0 /𝑃𝑃
 Scale by monthly GDP: = �
𝑌𝑌 𝑀𝑀0 𝑌𝑌
• Implication: Given a ratio of central bank money to GDP of 1 (empirical average), to finance a
deficit of 10% of GDP through seigniorage, the growth rate of nominal money supply must be 10%.

• As money supply growth increases, inflation typically follows.

• Higher inflation leads people to reduce money holdings – to achieve the same level of revenues,
government needs to increase money supply growth further.

• Hyperinflation may result.

37
Money Financing and Hyperinflation 38

 The major hyperinflations that followed World War I and World War II were all
the result of money growth and thus inflation running at 50% per month or
more.

Table: Seven Hyperinflations of the 1920s and 1940s

38
 Debts and Growth 39
Do high debts affect growth? Reinhardt and Rogoff’s influential study from 2010

 Advanced countries: Debt levels beyond 90%
of GDP have a non-linear impact on growth.
 Observations with debt to GDP over 90
percent have median growth roughly 1 percent
lower than the lower debt burden groups and
mean levels of growth almost 4 percent lower.
 No systematic effect on inflation.
 Emerging markets: The growth thresholds for
external debt are considerably lower than the
thresholds for total public debt. Growth
deteriorates markedly at external debt levels
over 60 percent, and further still when external
debt levels exceed 90 percent.
 Inflation significantly higher only for the group of
observations with external debt over 90 percent.

Source: Reinhardt and Rogoff 2010, Growth in a time of Debt, AER Slide 39
Political consequences of the 90%-threshold 40
Justification for austerity in Eurozone

 Ideal case: Fiscal policy should be

counter-cyclical (tightening in booms,
expansion in recessions)
 Economist (2013):
“The 90% figure quickly became
ammunition in political arguments
over austerity. In a February letter to
European Union finance ministers
Olli Rehn, the vice-president of the
European Commission, touted the
“widely acknowledged” 90% limit as
a reason to press on with European
fiscal cuts.”
 In 2009, the financial produced
counter-cyclical fiscal policy via the
usual automatic stabilizers – falling
tax receipts and rising social
spending.
 From 2010, however, the fiscal
policy stance flipped from stimulus to
contraction.

40
Problem: Coding errors in Reinhardt & Rogoff’s analysis 41

 Problem: Coding errors

in the excel file
(discovered by
Thomas Herndon, PhD
student) and other
methodological issues
 Accounting for these:
High debt still has a
negative effect at the
mean, but not a
dramatical non-linear
effect.

Slide 41
Review questions chapter 4 42

(1) According to Milton Friedman, inflation is always and everywhere a monetary

phenomenon. Under which assumptions is this hypothesis valid?
(2) Paul Volcker, FED chairman from 1979-1987, became famous as being the chairman
that ended the high inflation episodes of the late 70’s and early 80’s. As a consequence
of his disinflation policy, unemployment rose sharply in the first years of the 80’s. Use
the Phillips Curve model to explain this.
(3) Consider the expectation-augmented Phillips Curve. Under which assumptions is it
plausible that the expected inflation is determined by the current inflation?
(4) Assume that there is a permanent income in government expenditures, financed by
debts. Analyse the effects on interest rates and income, using the IS-LM-PC-Model.
(5) Explain with reference to the Balassa-Samuelson model: The inflation rate in catch-up
countries in the European Monetary Union is higher than the Union’s average inflation
rate.
(6) After the recent increase in government expenditures due to the Corona pandemic, (i-g)
has become a highly controversial topic. Many people argue that with interest rates
close to 0, government debt is no longer a problem.
Why is the relationship between interest rates and GDP-growth important for the
sustainability of public debt?

42
List of symbols 43

i, r: Nominal, real interest rate Y: National Income (GDP)

rN: natural real interest rate G: Government expenditures
MS: :Money supply T: Tax revenues
L(Y,i): Money demand (G-T): Primary deficit
P: Price level D: Budget deficit
v: velocity of money B: debt level
�
𝑀𝑀: Growth rate of money supply d,b: deficit/debt as share of GDP
𝜋𝜋: Inflation rate
�
𝑌𝑌: Growth rate of real GDP
𝑣𝑣:
� Change in velocity
u: Unemployment rate
uN: Natural unemployment rate
𝑃𝑃𝑡𝑡𝑒𝑒 : Expectation in period t-1 about price level in period t
𝜋𝜋𝑡𝑡𝑒𝑒 : Expectation in period t-1 about inflation in period t
m mark-up

43