Conditional Forecasting Model - Economic Forecasting - Lecture Slides, Slides of Economics

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Macroeconomic Models III

Macroeconomic Models

Conditional Forecasting

Macro Model - Basic Graphs

r

Y

Y

p

SP

LP

LM

IS

IS = Commodity Mkt Equilibrium

LM = Asset Market Equilibrium

SP = Short-Run Phillips Curve

LP = Long-Run Phillips Curve

YN = “natural output”

YN

Macroeconomy - Initial

Conditions

 Assume:

• Initial inflation rate = 0.
• Initial Real Output = Natural Output
• Initially no unexpected inflation (actual and expected inflation are equal)
• Nominal Money Stock is held constant at some value M 0.

 Alternative initial conditions are possible (e.g. positive inflation and expected inflation); but these parameters keep difficulties to a minimum.

Unanticipated Fiscal Stimulus

II

r

Y

p

SP

LP

LM

IS’

Y

LM’

1. Positive inflation generates higher price level.
2. Higher Price level with fixed Nominal Money Supply reduces supply of Real Balances
3. LM curve Shifts up
4. Real interest rate increases; real output falls, inflation is lower, but still higher than initial value (0.0)

YN

Unanticipated Fiscal Stimulus

III

r

Y

p

SP

LP

IS’

Y

LM’

1. Left with a situation where inflation turned out to be different than agents forecast it to be (YN < Y).
2. State of the economy can’t remain here indefinitely unless we assume that agents never correct their forecast errors!

YN docsity.com

Anticipated Fiscal Stimulus I

 What happens to the economy if the fiscal stimulus is announced in advance of the action.

 Depends on whether agents think that the announcement is credible. Talk is cheap; if not believed then it is the same as making no announcement.

 If announcement is credible, then effect on economy depends on how agents forecast.

Anticipated Fiscal Stimulus II

 If agents make forecasts based only on history of economy, then the prospective fiscal change is not something they consider in constructing their forecasts.

 Their expectations of future inflation do not depend on information about future fiscal policy.

• any changes in inflation resulting from the preannounced policy are unexpected changes
• economy reacts as to the unanticipated stimulus

 If so: at time of the stimulus, inflation expectations adjust, SP curve shifts.

Fiscal Stimulus

 What is the initial effect of a fiscal shock in an environment where agents make perfect forecasts of inflation, or the ultimate effect in a world where agents make forecasting errors but eventually will correct them?

 on real output?

• on the price level?
• on inflation?
• on real interest rates?
• on nominal interest rates?

Deficits and Inflation

 What is the impact of the deficit created by the fiscal stimulus (anticipated or unanticipated) on:

• interest rates?
• sustained inflation?
• the price level?

Unanticipated Monetary

Stimulus II

r

Y

p

SP

LP

IS’

Y

LM’

1. Left with a situation where inflation turned out to be different than agents forecast it to be (YN < Y). 2. State of the economy can’t remain here indefinitely unless we assume that agents never correct their forecast errors!
2. Will the policy be cancelled? Will inflation cut the LM back? Will YN increase? YN

Anticipated Monetary

Stimulus I

 Issues here are the same as in fiscal policy:

• is the pre-announced policy taken seriously, so that agents react to the information?
• how do agents make forecasts of inflation (form inflation expectations)
• if agents make forecast conditional on future values of exogenous (including fiscal and monetary policy variables, how accurate are their forecasts and are they free to act?

Anticipated Monetary

Stimulus III

r

Y

p

SP

LP

LM

IS

SP’

1. Since Y must = YN, new IS-LM intersection must occur at Y=YN.
2. Increase in P that results from a perfect forecast of inflation will shift the LM back to its original position (since IS is not shifted by monetary stimulus).
3. real rate unchanged
4. ex-post nominal rate higher.

LM’

Anticipated Monetary Stimulus

IV

 Does this end the story of the response to a monetary stimulus when conditional forecasts of inflation are accurate?

 Depends on the nature of the monetary shock

• changes in the level of the nominal money stock.
• changes in the growth rate of the nominal money stock.