What Is the Impact of an Expected Fall in Inflation When an Economy Is in a Liquidity Trap - Assignment Example

Decide by Contents What is the impact of an expected fall in inflation when an economy is in a liquidity trap? 3 What difference does the Pigou effect make to a model of aggregate demand? 5 Use a model of aggregate demand based on IS and MP curves to show why policymakers often place particular emphasis on preventing expected deflation. 8 How should we model the possible effects of Quantitative Easing following the Great Recession? How well can these impacts are illustrated in a model of aggregate demand based on IS and MP curves? 12 Discuss the actual effects of QE in a country of your choice. 15 What is the impact of an expected fall in inflation when an economy is in a liquidity trap? The aim of most of the central banks is to keep the inflation level at lower level along with output at its anticipated level. The authorities have to work under a certain level of uncertainty about the state of the economy and lag the response of the economy towards actions of monetary policies. It is not possible to ignore the unanticipated shocks in demand and supply. Since uncertainties are associated in the economic planning the central banks o the concerned authorities try to look forward and make optimal use of the available information to forecast the macroeconomic indicators. The economic planning policies are planned in manner to respond towards the forecasted values in best possible fashion. Inflation is one such macroeconomic indicator. The sustained increase in the level of prices in an economy is regarded by the term inflation (Svensson, 2003, p. 1). A liquidity trap is described by a situation where injections of funds into the banking system by the central banks lack the potential to pull down the interest rates and in turn economic growth is at stake. A liquidity trap occurs when people take the initiative to hold cash and therefore there is no liquidity of money in the economy. The expected occurrence of deflation or insufficient aggregate demand can pave the way for liquidity trap to take place. The forecasted level of inflation and output can get influenced by subsidized negative shock to aggregate demand, correlation of overoptimistic growth as well as productivity expectations, uncertainties on future behaviour of other indicators and reckless fiscal policies. Researchers opine that in order to make monetary policy effective during recession it is required to stimulate the economy by creating price inflation. The immediate response to too low inflation is to lower the instrument rate of central bank (European Central Bank, 2003, p. 23). A low interest rate in the short run coupled with sluggish private sector inflation expectations will lower the short real interest rate. In an economy under liquidity trap, if the level of inflation falls, the money supply will get stimulated. Since inflation has taken the downturn the people will now be inclined to spend more and the liquidity of the economy will rise. The borrowings will occur and the banks will gain the potential to lend. This strategy is often adopted by the authorities to stimulate liquidity in the economy. The new spending will break the trap. The increase in expenditure will raise the aggregate demand which in turn will raise productivity and output levels. Therefore it can be anticipated that the economy will itself again on the growth path. Conventional monetary policy lacks the desire to provide sufficient stimulus to the economy. The problem is that the economy is ten saturated with liquidity and the central bank must take the initiative to expand the monetary base. During the liquidity trap the expenditures made by the public contracts which affect the level of aggregate demand. Since there is a fall is aggregate demand, there remains excess supply in the economy and the prices fall. The fall in aggregate demand leads to fall in fall in output productivity which poses serious concerns over the economy as growth or progress of the economy stops (Buiter, 2001, p. 2). So it is necessary to keep money circulation in the money as if people decides to hold money there will be no transaction in the economy and the financial system will crash. Prolonged fall in inflation had more serious concerns. When an economy falls under liquidity trap employment rate suffers. Job loss occurs in the economy and therefore the purchasing power of the economy hampers. Again when the economy finally finds the way to break the trap people regain their jobs, more opportunities of employment open up and the purchasing power of the people rises. Overall development in the economy takes place. Therefore expected fall in the level of inflation will pave the path for the economy to break the liquidity trap. What difference does the Pigou effect make to a model of aggregate demand? Pigou effect is used to denote the relationship between consumption, wealth, output and employment during the periods of deflation. It defines wealth as supply of money by current level of prices and states in situation of deflation of prices, the level of employment will rise along with increase in the level of wealth. The Pigou effect creates a mechanism for the economy to escape from the liquidity trap through rise in unemployment, fall in price level, rise in real balances and consumption level. The introduction of the Pigou effect moves the economy shifts the economy towards full employment. The inclusion of Pigou type real wealth effect in the market for Keynesian goods implies that a rise in the price levels leads to fall in real wealth while the consumption falls at each income level keeping other things constant. At each income level the level of savings raises which shifts the savings function upwards. A price rise in this case will only lead to rotate the LM curve anti clockwise while the IS curve shifts to the left as shown in the figure below. The next figure shows the aggregate demand curve in the new situation i.e. after inclusion of the wealth effect. At the initial price P0, the IS curve is denoted by IS0 and the LM curve has been denoted by LM0. The equilibrium real interest rate is Y0. Now in this situation if the price rise to P1 the shifts in the IS and the LM curve will lead to new equilibrium level of real interest rate at Y1. The new equilibrium of real interest rate is lower than the old equilibrium level which was in absence of wealth effect. The inclusion of Pigou effect is leading to flattening of the aggregate demand curve. In these cases the aggregate demand curve will slope downwards at all income levels since fall in prices will stimulate the equilibrium output demanded. The possibility arises simply because the inclusion of the Pigou effect in the model will leads to shift of the IS curve to the right and generates clockwise movement of the LM curve. The movement of the IS curve will produce downward sloping aggregate demand curve. The introduction of the Pigou effect leads to vertical aggregate demand curve at less than full employment (Murray and Bhaskar, 1976, p. 103-105). The combination of the vertical aggregate demand curve and vertical aggregate supply curve at full employment situation as stated by the classical labour market will produce a market situation where unemployment will be the outcome and prices and prices will suffer from the spiralling effects. The Pigou effect downward nature of the aggregate demand curve and the aggregate demand curve and the aggregate supply curve will intersect at the full employment situation if classical labour market conditions exist. The inclusion of the Pigou effect implies as long as classical labour market conditions are prevailing the market will tend to move towards full employment and can only be prevented by the hypothesis of wage rigidity as employed in the Keynesian system. It implies that the implication of Keynesian analysis of the possibility of equilibrium at less than full employment is based on the hypothesis of wage rigidity. Use a model of aggregate demand based on IS and MP curves to show why policymakers often place particular emphasis on preventing expected deflation. The deflationary forces are fundamentally structural. The real interest rate prevailing in the economy is negative and therefore even with near zero nominal rate of interest the economy is underemployed and produces deflation if policy makers continues to ignore the expectations. The reason of deflationary twist implies that an economy is positive real interest rate can get into deflation if the policy makers are too cautious. The time they realize the seriousness of the problem it is too late. Consider a simple ISLM model where inflation expectations are adaptive rather than being rational. In this case people make expectations on the basis of past expectations rather than expecting the future government policies. In the model it has been assumed that anticipated inflation rate that enters into the process is same as the rate anticipated affecting the spending decisions. The economy is closed in the model. The deviation of real output from the natural level depends on real interest rates. y = a - b(i - n), n is anticipated inflation rate and i is nominal interest rate. The demand for real balances is dependent on real interest rate as well as income. m - p = c + dy – ei The augmented Phillips curve contributes in determining the rate of inflation. dp/dt = hy + n The anticipated rate of inflation and the actual rate of inflation gradually adjust. dn/dt = k(dp/dt - n) The monetary policy assumes constant growth of supply of money. dm/dt = g The figure below represents the dynamics of the model. The arrows point out towards the dynamics of the system. At the natural level of output, the expected inflation rate does not change. The schedule is downward sloping since high anticipated inflation means higher observed inflation and also represents larger supply of money. The second schedule is flatter than the first. An increase money supply leads to higher expected inflation in the long run and smaller supply of money. As output falls and inflation is on the rise, stagflation is eminent in the economy. The next figure shows the dynamics of the model after incorporation of liquidity trap. In this case a zero lower bound on the interest rate has been introduced. The interest rate depends on expected inflation rate and supply of money. The dotted line in the above figure depicts the zero bound interest rate. In the above case the schedules make a sharp left turn which makes money supply irrelevant at the margin and therefore the schedules become flat while inflation as well as output depends only on anticipated rate of inflation. The equilibrium inflation rate is zero in this case while the equilibrium real interest rate is positive. The economy can still find itself in liquidity trap if people anticipate rapid deflation. If the economy falls below the line of y=0 it will witness excess capacity and will also fall below i=0. In other words it falls under the liquidity trap. The output gap worsens as nominal interest rate cannot fall and the gap in output feeds the anticipations of deflation. Once the economy is trapped under the deflationary spiral, the growth of money supply fails to accelerate the growth process (Massachusetts Institute of Technology, 2012, p. 2-5). How should we model the possible effects of Quantitative Easing following the Great Recession? How well can these impacts are illustrated in a model of aggregate demand based on IS and MP curves? The common perception states that increasing money supply leads to rise in prices. The perception assumes no change in quantity of goods. Prices can take the declining curve if increase in money supply is less than the change in quantity of goods. Therefore the assumption of in change in quantity of goods is not realistic and the point of Quantitative easing and stimulus packages from the part of the government was to raise employment opportunities and output levels. The supporters of money growth states inflation camp to be impossible. Inflation occurs when the central bank forces the people to hold more cash in reserves than they really want and the surplus is spent rapidly causing inflation in proportion to increase in supply of money. The authorities can take the help of two ways to create money. One is purchase of government securities and the other is loans to the private banks. The later means contributes in creating brand new cash demand even if the central bank does not intervene. Researchers opine quantitative easing to be the causing factor of inflation. Firms want to increase their productivity, hire more workers if the interest rates are on the declining curve and the banks have excess reserves (Harvey, 2011). The increase in money supply will decrease the rate of interest. The impact of increase in money supply will only benefit if GDP increases. In this case the increase in money supply can potentially increase GDP by lowering constraints to home buyers. It has been assumed that there is sufficient demand and an increase in the investment in goods market. The increase in the rate of investment will shift the IS curve to the right while the LM curve is basically flat since the rate of interest is at zero percent. No one expects the investment to surpass the point where the LM curve becomes flat. The interest rate is already low and so it is not possible for the authorities to make it easier for the people to borrow money, usually a stimulus tool (Weiss, 2012). Discuss the actual effects of QE in a country of your choice. In United States the Federal government plays a progressively livelier role in recital of the economy through the use of various financial tools. The popular measure is to set the interest rates in the short run which have the potential to influence the economic trends. In order to contain with inflation central banks maintain high rates of interest. In the recent years the federal government cut the rates to zero which acted to be the constraint in reducing the interest rates further. The problem prompted the government to turn into quantitative easing (Krishnamurthy and Jorgensen, 2011, p. 2). In the middle of 2008 in the phase of global recession the federal government was forced to turn towards quantitative easing. The program lacked to have significant impact in the initial stages and so the authority announced expansion of the program in 2009. After the program got wrapped up trouble emerged. The country got exposed to slower growth, the ill effects of the European debt crisis created a vicious circle. The financial market got destabilised further. Uncertainty accrued in the financial system. The federal government moved into the second round of quantitative easing, which involved purchase of short term debts amounting to 600 billion dollars. The second round of quantitative easing ran from November, 2010 to June, 2011. In spite the quantitative easing sparked rally in the financial markets it failed to contribute in the sustainable economic growth. The conclusion of the second round of quantitative easing was the same as the first round of quantitative easing followed by weak economic data as well as poor performance in the stock market. The market began to expect to expect another round of quantitative easing. The third round of quantitative easing was introduced in September, 2012 (Chen, Filardo, He, and Zhu, n.d., p. 3). The federal government announced to keep the short term interest rate lower till 2015. In this round the government can pump in money into the economy for indefinite period. References Buiter, W. 2001. The Liquidity Trap in an Open Economy. [pdf]. Available at: http://www.willembuiter.com/openliq.pdf. [Accessed: 19th January, 2013]. Chen, Q., Filardo, A., He, D. And Zhu, F. n.d. International spill overs of central bank balance sheet policies. [pdf]. Available at: http://www.bis.org/publ/bppdf/bispap66p.pdf. [Accessed: 19th January, 2013]. European Central Bank. 2003. INFLATION TARGETS AND THE LIQUIDITY TRAP. [pdf]. Available at: http://www.ecb.int/pub/pdf/scpwps/ecbwp272.pdf. [Accessed: 19th January, 2013]. Harvey, T. 2011. The Real Impact of Quantitative Easing (Next to Nothing!). [online]. Available at: http://www.forbes.com/sites/johntharvey/2011/11/16/real-impact-of-qe/. [Accessed: 19th January, 2013]. Krishnamurthy, A. And Jorgensen, A. 2011. The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy. [pdf]. Available at: http://www.brookings.edu/~/media/Projects/BPEA/Fall%202011/2011b_bpea_krishnamurthy.PDF. [Accessed: 19th January, 2013]. MacKenzie, D. 2008. Liquidity Traps versus Inflation Traps. [online]. Available at: http://mises.org/daily/3266. [Accessed: 19th January, 2013]. Massachusetts Institute of Technology, 2012. DEFLATIONARY SPIRALS. [pdf]. Available at: http://web.mit.edu/krugman/www/spiral.html. [Accessed: 19th January, 2013]. Murray, D. And Bhaskar, K. 1976. Microeconomic Systems. Taylor & Francis, UK. Svensson, L. 2003. Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others. [pdf]. Available at: http://people.su.se/~leosven/papers/jep2.pdf. [Accessed: 19th January, 2013]. Weiss, A. 2012. The Fed’s Action and IS-LM. [online]. Available at: http://www.politicalcreativity.net/?p=293. [Accessed: 19th January, 2013]. Read More