ECO 348 class 2

Paul Krugman

Our goal today is to cover the mainstream interpretation

of slumps like the one were still in
What is mainstream? Good question
Deep division in academic macroeconomics freshwater/
saltwater
Deep division in policy circles confidence versus multipliers
Much less division in applied research: IMF, central banks,
private-sector forecasters
Strategy: teach the mainstream, then the controversy

So, the mainstream interpretation is that were suffering

from inadequate aggregate demand
How is that possible? Dont people have to spend their money
on something? (Says Law)
No income = spending is an accounting identity, it doesnt
tell you which way the causation runs

The IS curve

But what determines the interest rate?

You might want to say supply and demand for funds
but thats already taken account of in the IS curve
Income = Consumption + Savings = Consumption + Investment
If planned expenditure = income = actual expenditure,
desired savings = planned investment
So something else has to be brought in: Liquidity preference

IS-LM says r adjusts to match supply and demand for M

In the modern world, central banks control the quantity

of reserves + currency; they use this power to set short-term
interest rate targets.
Well come back later to IS-LM or version thereof; but for
most purposes you want to think of determination of rates
as reflecting not a what but a who:

How do we think about central bank policy?

Central banks have mandates, things theyre supposed to achieve
For many its just a target inflation rate, usually around 2

For the Fed its both stable prices and full employment
Not necessarily that much difference: stable inflation at 2
percent probably requires more or less full employment

One way to think of CB behavior is optimal control:

carefully calibrating policy to hit targets
But often we think in terms of simple rules of thumb

Taylor rule was originally proposed as a way to guide the

Fed; now its often used to describe the Fed and other
central banks
Taylor rule sometimes written in terms of unemployment,
sometimes in terms of output gap (how far economy operating
below capacity

What if theres a really severe negative shock?

Interest rate

MP

Output
IS1

Monetary policy loses traction

IS2

Assume b=c for simplicity:

Zero lower bound aka liquidity trap

A couple of side notes about interest rates:

1. The central bank controls short-term rates

2. Long-term rates reflect expected future short rates
3. LT rates may also reflect a term premium
4. Private sector borrowing costs add in a risk premium
So the central bank may have some power even at the ZLB:
it can try to manage expectations (also expected inflation),
it can buy long-term bonds and maybe private or quasi-private
bonds quantitative easing. But not easy

A note on alternative views:

Real business cycle theory has been very influential in
academic macroeconomics; it argues that recessions are
normally supply-side, not demand-side shocks, driven by
technological setbacks

The technology story is hard to tell for 2008-, but many argue
that policy shocks expectations of future tax hikes, health
reform, whatever, have reduced supply
Also widespread assertions of structural problems with labor
force, etc.

Well look at evidence in later classes. But the story weve just
told is what most policy analysts believe

So, whats different about these times?

Not just severe recession and depressed economy, but loss
of the usual tools to fight a slump
Monetary policy is the usual line of defense but now has hit
limits, and unconventional monetary policy faces fierce opposition
Fiscal policy becomes much more effective but deficits soared
in the slump, and many people pushing to spend less, not more
In short, confusion, conflict, and ineffective policy
Otherwise, things are great