XVI. Oil shocks and disinflation policies (1973-1985)

1. XVI. Oil shocks and disinflation policies (1973-1985)

2. XVI.1 Stagflation of 1970s • Stagflation: inflation + unemployment + low growth • US as well as Europe • Trigger: oil shocks, 1973 and 1979 • In 1973-4 and in 1979-1982, two dramatic increases in price of oil: 1960: 100, 1972: 93, 1974: 135, 1982: 264 • Increase in oil price →substantial increase in P without a link to change in wages (and unemployment) • Economic policies were not able to react immediately → problems lasted till 1980s

3. Main indicators, 1963-2005

4. US data

5. What policies? • Stagflation: challenging framework for policy decisions • Keynesian: so far based on inflation vs. unemployment trade-off, no use • Monetarist: provided credible explanation what happened, but the advice for stable increase of money supply was not of much help either

6. Rational expectations and policy credibility • Anticipated policies → immediate adjustment towards new equilibrium, consistent with natural values • Un-anticipated → new equilibrium, but not at natural values, i.e. with higher inflation or higher unemployment • Effective policy: must be credible, i.e. agents must believe that authorities will indeed pursue that policy that they announce

7. Difficult policy options after 1973 • Oil shocks: un-anticipated, economy reacted according new-classical theory • Price increase, contraction, higher unemployment • Policy response: difficult, see Case study I bellow • Disinflation after 1979: mainly the problem of credibility – will the authorities hold monetary contraction? • See Case study II bellow

8. XVI.2 Case study:Oil shock, part I 1973-1979: Monetary expansion

9. Effect on prices • Oil and energy inputs more expensive → all prices oil importing countries up • Expectations: price increases will continue • Both in US and Europe – accumulated inflationary pressures via wage negotiations already from 1960s • Speculative hoarding of commodities stocks

10. Effect on output • Sharp price increase→ fall of AD → fall of output • Sharp increase of unemployment • Stagflation: inflation with unemployment

11. Effect on CA • Oil importing developed countries: sharp decrease (deficit), later improvement (as spending on imports fell down) • OPEC countries: sharp increase (surplus), investing the revenues (“petrodollars”) in developed countries • Oil importing developing countries: mild deficits (lower energy intensity) • No problem how to finance deficits (out of petrodollars)

12. Policy options • Both internal and external disequilibria, need for action, options • Return to fix? • Danger of speculative attacks • Monetary contraction to fight inflation? • It seemed as politically unfeasible • Monetary expansion to fight unemployment • Selected policy, consequences?

13. Monetary expansion • US immediately 1974, Europe much later (1978) • US: • Output recovery, unemployment improved • Further inflation, larger than Europe • Depreciation, both nominal and real • CA deficit: contrary to model, as depreciation helps exports; here domestic expansion fostered imports (despite that more expensive), due to continuing recession in Europe, no demand for exports → deterioration of the deficit

14. Crucial consequences for developed countries • Weak dollar – psychological impact on US population • Entirely different understanding about scarcity of energy resources • US – growth resumed and unemployment – at least partially – improved • Europe – growth resumed as well (not as in US), unemployment persistent

15. XVI.3 Case study:Oil shock, part II 1980-1985: US Monetary Contraction and Fiscal Expansion

16. The burden of inflation • Very high US inflation through 1970s • Due to monetary expansion when fighting unemployment of 1970s • Eroding the health of US economy • 1979: new FED’s chairman Paul Volcker • Strong commitment to monetary contraction to lower inflation • Credibility problem • January 1981: President Ronald Reagan • New economic policies, based on tax cuts, anti-inflationary policies and support to private business • Later (1983): fiscal expansion, mainly due to political reasons (military expenditures)

17. Supply side economics • Lower taxes ↔ incentives to private sector to increase both effort and productivity • Strategy: lower tax means higher budget deficit now, but stronger growth in the future and larger tax revenues with deficit improvement in the future • Supply side economic, Laffer curve Tax revenue Tax rate 0% 100%

18. The data

19. A detour: policies in large open economies • No longer small country assumption • No prevailing world interest rate • Changes in inflation and output do influence inflation and output in other economies • Changes to policy effects compared to M-F model • Monetary expansion: domestic output up, domestic currency depreciates, foreign outputs ambiguous • Fiscal expansion: domestic output up (different from standard M-F model in Lecture XII), home currency appreciates, foreign output up

20. XVI.3.1 Reducing the inflation

21. The costs of disinflation • Sacrifice ratio: the amount of lost output during the period of reducing inflation • Keynesian view: sacrifice ratio large, due to price and wage rigidities • Monetarist view: • there is always some sacrifice ratio • Probably much lower than Keynesians believe • Depends on institutional adaptations and – mainly – how quickly people adapt their expectations (AEH) • New classical school (rational expectations) • If policies credible (anticipated) → sacrifice ratio might be close to zero • If policies not credible (un-anticipated) → sacrifice ratio might be substantial

22. Monetary restriction after 1979 • Strong, convincing commitment to monetary restriction, quick change of expectations and quick impact: • Real interest ↑, Y↓, P ↓, real (and nominal) appreciation of USD • The credibility problem: most people did not believe that Reagan/Volcker team will be politically strong to reduce inflation quickly • Behaviour according rational expectation models: un-anticipated policy → decrease of output and increase of unemployment • Whenever credibility established → growth resumed and unemployment started to fall • Strong monetary contraction and subsequent volatility of macroeconomic parameters → impact on the position of USD • Originally, very strong commitment towards floating ExR without intervention (“benign neglect”)

23. Other countries’ reaction • Usually: appreciation of domestic currency seen as welcome by foreign countries (positive effect on exports) • Different attitude in 1980-81: low US inflation relatively increased inflation in foreign (European) countries → additional inflationary pressure in European economy → monetary contraction in Europe (and Japan) as well • Technically, contraction as a result of intervention against USD’s appreciation → sale of USD assets (to undermine USD), i.e. money restriction

24. Effects of Monetary Contraction • 1980-1982 – US economic development dominated by the effects of monetary contraction • M.-F. model’s prediction: in case of flexible exchange rate monetary policy is efficient, see data: • Output contraction • Real appreciation of USD • Inflation sharply down • Remark: US is large economy, interest rate is not fixed on the “world” level

25. World recession after 2nd oil shock Difficult coincidence: • Second oil shock • Monetary restrictions in all major parts of the world • Lack of forex policy coordination → deep recession worldwide, the most serious after Great Depression

26. Effects of Fiscal Expansion • After 1982 – stronger effect of fiscal expansion • Reagan: additional military expenditures • M.-F. model: fiscal policy less efficient, but here model’s predictions did not come true fully • There was a further appreciation of USD, in accord with M.-F. • There was a strong expansion of output, contrary to original version of M.-F. model • US is a large economy, interest rate is not fixed and appreciation is consistent with interest rate decrease → stimulation of AD and output

27. XVI.3.2 Exchange rate policies

28. Twin deficits and consequences • Increased military expenditures outweighed increased tax revenues due to faster growth • The budget deficit further deteriorated • Continuing USD appreciation slowed exports and increased imports • Trade deficit started to increase • Result: US economy started to mount both trade and budget deficits → the problem of twin deficits • Strong deficit and strong USD → calls for protectionism in the US, threat to overall world trading system → need for ExR adjustment, i.e. need for an intervention

29. Plaza Agreement • September 22, 1985: officials from US, UK, France and Germany announced a joint intervention to depreciate USD • Given strong commitment → change in expected ExR → drop of USD immediately next day • Accompanied by slight monetary expansion → continuous decline of USD in 1986-87, US interest rates down relative to other countries • Second half of 1980s: • much stronger growth, world out of recession • lower unemployment • resumption of world trade • macroeconomic stabilization

30. XVI.4 Conclusions from oil shocks • Stagflation – a phenomena, neither known and expected by both economists and public • Keynesian economics (and policies) on retreat • Disinflation policies of 1980s opened a new era in economic policies • Success in reducing the inflation • International economics and coordination • The role monetary policies and of Central Banks • Twin deficits and period of weak USD

31. Open issues • Fix of float? – never ending story • Should there be an international coordination on exchange rates policies? • Anti-inflationary policies emerged as a pivotal element in economic policy making • Expectations as a central notion both in economic theory and practice (see next Lecture) • The start of formation of the framework of macroeconomic policies for 21st century (see the last Lecture)

32. Literature to Ch. XVI • Krugman, Obstfeld, ch.19 • Snowdon, Vane, Modern Macroeconomics, Edvard Elgar, 2005 (part 5.5.3) • Romer, Ch., Romer, D., Reducing Inflation, The University of Chicago Press, 1997