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MACROECONOMICS PAPER

Three Journal About Macroeconomics, Fiscal Policy,


and Mundell - Fleming
Lecture : Dias Satria SE., M.App.Ec.

Andistya Oktaning Listra (0910210022)


Faculty Of Economy
Economic Development Major
University Of Brawijaya Malang
A. Natural Disasters Impacting a Macroeconomics Model with
Endogenous Dynamics
RESUME
Natural disaster might depend on the pre-existing economic situation. The
recovery effect from the additional activity due to reconstruction might, in fact, have
compensated, at least partly, the direct damages of the disaster. Investigating this
problem requires one to model economic fluctuations, and macroeconomists are still
quite divided on how best to do this. The dominant one today is known as real
business cycle (RBC) theory and is implemented within Stochastic Dynamic General
Equilibrium models. It originates from embedded into the general equilibrium
framework with rational expectations. This theory assumes that economic fluctuations
arise from exogenous shocks and that the economic system is otherwise stable. The
second one is Endogenous Business Cycle (EnBC) theory, which proposes that
economic fluctuations are due to intrinsic processes that endogenously destabilize the
economic system. The existence of these two alternative theories of economic
fluctuations is a significant obstacle in attempting to assess the economic cost of
natural disasters. Overcoming the controversy between the RBC and EnBC theories
and achieving a constructive synthesis between the two would thus reduce in a
significant manner uncertainties in the assessment of disaster and policy costs. On the
other hand, investigating the consequences of exogenous shocks, like natural
disasters, can also provide useful insights into economic behavior in general and help
achieve a unified theory of business cycles.

Non-Equilibrium Dynamic Model (NEDyM) exhibits business cycles that


reproduce several realistic features of the historical data which natural disasters
destroy the productive capital through the use of a modified production function and in
which reconstruction investments are explicitly represented. NEDyM to show that the
particular phase of a business cycle matters greatly in assessing the economic impacts
of natural disasters. In our EnBC model, this impact is enhanced by internal economic
processes when the shock occurs during an expansion phase, while the opposite is
the case during a recession. The NEDyM investment flexibility summarizes many
characteristics of an economy, and differences in can arise from many factors:

a. Investing more requires producing more investment goods, and this cannot be
done instantaneously.

b. What is true for the productive capital is also valid for human capital.

c. Differences in capital market and financial situation can explain differences in


investment flexibility at the firm level , also making a difference between
developed and developing countries.

d. Investment flexibility depends on company management and cultural factors.

To evaluate how the cost of a disaster depends on the pre-existing economic


situation, we apply the same loss of productive capital at different points in time along
the models business cycle. To assess the total GDP loss, we use the difference
between the 20-year total production in a baseline scenario, with no disaster, and the
20-year total production in the disaster scenario; no discounting was applied in
assessing this difference.

CHAPTER 1

INTRODUCTION

Benson and Clay (2004), among others, have suggested that the overall cost of
a natural disaster might depend on the pre-existing economic situation. The recovery
effects from the additional activity due to reconstruction might, in fact, have
compensated, at least partly, the direct damages of the disaster. Investigating this
problem requires one to model economic fluctuations, and macroeconomists are still
quite divided on how best to do this. Two main theories have attempted, over the
years, to explain the causes and characteristics of business cycles. The dominant
one today is known as real business cycle (RBC) theory and is implemented within
Stochastic Dynamic General Equilibrium models with rational expectations. This
theory assumes that economic fluctuations arise from exogenous shocks and that the
economic system is otherwise stable. The second one is Endogenous Business Cycle
(EnBC) theory, which proposes that economic fluctuations are due to intrinsic
processes that endogenously destabilize the economic system Both theories have
their successes and shortcomings, but it is RBC theory that garners consensus in the
current economic literature.

The existence of these two alternative theories of economic fluctuations is a


significant obstacle in attempting to assess the economic cost of natural disasters,
such as hurricanes or earthquakes, or of other exogenous shocks, e.g., the
implementation of climate policies aimed at reducing the emissions of greenhouse
gases. Indeed, to carry out such an assessment, one has to decide first within which
macroeconomic setting to work, as the underlying economic hypotheses can strongly
influence the results. Overcoming the controversy between the RBC and EnBC
theories and achieving a constructive synthesis between the two would thus reduce in
a significant manner uncertainties in the assessment of disaster and policy costs. On
the other hand, investigating the consequences of exogenous shocks, like natural
disasters, can also provide useful insights into economic behavior in general and help
achieve a unified theory of business cycles. The validation of RBC and EnBC models
against 3the history of past disasters could provide evidence in support of such a
unified theory. To do so, we apply the Non-Equilibrium Dynamic Model (NEDyM) of
Hallegatte et al., which exhibits business cycles that reproduce several realistic
features of the historical data. We introduce into this model the disaster-modeling
scheme of Hallegatte et al, in which natural disasters destroy the productive capital
through the use of a modified production function and in which reconstruction
investments are explicitly represented. In the latter paper, however, disasters were
investigated in an economy initially at equilibrium. The main contribution of the
present article is to consider a fluctuating economy, and to investigate the sensitivity
of the economic consequences of natural disasters with respect to the phase of the
business cycle. From this, we summarize the main features of NEDyM emphasizing
the role of investment flexibility in the model solutions’ behavior.
CHAPTER 2
RESEARCH QUESTION
1. Why endogenous dynamic in macroeconomics model impacting by
natural disaster?

2. Why natural disasters also influence financial condition in the country?

3. How about macroeconomics cost of natural disaster?

4. How about the catastrophic natural disaster and economic growth?

5. What is endogenous business cycles and the economic response to


exogenous shocks?

6. Why long term policy consequences of natural disasters?

7. Describe the implications for relief and post-disaster reconstruction?

8. What is political model of natural disasters?

9. What we should be looking at are the underlying social and economic


processes within developing countries which structure the impact of natural
disasters, rather than at disasters as unforeseen events requiring large scale
intervention?
CHAPTER 3
METHODS FROM MACROECONOMICS JOURNAL
1. The main changes applied to the basic Solow model, starting with its core set of
equations where Y is production, K is productive capital, L is labor, A is total
productivity, C is consumption, S is consumer savings, I is investment,

is the investment (or, equivalently, saving) ratio, ,, is the depreciation time, and
is the labor at full employment:
2. Goods market: A goods inventory H is introduced, opening the possibility of
temporary imbalances between production and demand, instead of a market
clearing at each point in time. Thus

This inventory can be either positive or negative and it encompasses all sources of
delay in the adjustment between supply and demand, including technical lags in
producing, transporting and distributing goods. Its situation affects price
movements:

Thus price adjustments do not operate instantaneously and the conventional


market clearing conditions are verified only over the long term.

3. Labor market : The producer sets the optimal labor demand that maximizes
profits, as a function of real wage and marginal labor productivity:

But full employment is not guaranteed at each point in time, because (i) institutional
and technical constraints create a delay between a change in the optimal labor
demand and the corresponding change in the number of actually employed workers:

and (ii) wages are partially rigid over the short term; they progressively restore the full
employment rate by increasing if labor demand is higher than and decreasing
when it is lower:

4. Household behavior : Like the Solow model, NEDyM uses a constant saving ratio but it
makes the tradeoff between consumption and saving more sophisticated by
considering that households (i) consume (ii) make their savings available for investment
through the savings, and (iii) hoard up a stock of money that is not immediately
available for investment.

5. Producer behavior : Instead of automatically equating investments and savings),


NEDyM describes an investment behavior “`” It introduces a stock of liquid assets F
held by banksand companies, which is filled by the difference between sales p(C+I)
and wages wL, and by the savings S received from consumers. Theseassets are used
to redistribute share dividends. Div and to invest in the amount pI. This formulation
creates a wedge between investment and savings, reflected by changes in F:
The dynamics of the system is governed by an investment ratio that allocates these
assets between productive investments and share dividends:

The producer’s net profit follows the accounting definition of profit that is gross
profits minus capital depreciation:

and the investment ratio follows the prognostic rule:

The distribution between dividends and investment depends on the expected net profits
per capital unit compared with a standard of profitability ν. If the expected net profit
per capital unit is higher than this standard, the producer increases his/her
physical investments; if, on the contrary, the expected profit is lower than ν, investments
are reduced. Assuming that observed values are the best guess of expected values at
each point in time leads to:

6. Cobb Douglas Function

Effective capital is K = ξK

is the potential productive capital, which is the stock of capital in the absence of any
disaster.
With this new function, a destruction of x% of the productive capital reduces production
by x%. The replacement of the productive capital K by the two new variables K0 and ξK
makes it necessary to modify the modeling of investment and to introduce the
distinction between regular investments, carried out to increase the production capacity,
and reconstruction investments that follow a disaster. To capture how these constraints
may impact the pathways back to equilibrium, we bounded by the fraction of total
investment that reconstruction can mobilize.
Long-term averaged GDP losses due to the distribution of natural disasters for
different types of economic dynamics of the table) or very low (not shown), the
economy is incapable of responding to the natural disasters through investment
increases aimed at reconstruction. Total production losses, therefore, are very large,
amounting to 0.15% of GDP when the flexibility is null. Such an economy behaves
according to a pure Solow growth model, where the savings, and therefore the
investment, ratio is constant.

When investment can respond to profitability signals without destabilizing the


economy, i.e. when αinv is non-null but still lower than 1.39, the economy has a new
degree of freedom to improve its situation and respond to productive capital shocks.
Such an economy is much more resilient to disasters, because it can adjust its level
of investment in the disaster’s aftermath: for αinv = 1.0 (second row of the table),
GDP losses are as low as 0.01% of GDP, a decrease by a factor of 15 with respect to
a constant investment ratio, thanks to the added investment flexibility.
CHAPTER 4
PREVIOUS STUDIES OR REFERENCES
A). 1. TITLE

Understanding the Economic and Financial Impacts of Natural Disaster by


Charlotte Benson and Edward J. Clay

2. FORMULATION OF THE PROBLEM

1. What is the impact of natural disasters in economic, financial, and public


policy?

2. Can disasters impose continuing pressures on public finance to the extent


that governments undertake mitigation and preparedness measures?

3. How about financial inventory to overcome lack of cost causes by natural


disasters risk in the future?

3. METHODS

1. The quantitative investigations are partial, involving a combination of


regression analysis, the use of charts to examine movement around trends,
and “before-and-after” comparison of disaster impacts and of forecast and
actual economic performance. The implied null hypothesis is that there is no
direct link between disaster shocks and the relevant aspect of economic
performance. Such analysis cannot always be definitive, but the results at
least provide a basis for further reflection and investigation. If impacts are not
apparent at an aggregate level, the analysis moves on to consider possible
effects within the composition of the relevant economic indicator. A qualitative
political-economic analysis is also employed in a complementary way to
place quantitative results within the specific economic and social policy
context of each case study country. Where similar qualitative results
repeatedly emerge from previous and current studies, this is taken to be
preliminary evidence of a more general finding about the economic
consequences of natural disasters.

2. A natural modeling option to represent disasters is to consider that they


reduce instantaneously the total productive capital K by an amount ∆K. To
avoid underestimating natural disaster impacts because of decreasing returns
in the production function the Cobb-Douglas production function by
introducing a term ξK, which is the proportion of capital that was not
destroyed. This new variable ξK is such that the effective capital is K = ξK ·
K0, where K0 is the potential productive capital, which is the stock of capital
in the absence of any disaster. Instead of replacing K by ξK ·K0 in Eq. (A-2),
we introduce the new production function:
With this new function, a destruction of x% of the productive capital reduces
production by x%. The replacement of the productive capital K by the two
new variables K0 and ξK makes it necessary to modify the modeling of
investment and to introduce the distinction between regular investments,
carried out to increase the production capacity, and reconstruction
investments that follow a disaster. Denoting by In the investments that
increase the potential capital K0, and by the reconstruction investments
that increase ξK, we have:

4. RESULT

Hypotheses:

The null hypothesis is that there is no relationship i.e. β1 = 0. We usually hope


HA is true. Look at the p value or sig value (based on a t statistic).

Y depend on X (Y depend on X factor for instance economic, financial, and


public policy which impacting by natural disaster)

Remember that we have a small sample and are trying to estimate a


relationship between variables in a target population.

• Consider Y = β0 + β1 X + ε.

• If X changes, Y must change.

• If X increase by 1 unit, Y increases by β1 units.

• Unless, of course, β1 = 0.

• Then Y doesn’t depend on X.

• This is how our test works

: β1 = 0 (Y does not depend on X).

• : β1 ≠ 0 (Y does depend on X)

A Priori Considerations

Sign tests:

• The coefficient of P should be negative.

• The coefficient of Y should be positive (probably).

• If the a priori signs do not agree with those in the estimated


model, the regression may be worthless.

• Also consider the magnitudes of the coefficients effect of a


regressor seem unbelievably large (or small).
Regression standard error

Forecast errors:

• The standard error is the average forecast error (difference


between actual and values predicted by the estimated equation).

• Small values indicate that the estimated model fits the observed
data closely (min SE = 0).

Goodness of Fit of the Estimated Parameters

• The standard error (SE) and ‘t’ statistics.

The smaller the value of SE of the regression, the better is the fit of the
regression line.

• ‘t’ statistic or t-ratio

RULE: If absolute value of the estimated t > Critical-t, then it is


significant.

Critical t , Large Samples,t ≅ 2N > 30Small Samples, critical ‘t’ is on


Student’s

t-table

D.F. = # observations, minus number of independent variables, minus


one. N < 30

Cobb Douglas Function

Effective capital is K = ξK

is the potential productive capital, which is the stock of capital in the


absence of any disaster.

With this new function, a destruction of x% of the productive capital


reduces production by x%. The replacement of the productive capital K by
the two new variables K0 and ξK makes it necessary to modify the
modeling of investment and to introduce the distinction between
regular investments, carried out to increase the production capacity,
and reconstruction investments that follow a disaster.

B)
1. TITLE

Catastrophic Natural Disasters and Economic Growth by Eduardo Cavallo,


Sebastián Galiani, Ilan Noy, and Juan Pantano

2. FORMULATION OF THE PROBLEM

1. What is natural disasters affect economic growth is ultimately an empirical


one?

2. What is the path of gross domestic product (GDP) of the affected country in
the absence of natural disasters and to assess the disaster’s impact by
comparing the counterfactual to the actual path observed?

3. Why endogenous growth models provide less clear-cut predictions with


respect to output dynamics?

4. How to estimate the impact of large disasters with comparative case


studies?

5. How about computational issues which affected by the catastrophic event


and the relationship with vector of post-disaster outcomes for the exposed
country and matrix of post-disaster outcomes for the potential control
countries?

3. METHODS

1. be the GDP per capita that would be observed for country i at time t in
the absence of the disaster, for countries i = 1……,J + 1, and time periods =
1………T . be the number of periods before the disaster, with
. be the outcome that would be observed for country i at time t if country i
is exposed to the disaster and its aftermath from period . Of course,
to
the extent that the occurrence of a large disaster is unpredictable, it has no
effect on the outcome before the intervention, so for t
we have that

2. be the effect of the disaster for country i at time t, if


country i is exposed to the intervention in periods

Note that we allow this effect to potentially vary over time. Again, the
intervention, in our context, is the disaster and its aftermath. Therefore:
Let be an indicator that takes value one if country i is exposed to the
intervention at time t and value zero otherwise. The observed output per
capita for country i at time t is :

3. Because only the first country (country “one”) is exposed to the intervention
and only after period

Our parameters of interest are the lead-specific


causal effect of the catastrophic event on the outcome of interest

4. The outcome variable of interest, say GDP per capita, is observed for T
periods for the country affected by the catastrophic event

and the unaffected countries

be the number of available post-disaster periods. Let be the

vector of post-disaster outcomes for the exposed country, and

matrix of post-disaster outcomes for the potential control


countries. Let the define a linear
combination of pre-disaster outcomes:

4. RESULT
One obvious choice for the set of linear combinations of pre-disaster outcomes

would be :

C) 1. TITLE

Irregular Growth Cycle by Richard H. Day (The American Economic Review)

2. FORMULATION OF THE PROBLEM

1. Why the interaction of the propensity to save and the productivity of capital
can lead to growth cycles that exhibit the wandering, in case not coverage to
a cycle of any regular periodic?

2. What is “chaotic” trajectories which unstable, errors of estimation in


parameters or initial conditions?

3. How about neoclassical model in Discrete times?

3. METHODS

1. Use mathematical theory of “chaos” which originated in the work of Edward


Lorenz. A formal definition of chaos and sufficient conditions for chaotic
transectories.

2. Provides a detailed analysis of Trygue Haavelmo’s growth model in an


application of overlapping generations model and forth coming study of the
classical growth model

3. Standard neoclassical growth model modified by introducing a difference


equation in capital labor ratio

4. RESULT

In which s is the saving ratio, f the per capita production function, and the
natural rate of population growth. Aggregate output is of course given by the
aggregate production function, where the aggregate
capital stock is and the supply of labor is = . The saving ratio
may dependence income, wealth, and the interest rate, but using y = f(k) and
the real interest rate , it reduces to a dependence on k alone.
CHAPTER 5
RESULT MACROECONOMICS JOURNAL

Hypotheses:

The null hypothesis is that there is no relationship i.e. β1 = 0. We usually hope HA is


true. Look at the p value or sig value (based on a t statistic).

Y depend on X (Y depend on X factor for instance economic, financial, and public


policy which impacting by natural disaster)

Remember that we have a small sample and are trying to estimate a relationship
between variables in a target population.

• Consider Y = β0 + β1 X + ε.

• If X changes, Y must change.

• If X increase by 1 unit, Y increases by β1 units.

• Unless, of course, β1 = 0.

• Then Y doesn’t depend on X.

• This is how our test works

: β1 = 0 (Y does not depend on X).

• : β1 ≠ 0 (Y does depend on X)

A Priori Considerations

Sign tests:

• The coefficient of P should be negative.

• The coefficient of Y should be positive (probably).

• If the a priori signs do not agree with those in the estimated model, the
regression may be worthless.

• Also consider the magnitudes of the coefficients effect of a regressor seem


unbelievably large (or small).

Regression standard error

Forecast errors:

• The standard error is the average forecast error (difference


between actual and values predicted by the estimated equation).
• Small values indicate that the estimated model fits the observed
data closely (min SE = 0).

Goodness of Fit of the Estimated Parameters

• The standard error (SE) and ‘t’ statistics.

The smaller the value of SE of the regression, the better is the fit of the regression
line.

• ‘t’ statistic or t-ratio

RULE: If absolute value of the estimated t > Critical-t, then it is significant.

Critical t , Large Samples,t ≅ 2N > 30Small Samples, critical ‘t’ is on Student’s

• t-table

D.F. = # observations, minus number of independent variables, minus one. N < 30

1. The main changes applied to the basic Solow model, starting with its core set of
equations where Y is production, K is productive capital, L is labor, A is total
productivity, C is consumption, S is consumer savings, I is investment,

is the investment (or, equivalently, saving) ratio, ,, is the depreciation time, and
is the labor at full employment:

2. Goods market: A goods inventory H is introduced, opening the possibility of


temporary imbalances between production and demand, instead of a market
clearing at each point in time. Thus
This inventory can be either positive or negative and it encompasses all sources of
delay in the adjustment between supply and demand, including technical lags in
producing, transporting and distributing goods. Its situation affects price
movements:

Thus price adjustments do not operate instantaneously and the conventional


market clearing conditions are verified only over the long term.

3. Labor market : The producer sets the optimal labor demand that maximizes
profits, as a function of real wage and marginal labor productivity:

But full employment is not guaranteed at each point in time, because (i) institutional
and technical constraints create a delay between a change in the optimal labor
demand and the corresponding change in the number of actually employed workers:

and (ii) wages are partially rigid over the short term; they progressively restore the full
employment rate by increasing if labor demand is higher than and decreasing
when it is lower:

4. Household behavior : Like the Solow model, NEDyM uses a constant saving ratio but it
makes the tradeoff between consumption and saving more sophisticated by
considering that households (i) consume (ii) make their savings available for investment
through the savings, and (iii) hoard up a stock of money that is not immediately
available for investment.

5. Producer behavior : Instead of automatically equating investments and savings),


NEDyM describes an investment behavior “`” It introduces a stock of liquid assets F
held by banksand companies, which is filled by the difference between sales p(C+I)
and wages wL, and by the savings S received from consumers. Theseassets are used
to redistribute share dividends. Div and to invest in the amount pI. This formulation
creates a wedge between investment and savings, reflected by changes in F:

The dynamics of the system is governed by an investment ratio that allocates these
assets between productive investments and share dividends:
The producer’s net profit follows the accounting definition of profit that is gross
profits minus capital depreciation:

and the investment ratio follows the prognostic rule:

The distribution between dividends and investment depends on the expected net profits
per capital unit compared with a standard of profitability ν. If the expected net profit
per capital unit is higher than this standard, the producer increases his/her
physical investments; if, on the contrary, the expected profit is lower than ν, investments
are reduced. Assuming that observed values are the best guess of expected values at
each point in time leads to:

6. Cobb Douglas Function

Effective capital is K = ξK

is the potential productive capital, which is the stock of capital in the absence of any
disaster.

With this new function, a destruction of x% of the productive capital reduces production
by x%. The replacement of the productive capital K by the two new variables K0 and ξK
makes it necessary to modify the modeling of investment and to introduce the
distinction between regular investments, carried out to increase the production capacity,
and reconstruction investments that follow a disaster. To capture how these constraints
may impact the pathways back to equilibrium, we bounded by the fraction of total
investment that reconstruction can mobilize.
Long-term averaged GDP losses due to the distribution of natural disasters for
different types of economic dynamics of the table) or very low (not shown), the
economy is incapable of responding to the natural disasters through investment
increases aimed at reconstruction. Total production losses, therefore, are very large,
amounting to 0.15% of GDP when the flexibility is null. Such an economy behaves
according to a pure Solow growth model, where the savings, and therefore the
investment, ratio is constant.

When investment can respond to profitability signals without destabilizing the


economy, i.e. when αinv is non-null but still lower than 1.39, the economy has a new
degree of freedom to improve its situation and respond to productive capital shocks.
Such an economy is much more resilient to disasters, because it can adjust its level
of investment in the disaster’s aftermath: for αinv = 1.0 (second row of the table),
GDP losses are as low as 0.01% of GDP, a decrease by a factor of 15 with respect to
a constant investment ratio, thanks to the added investment flexibility.

One obvious choice for the set of linear combinations of pre-disaster outcomes
would be :

In which s is the saving ratio, f the per capita production function, and the natural rate
of population growth. Aggregate output is of course given by the aggregate production
function, where the aggregate capital stock is and the
supply of labor is = . The saving ratio may dependence income, wealth,
and the interest rate, but using y = f(k) and the real interest rate , it reduces to
a dependence on k alone.

Policy Implications

The findings from the study have implications for national development and
macroeconomic policies, public finance, the generation and use of information, and the

financing of disaster costs. A precondition for improvement in all these areas is good
governance. National Development Policy and the Macroeconomic Natural hazards
warrant more serious consideration in the formulation of national economic policies and
strategies. Risk assessments should be made from a broad macroeconomic standpoint,
exploring areas of both sensitivity and resilience. Assessments should seek to
understand the underlying factors determining vulnerability, including the potentially
complex and dynamic interlink ages between various influences and the scope for risk
reduction. Vulnerability has to be assessed according to the particular type of hazard.

1. Regular assessment of hazard risk is required to ensure that risk management


strategies are appropriate. From a macroeconomic perspective, vulnerability can
shift quickly, particularly in countries experiencing rapid growth and socio economic
change, including urbanization.

2. For geographically large countries, where nation wide disasters are rare, regional
analysis is potentially more appropriate than country-level analysis for understanding
vulnerability and designing relevant policies.

3. Risk management necessarily involves the private sector and civil society, as well as
the public sector. The private sector should be encouraged and supported in
enhancing its understanding of natural hazard risks and adopting appropriate risk
management tools. Both structural and nonstructural measures may be required.

4. Post disaster reconstruction needs to be better planned and carefully orchestrated to


exploit potential organizational, technological, and other improvements that could be
made in rebuilding an economy while keeping priority development objectives on
track.

5. Governments should consider preplanning possible reconstruction and rehabilitation


programs on the basis of disaster scenarios and, within that, identifying critical
projects that should receive priority in post disaster funding. There is a case for
exploring economic policy options through disaster scenarios that include the likely
effects of fiscal changes and monetary measures in order to develop guidelines for
policymakers in responding to disasters (see “Public Finance,” below).
6. National or economy wide disaster impacts, including total financial losses, should
be reassessed as a matter of course 12 to 18 months after an event. This task might
be undertaken as part of an end-of-project report for a recovery loan or in a paper for
consideration at an annual consortium or roundtable meeting.

B. Fiscal theory, and fiscal and monetary policy in the financial


crisis
RESUME
Interest rates near zero, money and government bonds are nearly perfect
substitutes, especially for the banks and financial institutions at the center of economic
events. Conventional monetary policy analysis aimed at the split of government debt
holdings between “monetary” and “debt” assets seems rather irrelevant; the big events
seem to be the huge demand for both kinds of government debt, and the large interest
rate spreads that have opened up between government and non-government debt. The
massive fiscal deficits, credit guarantees, and Federal Reserve purchases of risky
private assets raises the question of the fiscal limits of monetary policy. All analyses of
monetary policy operate against a fiscal backdrop. At some point the fiscal constraints
of monetary policy must take hold. The fiscal price equilibrating mechanism feels
exactly like “aggregate demand.” Suppose the price level is too low. Then the value of
debt is higher than expected future surpluses. People try to get rid of government debt,
buying goods and services instead. This extra demand raises the price level to its
equilibrium level. More deeply, “aggregate demand” is really just the mirror image of
demand for government debt. The household budget constraint says that after-tax
income must be consumed, invested, or result in purchase of government debt. The
only way to consume or invest more is to hold less government debt.

However, there is somewhere a limit to how much taxes a government can


raise, so at some point any monetary policy runs into its fiscal limit. At some point, the
government cannot run a “Ricardian” regime, and inflation results no matter what the
government attempts regarding the split of its liabilities between money and bonds.
Argentina has found that limit. So far, the US may has not — if the fiscal theory governs
our price level, it is by choice. But there is some limit, some point where the government
simply cannot raise the present value of future surpluses, and US economists may be
rudely surprised when it arrives. In addition, interest rates on government bonds fell to
dramatic lows, including some negative rates. In combination with reserves paying
interest, the distinction between government bonds and money (reserves) was a third-
order issue for financial institutions, especially compared to the very high interest rates,
lack of collateralizability, and dramatic illiquidity of any instrument that carried a whiff of
credit risk. In short, financial institutions didn’t want more money and less bonds. They
wanted more of both, and less of other assets, and in massive quantities. The “special”
or “liquidity” services we usually associate with money applied with nearly equal force to
all government debt to these actors. The asset pricing literature has concluded that
time-varying discount rates account for essentially all stock market price fluctuations.
This event suggests that we might similarly account for “aggregate demand”
fluctuations by changes in the discount rate for government debt rather than (or as well
as) changes in expectations of future surpluses. People fly to quality quite generally in
recessions. Perhaps this flight is a crucial part of lower “aggregate demand.” MV = PY
with constant velocity (“stable money demand”) and long and variable lags seems a
likely casualty. The Fed has pretty clearly accommodated a large shift in money
demand. When that shift reverses, the Fed can (subject to a fiscal limit) reverse course
and soak up that money. Simply looking at current aggregates is not a serious sign of
future inflation.

CHAPTER 1

INTRODUCTION

The fiscal theory offers an attractive perspective. First, with interest rates near
zero, money and government bonds are nearly perfect substitutes, especially for the
banks and financial institutions at the center of economic events. Conventional
monetary policy analysis aimed at the split of government debt holdings between
“monetary” and “debt” assets seems rather irrelevant; the big events seem to be the
huge demand for both kinds of government debt, and the large interest rate spreads
that have opened up between government and non-government debt. Second, the
massive fiscal deficits, credit guarantees, and Federal Reserve purchases of risky
private assets raises the question of the fiscal limits of monetary policy. All analyses of
monetary policy operate against a fiscal backdrop. At some point the fiscal constraints
of monetary policy must take hold. That point may be coming faster than we think.

After a quick review of the fiscal theory, the following points:

1. Fall 2008 saw a large increase in demand for both money and government debt.
This makes sense in the fiscal theory as a deflationary decrease in the discount
rate for government debt. Many of the Government’s innovative policies can be
understood as ways to accommodate this demand, which a conventional swap of
money for government debt does not address.

2. Surpluses can generate inflation (the same thing as “stimulate” here) if people do
not expect future taxes. However, no irrationality or market failure is required for
this expectation. prospective deficits are just as “stimulative” as current deficits, the
Government’s announcements can be read both ways, and I show that we can
measure the state of private expectations in the bond market.

3. Credit guarantees make matters much worse than actual deficits suggest. I also
point out that since the present value of deficits matters, if taxes have any effect on
growth, the ‘Laffer limit’ of taxation may come much sooner than static analysis
suggests.

4. Fiscal inflations, and in particular inflations that come from collapsing expectations
of deficits, may have quite different output effects. Thus a fiscal inflation, an event
outside recent US experience, may well lead to stagflation, not recovery.
CHAPTER 2
RESEARCH QUESTION
1. Why fiscal theory of the price level focuses on the valuation equation for
government debt?

2. Will fiscal policy stimulus stimulate?

3. Why “aggregate demand” is really just the mirror image of demand for
government debt?

4. Can price level determine a frictionless economy?

5. Describe the two effects in credit guarantees which most obviously, having to
make good on these guarantees on top of large budget deficits can be the piece of
poor surplus news that kicks us against the fiscal limit and nominal credit
guarantees mean that government finances are much worse if the price level goes
down, and much better if there is inflation?

6. What is the measure of fiscal limit which determine by the price level in the
dynamic laffer curve?
CHAPTER 3
METHODS FROM FISCAL POLICY JOURNAL

1. The fiscal theory of the price level focuses on the valuation equation for government
debt,

where is the real stochastic discount factor, which we can also think of as a
discount rate are real primary surpluses. This
equation is an equilibrium condition, not a budget constraint. It operates just like the
standard asset pricing equation for valuing a stock as the present value of its
dividend payments. The Government may choose a “Ricardian regime” in which it
adjusts taxes and spending ex-post so this equation holds for any price level Pt, but
no budget constraint logic forces it to do so. Analogously, no constraint forces
Microsoft to raise earnings in response to an “off-equilibrium” or “bubble” in its stock
price.

2. More deeply, “aggregate demand” is really just the mirror image of demand for
government debt. The household budget constraint says that after-tax income must
be consumed, invested, or result in purchase of government debt,

3. The valuation equation (1) can determine the price level even in a frictionless
economy with . But to understand monetary policy with we also
need a money demand function, that captures the “special” nature of money,
4. The timing of the fiscal equation (1) is quite different with long-term debt. For
example, if debt consists of a constant coupon c that is redeemed each period, with
no other debt purchases and sales, then we have

5. Each period. Equation (1) still holds, but the market value of long term debt
fluctuates overtime as well as the price level. However, most US debt is rolled over
every few years, so if we take a time interval of a few years we will not go too far
wrong in the qualitative analysis

6. We can accommodate a “flight to quality” event in our fiscal framework by


recognizing that the discount rate for government debt declined dramatically.
In our fiscal framework, R declined in

7. In our fiscal framework, let Dt denote private debt owned by the government in
exchange for additional Treasury debt. Our fiscal equation becomes

8. The fiscal valuation equation

9. With one-period debt, the fiscal equation is

is debt issued at time t − 1,coming due at time t.

10.
11. Real revenue from debt sales are

12. where the nominal bond price is

13. Substituting from (4) at time t +1,we obtain

14. We also know from past fiscally - induced currency collapses that the turning point
comes suddenly and irretrievably, as do stock market collapses.

15. Nominal credit guarantees mean that government finances are much worse if the
price level goes down, and much better if there is inflation. Surpluses are not
independent of the price level. Our equation is really

We are used to thinking of the static Laffer curve, in which tax revenue T is
generated by a tax rate τ from income Y as and The marginal revenue generated
from an increase in taxes is
CHAPTER 4
PREVIOUS STUDIES OR REFERENCES
A).1. TITLE

Prospective Deficits and the Asian Currency Crisis by Craig Burnside, Martin
Enchenbaum, and Sergio Rebelo.

2. FORMULATION OF THE PROBLEM

1. Why alternative explanation of Asian currency crisis reflected profligate fiscal


policy?

2. What is the empirical motivation of the crisis background/

3. What is the model of Asian currency crisis from continuous time, perfect
foresight endowment economy populated by infinitely lived representative
agent and government?

4. How to characterize the time at which the fixed exchange rate regime
collapses, and the post - crisis behavior economy.

5. How about determinants of speculative attacks in version on the model


calibrated for analyze the nature of optimal monetary policy in our model?

3. METHODS
4. RESULT

1. The fiscal theory of the price level focuses on the valuation equation for government
debt,

where is the real stochastic discount factor, which we can also think of as a
discount rate are real primary surpluses. This
equation is an equilibrium condition, not a budget constraint. It operates just like the
standard asset pricing equation for valuing a stock as the present value of its
dividend payments. The Government may choose a “Ricardian regime” in which it
adjusts taxes and spending ex-post so this equation holds for any price level Pt, but
no budget constraint logic forces it to do so. Analogously, no constraint forces
Microsoft to raise earnings in response to an “off-equilibrium” or “bubble” in its stock
price.

2. More deeply, “aggregate demand” is really just the mirror image of demand for
government debt. The household budget constraint says that after-tax income must
be consumed, invested, or result in purchase of government debt,

3. The valuation equation (1) can determine the price level even in a frictionless
economy with . But to understand monetary policy with we also
need a money demand function, that captures the “special” nature of money,

4. The timing of the fiscal equation (1) is quite different with long-term debt. For
example, if debt consists of a constant coupon c that is redeemed each period, with
no other debt purchases and sales, then we have

5. Each period. Equation (1) still holds, but the market value of long term debt
fluctuates overtime as well as the price level. However, most US debt is rolled over
every few years, so if we take a time interval of a few years we will not go too far
wrong in the qualitative analysis

6. We can accommodate a “flight to quality” event in our fiscal framework by


recognizing that the discount rate for government debt declined dramatically.
In our fiscal framework, R declined in
7. In our fiscal framework, let Dt denote private debt owned by the government in
exchange for additional Treasury debt. Our fiscal equation becomes

8. The fiscal valuation equation

9. With one-period debt, the fiscal equation is

is debt issued at time t − 1,coming due at time t.

10.

11. Real revenue from debt sales are

12. where the nominal bond price is

13. Substituting from (4) at time t +1,we obtain


14. We also know from past fiscally - induced currency collapses that the turning point
comes suddenly and irretrievably, as do stock market collapses.

15. Nominal credit guarantees mean that government finances are much worse if the
price level goes down, and much better if there is inflation. Surpluses are not
independent of the price level. Our equation is really

We are used to thinking of the static Laffer curve, in which tax revenue T is
generated by a tax rate τ from income Y as and The marginal revenue generated
from an increase in taxes is
C. Mundell–Fleming model
RESUME
The Mundell-Fleming model is an economic model first set forth by Robert
Mundell and Marcus Fleming. The model is an extension of the IS-LM model. Whereas
the traditional IS-LM Model deals with economy under autarky (or a closed economy),
the Mundell-Fleming model tries to describe an open economy. Typically, the Mundell-
Fleming model portrays the relationship between the nominal exchange rate and an M
economy's output (unlike the relationship between interest rate and the output in the IS-
LM model) in the short run.The Mundell-Fleming model has been used to argue that an
economy cannot simultaneously maintain a fixed exchange rate, free capital movement,
and an independent monetary policy. This principle is frequently called "the Unholy
Trinity," the "Irreconcilable Trinity," the "Inconsistent trinity" or the Mundell-Fleming
"trilemma."

Changes in money supply

An increase in money supply shifts the LM curve downward. This directly


reduces the local interest rate and in turn forces the local interest rate lower than the
global interest rate. This depreciates the exchange rate of local currency through capital
outflow. (Hot money flows out to take advantage of higher interest rate abroad and
hence currency depreciates.) The depreciation makes local goods cheaper compared
to foreign goods and increases export and decreases import. Increased net export
leads to the shifting of the IS curve (which is Y = C + I + G + NX) to the right to the point
where the local interest rate equalizes with the global rate. At the same time, the BoP is
supposed to shift too, as to reflect(1)depreciation of home currency and (2)an increase
in current account or in other word, the increase in net export.

Changes in government spending


An increase in government expenditure shifts the IS curve to the right. The shift causes
the local interest rate to go above the global rate. The increase in local interest causes
capital inflow, and the inflow makes the local currency stronger compared to foreign
currencies. Strong exchange rate also makes foreign goods cheaper compared to local

goods. The level of income of the local economy stays the same. The LM curve is not
at all affected. A decrease in government expenditure reverses the process.

Changes in global interest rate

An increase in the global interest rate causes an upward pressure on the local interest
rate. The pressure subsides as

the local rate closes in on the global rate. When a positive differential between the
global and the local rate occurs,

holding the LM curve constant, capital flows out of the local economy. This depreciates
the local currency and helps

boost net export. Increasing net export shifts the IS to the right. This shift continues to
the right until the local

interest rate becomes as high as the global rate. A decrease in global interest rate
causes the reverse to occur.