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

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

Main indicators, 1963-200563-72 73-82 83-92 93-02 03 04 05

inflation

USA 3.3 8.7 4.0 2.6 2.3 3.0 3.0

Europe 4.4. 10.7 5.1 2.4 2.0 2.2 2.0

Japan 5.6 8.6 1.8 0.2 -0.2 -0.2 -0.2

Unemployment

USA 4.7 7.0 6.8 5.2 6.0 5.5 5.4

Europe 1.9 5.5 9.4 9.6 8.9 9.0 8.7

Japan 1.2 1.9 2.5 3.9 5.3 4.7 4.5

per capita real GDP growth

USA 2.8 0.9 2.4 2.1 2.0 3.3 2.5

Europe 3.9 2.0 3.0 2.0 -0.1 1.9 1.9

Japan 8.5 2.9 3.4 0.7 2.3 4.3 2.3

US data

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

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

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

XVI.2 Case study:Oil shock, part I

1973-1979: Monetary expansion

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

Effect on output

• Sharp price increase → fall of AD → fall of output

• Sharp increase of unemployment

• Stagflation: inflation with unemployment

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)

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?

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

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

XVI.3 Case study:Oil shock, part II

1980-1985: US Monetary Contraction and Fiscal Expansion

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)

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 curveTaxrevenue

Taxrate

0% 100%

The data

1980 1981 1982 1983 1984GDP growth % -0.5 1.8 -2.2 3.9 6.2

Unemployment % 7.1 7.6 9.7 9.6 7.5

Inflation – CPI % 12.5 8.9 3.8 3.8 3.9

Nominal interest % 11.5 14.0 10.6 8.6 9.6

Real interest% 2.5 4.9 6.0 5.1 5.9

Real ExR (73=100) 117 99 89 85 77

Trade surplus -0.5 -0.4 -0.6 -1.5 -2.7

Budget surplus -1.8 -2.0 -3.5 -5.6 -4.5

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

XVI.3.1 Reducing the inflation

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

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”)

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

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

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

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

XVI.3.2 Exchange rate policies

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

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

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

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)

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