A positive AD shock
A negative external supply-side shock: an oil price rise
Macroeconomic CSI: Shocks and policy responses in the open economy Rodolphe Desbordes
http://www.rodolphedesbordes.com/
A positive AD shock
A negative external supply-side shock: an oil price rise
Table of Contents I
1
A positive AD shock Equilibrium Short-run Medium-run Medium-run equilibrium
2
A negative external supply-side shock: an oil price rise Supply-side effect Demand-side effect Cumulative effects
A positive AD shock
A negative external supply-side shock: an oil price rise
Equilibrium at the beginning of period 0 I RER
AD A
θ_0 ERU
r A r* IS Inflation PC A π*
MR Y_0
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
Equilibrium at the beginning of period 0 II
We assume that π = π ∗ and r = r ∗ , hence i = i ∗ .
A positive AD shock
A negative external supply-side shock: an oil price rise
Positive AD shock in period 0 I RER
θ_0
AD
A
AD’’
B
ERU
r
r*
B
A
IS’ IS
Inflation
PC π*
A
B
MR Y_0
Y_1
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
Positive AD shock in period 0 II
During period 0, the inflation rate does not increase as wages and prices have been negotiated/set at the beginning of period 0. Hence A −→ B and that period is the short-run in the sense that wages and prices do not respond to the increase in output. Only quantities of employment/output change .
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 1: inflation above inflation target I RER
θ_0
AD
A
AD’’
B
ERU
D r
r*
B
A D
IS’ IS
Inflation
PC π_1 π*
PC’’
B’
A D
B MR
Y_0
Y_en Y_1
MR’
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 1: inflation above inflation target II In period 1, the central bank knows that in the medium-run, output will be equal to Yen . It adjusts its MR policy function (MR −→ MR 0 ). Given that Yen is known, the central bank can work out the current PC curve (PC 00 ), which shows that inflation is going to be above target inflation (π1 > π ∗ at B 0 ). Inflation will be above target inflation because workers have asked for a higher wage increase than before at the beginning of period 1, given that output is above the initial medium-run level of output. The medium run begins as wages and prices are free to move.
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 1: intervention of the central bank I RER
AD AD’
θ_0
A
C
AD’’
B
ERU
D r r’ r*
C B
A D
IS’ IS
Inflation
PC π_2 π*
A
PC’
B’
C
PC’’
D MR’ MR Y_2 Y_enY_1
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 1: intervention of the central bank II
Given B 0 on the current PC curve, the central bank works out next period’s PC curve (PC 0 ) and sets the real interest rate in period 1 such as the economy will be on the MR 0 curve in period 2, at point C: the real interest rate increases and i > i ∗ . i > i ∗ and π > π ∗ : the RER should appreciate. However, if we make the reasonable assumption that changes in the RER do not have an immediate impact on AD, θ can be kept unchanged (θ0 ).
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 2...: CB’s interventions and AD effects of the RER I RER
AD AD’
θ_0
A
C
AD’’
B
ERU
D r C
r’
B
r*
A
D
IS’ IS
Inflation
IS’’
PC π_2 π*
C A
PC’
B’
PC’’
D MR’ MR Y_2 Y_en
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
t = 2...: CB’s interventions and AD effects of the RER II The economy is now at point C (or slightly below C) at the beginning of period 2: 1
2
3
i > i ∗ and π > π ∗ : eventually, the country’s export market share decreases as RER appreciates, the trade balance worsens and the IS curve shifts down. Y2 < Yen : there is a negative output gap, inflation falls (but is still above π ∗ ) and the central bank starts decreasing the real interest rate. Given that the economy moves along the MR 0 curve towards D, the positive impact of a cut in the real interest rate is higher than the negative effect of the real appreciation. The AD curve shifts gradually to the right.
A positive AD shock
A negative external supply-side shock: an oil price rise
t = en: New medium-run equilibrium I RER
θ_0
AD AD’’
A
θ_3
ERU
D
r
r*
A
D IS
Inflation
IS’’
PC PC’’ π*
A
D MR’ MR Y_en
Output
A positive AD shock
A negative external supply-side shock: an oil price rise
t = en: New medium-run equilibrium II
B A
A positive AD shock
A negative external supply-side shock: an oil price rise
Effect of an oil price rise on domestic prices I For simplicity, assume that the country exports manufactures and only imports oil, which is used as an intermediate input by firms in their production of final goods . In a closed W economy, we know that P = (1−µ)λ . We can write it in a slightly different way: W (1 − µ)λ
P
=
P
=
µP |{z}
+
W λ |{z}
Price
=
Profit per unit
+
cost per unit
We ‘open’ the economy by assuming that production of the final good now requires ∗ for one oil unit some oil as an intermediate input, which is imported at the price ePoil OIL units and used in the proportion υ = per unit of output. Firms will raise their prices to Y cover this additional cost:
PC
=
PC
=
W ∗ + υePoil λ ∗ P + υePoil
µP +
A positive AD shock
A negative external supply-side shock: an oil price rise
Effect of an oil price rise on domestic prices II Another way of looking at it is simply to see the price of the final good as the sum: 1
∗ the cost of oil: ePoil
2
the value added by domestic firms P =
W . (1−µ)λ
Now assume that there is world pricing of exports in the sense that the price of country’s exports is set according to the world price for manufactured goods: PX = ePC∗ . We also assume that the oil input requirement affect prices uniformly across countries in the sense that the proportionate rise in domestic prices due to oil is the same in every country: PC = (1 + α)P and PC∗ = (1 + α)P ∗ . In that case, the RER, θ = (1+α)eP ∗ (1+α)P
=
eP ∗ P
∗ ePC PC
=
remains constant whatever the evolution of oil prices.
We can define τ as the terms of trade (price of imports divided by the price of exports) at the world level between oil and manufactures: τ =
∗ Poil ∗ PC
We can rewrite the price equation as PC
=
∗ P + υePoil
PC
=
P + υτ ePC∗
.
A positive AD shock
A negative external supply-side shock: an oil price rise
Effect of an oil price rise on real wages Divide both sides of the equation by PC and use P = PC
=
1
=
1
=
W PC
=
W : (1−µ)λ
P + υτ ePC∗ eP ∗ W 1 + υτ C PC (1 − µ)λ PC W 1 + υτ θ PC (1 − µ)λ (1 − µ)λ × (1 − υτ θ)
For a given θ, WPS will be lower: The higher τ : the more expensive is oil relative to the price of manufactured goods as firms raise their prices to protect their profits. The higher υ: an economy which is not very energy efficient has to import more oil for a given volume of production, increasing the cost of using intermediate inputs and, ultimately, prices. Given that the PS curve shifts, generating a new ERU and Ye , while RER remains constant, an oil price shock (a change in τ ) shifts the ERU curve.
A positive AD shock
A negative external supply-side shock: an oil price rise
The supply-side effect of a negative external supply shock
A positive AD shock
A negative external supply-side shock: an oil price rise
External trade shock I We have assumed that there is world pricing of exports: PX = ePC∗ . Hence eP ∗ real exports are P C X = θX . C
We have also assumed that a country only imports oil: 1
Given that oil is used in the proportion υ = OILYunits per unit of output, M = OIL units will be imported for a volume of production Y .
2
We have seen that the price of oil can be expressed as τ ePC∗ .
3
Hence real imports are τ
∗ ePC M PC
= θτ M.
Our IS equation is now: Y
=
C + I + G + θ(X − τ M)
In addition to being a negative supply side shock, an oil price rise is also a negative external trade shock, i.e. an aggregate demand shock caused by a fall in net exports for a given value of θ.
A positive AD shock
A negative external supply-side shock: an oil price rise
External trade shock II External trade shock I: The trade balance [θ(X − τ M)] deteriorates as the real price of oil increases. Less oil imports can be bought for a given volume of manufactured exports. If the trade balance worsens, AD falls. A higher proportion of income is absorbed by expenditure on imports. Expenditures on domestic production fall. External trade shock II: All oil importing countries in the world are hit by the oil shock, leading to a fall in world income and a fall in exports. The fall in exports leads to an additional fall in AD. The BT curve shifts to the left because, at the current RER, a lower volume of output would be necessary for trade to be balanced. The AD curve shifts to the left.
A positive AD shock
A negative external supply-side shock: an oil price rise
The cumulative effects of a negative external supply shock Under interest rate targeting:
1
Output falls as the oil price rise creates an external trade shock A â&#x2C6;&#x2019;â&#x2020;&#x2019; C.
2
If the shock was purely an external trade shock, inflation would fall at C.
3
However, the oil price rise is also a supply-side shock: the ERU has shifted to the left.
4
That means that at C, wWS > wPS and inflation increases.
5
A situation in which output falls and inflation rises simultaneously is called stagflation.
6
The central bank will have to raise the real interest rate until B 0 is reached.