policy options for a depressed economy · jordi galí (crei, upf and barcelona gse) federico...

Policy Options for a Depressed Economy

Jordi Galí

CREI, UPF and Barcelona GSE

Federico Ca¤è Lectures 2014

Jordi Galí (CREI, UPF and Barcelona GSE) Federico Ca¤è Lectures Federico Ca¤è Lectures 2014 1 / 21

The Legacy of the Financial Crisis

Persistent decline in economic activity


The Legacy of the Financial Crisis Employment Rates for Selected Countries



Monetary policy: Policy rates at the zero lower bound


Source: FRB Dallas

The Legacy of the Financial Crisis Policy Rates




Fiscal policy: High debt/GDP ratios


0

20

40

60

80

100

120

140

160

180

200

Debt/GDP 2007 Debt/GDP 2013

The Legacy of the Financial Crisis Debt/GDP Ratios




Fiscal policy: High debt/GDP ratios

What is to be done?

Answer : It depends on one�s "model" of the determinants of economicactivity

Key message: Policy choices based on "the wrong model" may beine¤ective or have unintended consequences


Outline of the Lectures

First Lecture:

a) What determines economic activity? Classical vs. Keynesian viewsb) Policy options (I): Supply-side policies

Second Lecture:

a) Policy options (II): Demand-side policiesb) Concluding remarks


What Determines Aggregate Activity? The Classical View

Key ingredient: Perfect competition in goods markets

Firm�s problem:maxNt

PtYt �WtNt

subject toYt = AtN1�α

t

Optimality condition:

Pt =Wt

(1� α)AtN�αt


Employment

Price

Marginal cost

P

N

What Determines Economic Activity? The Classical View


Key ingredient: Perfect competition in goods markets

Firm�s problem:maxNt

PtYt �WtNt


t


Pt =Wt

(1� α)AtN�αt

Equivalently:

(1� α)AtN�αt =

Wt

Pt

) "labor demand"


Employment

Real wage

Labor demand

W/P

N



Key ingredient: Perfect competition in goods marketsFirm�s problem:

maxNt

PtYt �WtNt


t


Pt =Wt

(1� α)AtN�αt

Equivalently:

(1� α)AtN�αt =

Wt

Pt

) "labor demand"

Competitive ("Walrasian") equilibrium


Employment

Real wage Labor supply

Labor demand


W/P

N

What Determines Aggregate Activity? The Keynesian View

Key ingredients:

(i) Imperfect competition in goods markets(ii) Infrequent price adjustment by �rms

Pt =Mt

�Wt

(1� α)AtN�αt

�with markupMt variable in the short-run, constant in the long-run.Equivalently ("price-wage schedule"):

(1� α)AtN�αt

Mt=Wt

Pt(iii) Demand determined output

Yt = Ct + It + Gt +NXt

Labor demand:

Nt =�YtAt

� 11�α


Employment

Real wage

What Determines Economic Activity? The Keynesian View

N

Labor demand

Employment

Real wage

What Determines Economic Activity? The Keynesian View

N

Labor demand Labor supply

Price-wage schedule

W/P

Policy Options (I): Supply-side Policies

Example #1: "Structural reforms" aimed at increasing aggregatee¢ ciency (" At)Example #2: Reduction in payroll taxes, aimed at stimulatingemployment.


The Short Run E¤ects of "Structural Reforms"

Classical view:Wt

Pt= (1� α)AtN�α

t

) increase in labor demand, given the wage.


Employment


Labor demand

The Short Run Effects of an Increase in Aggregate Efficiency The Classical View

(W/P)1

(W/P)0

N0 N1

E0

E1


Classical view:Wt


t


Keynesian view:

Nt =�YtAt

� 11�α

) decrease in labor demand, given output.


Employment

Real wage

N0


Price-wage schedule

N1

E0

E1

(W/P)0

(W/P)1

The Short Run Effects of an Increase in Aggregate Efficiency The Keynesian View


Classical view:Wt


t


Keynesian view:

Nt =�YtAt

� 11�α

) decrease in labor demand, given output.

Empirical evidence: Galí (AER, 1999), Basu et al. (AER, 2006).


Source: Galí (AER 1999)

Evidence on the Effects of Technology Shocks (I)

Source: Basu, Fernald and Kimball (AER 2006)

Evidence on the Effects of Technology Shocks (2)

The Short Run E¤ects of a Payroll Tax Cut

Classical view:(1+ τt )Wt


t

Equivalently,Wt

Pt=(1� α)AtN�α

t

1+ τt



Employment


Labor demand

The Short Run Effects of a Payroll Tax Cut The Classical View

(W/P)1

(W/P)0

N0 N1

E0

E1

The Short Run E¤ects of a Payroll Tax Cut

Classical view:(1+ τt )Wt


t

Equivalently,Wt

Pt=(1� α)AtN�α

t

1+ τt


Keynesian view:

Nt = Nt =�YtAt

� 11�α

) unchanged labor demand, given output.


Employment

Real wage

N0


Price-wage schedule

E0 (W/P)0

The Short Run Effects of a Payroll Tax Cut The Keynesian View

(W/P)1 E1

Dynamic Adjustment to Supply-side Shocks: The Role ofMonetary Policy

Key assumptions of the New Keynesian model:

(i) monopolistic competition in goods and labor markets(ii) staggered nominal wage and price setting à la Calvo(iii) no capital accumulation, closed economy(iv) monetary policy rule:

it = ρ+ φpπpt + φybytTransmission mechanism to output and employment

" a , # τ ) # πp ) # i ) # r ) " y ) " n

) key role for endogenous monetary policy response

Simulations

- technology shocks- payroll tax cut


0 5 10 150

0.2

0.4

0.6

0.8

1

1.2

1.4

output

φp = 1.5

φp = 1.1

φp = 3

0 5 10 15-1.5

-1

-0.5

0

0.5

1

employment0 5 10 15

-1

-0.8

-0.6

-0.4

-0.2

0

inflation

0 5 10 15-1.4

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

nominal rate0 5 10 15

-1

-0.8

-0.6

-0.4

-0.2

0

real rate0 5 10 15

0

0.2

0.4

0.6

0.8

1

1.2

1.4

technology

Responses to a Technology Shock in the New Keynesian Model: The Role of Monetary Policy

0 5 10 15-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

output

0 5 10 15-0.5

0

0.5

1

1.5

2

2.5

employment0 5 10 15

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

inflation

0 5 10 15-2

-1.5

-1

-0.5

0

0.5


-1.4

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

real rate0 5 10 15

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

payroll tax

φp =1.5

φp =1.1

φp =3

Responses to a Payroll Tax Cut in the New Keynesian Model: The Role of Monetary Policy

Dynamic Adjustment to Supply-side Shocks: The Role ofMonetary Policy

Key assumptions of the New Keynesian model:

(i) monopolistic competition in goods and labor markets(ii) staggered nominal wage and price setting à la Calvo(iii) no capital accumulation, closed economy(iv) monetary policy rule:

it = ρ+ φpπpt + φybytTransmission mechanism to output and employment

" a , # τ ) # πp ) # i ) # r ) " y ) " n) key role for endogenous monetary policy response

SimulationsEmpirical evidence on the role of monetary policy (Galí, López-Salido andVallés, JME 2003)


The Response of Hours to a Technology Shock: Empirical Evidence on The Role of Monetary Policy

Pre-Volcker period Volcker-Greenspan period

Source: Galí, López-Salido and Vallés (JME, 2003)

Dynamic Adjustment to Supply-side Shocks: The Role ofthe Exchange Rate Regime

Based on Galí and Monacelli (2014): small open economy New Keynesianmodel, producer currency pricing, complete markets.Regime #1 : In�ation targeting, �exible exchange rate:

πpt = 0

- transmission mechanism:

" a , # τ ) # πp ) ## i ) # r , " e ) " y ) " n

Regime #2: Exchange rate peg/Currency union:

et = 0 ) it = i�t

- transmission mechanism:

" a , # τ ) # πp ) # pH , " st , " r ) ' y , ' n

Simulation: in�ation targeting vs. currency unionJordi Galí (CREI, UPF and Barcelona GSE) Federico Ca¤è Lectures Federico Ca¤è Lectures 2014 19 / 21

0 5 10 15-1

0

1

2

3

output

inflation targetingcurrency union

0 5 10 15-1

0

1

2

3

4

employment0 5 10 15

-0.5

0

0.5

1

1.5

consumption

0 5 10 15-0.3

-0.2

-0.1

0

0.1

inflation0 5 10 15

-3

-2

-1

0

1


-3

-2

-1

0

1

real rate

0 5 10 15-1

0

1

2

3

nominal exchange rate0 5 10 15

-1

0

1

2

3

terms of trade0 5 10 15

-1.5

-1

-0.5

0

payroll tax

Responses to a Payroll Tax Cut in the New Keynesian Small Open Economy Model: The Role of the Exchange Rate Regime

Lecture One: Key Ideas

Both Classical and Keynesian models are taught and used in economics,but they represent radically di¤erent views about the determination ofaggregate activity.

In a Classical world, supply-side policies are likely to be very e¤ective instimulating economic activity.

In a Keynesian world, supply-side policies may fail to stimulate economicactivity unless they are accompanied by su¢ ciently accommodatingmonetary policies.

Monetary policy rules that make interest rates highly responsive toin�ation in the face of supply-side policies are likely to make the lattermore e¤ective.

Supply-side policies are likely to be the least e¤ective in (small) countriesthat are part of a currency union (Galí-Monacelli 2014), or facing abinding zero lower bound constraint on the nominal interest rate(Eggertsson-Ferrero-Ra¤o 2014).


Thanks for your attention!


policy options for a depressed economy · jordi galí (crei, upf and barcelona gse) federico...

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