Shocks that Shift Curves in the International Finance Diagrams

Shocks Specific to the Short Run

Below, when I write “the Fed,” always interpret it as “the domestic central bank.”

The Fed can raise the real interest rate or cut (lower) the real interest rate. Often the shock will simply be stated that way. Sometimes, the question will be, in effect:

Q: Aggregate demand is too high. What should the Fed do? Or how should the Fed correct this?

A: Raise the real interest rate to reduce aggregate demand.

or

Q: Aggregate demand is too low. What should the Fed do? Or how should the Fed correct this?

A: Cut the real interest rate to increase aggregate demand.

Note that the Fed changes the real interest rate by changing the nominal interest rate. Inflation is sticky or “sluggish” in the short run. The Fed does not control inflation in the short run. With pi relatively unchanging in the short run, changing the nominal interest rate i changes the real interest rate by the definition of the real interest rate (Fisher equation) r = i - pi. So the Fed does control the real interest rate in the short run.

It is either unnecessary to deal with this directly when thinking about the Short-Run International Finance Diagram, or it can be dealt with totally separately in advance, but you should know that the Fed controls the short-term, risk-free nominal interest rate because (a) supply and demand for the monetary base determines the nominal interest rate, (b) the Fed completely controls the supply of the monetary base and (c) the Fed has many tools to modify the demand for the monetary base. And you should know that the short-term, risk-free nominal interest rate has a big effect on the full set of other interest rates. Usually, when it goes down, all of the other interest rates go down, too. Usually, when it goes up, all of the other interest rates go up, too.

Note that the supply and demand for loanable funds graph is useless in the short run because the Fed can and does override it in the short run.

Foreign Monetary Policy Shocks in the Short Run

Besides the Fed (the domestic central bank) raising or lowering its rate, there is one other type of shock that is unique to the short run: a foreign central bank raising or lowering its rate:

  • If a foreign central bank raises its rate, in the short run that shifts the Capital Flow curve, CF(r), outward, since capital wants to flow to where rates are high.

  • If a foreign central bank lowers its rate, in the short run that shifts the Capital Flow curve, CF(r), inward, since capital wants to flow away from where rates are low.

Every other type of shock begins its action by shifting the same curve in the same way in the short run as in the long run. That said, the general equilibrium effects of those shocks is often different in the short run than in the long run, even though they begin by the same curve shifting in the same way.

Shocks Specific to the Long Run

The Fed does not control the real interest rate in the long run. Instead, in the long run, the real interest rate is determined by the supply and demand for loanable funds.

  • The Fed can control inflation in the long run if it accepts the real interest rate determined by the supply and demand for loanable funds.

  • If the Fed keeps the real interest rate below the real interest rate determined by the supply and demand for loanable funds for a long time, it will cause hyperinflation.

  • If the Fed keeps the real interest rate above the real interest rate determined by the supply and demand for loanable funds for a long time, it will cause a serious recession (like the Great Recession) and deflation (=negative inflation). Imposing a zero lower bound on interest rates is one way the Fed might (and has in the past) kept the real interest rate above the real interest rate determined by supply and demand for loanable funds.

Note that when a big boom or even hyperinflation gets going, then for a while the Fed might need an interest rate substantially above the real interest rate determined by the supply and demand for loanable funds in order to effectively put on the brakes. When a bad recession gets going, then for a while the Fed might need an interest rate substantially below the real interest rate determined by the supply and demand for loanable funds in order to stimulate the economy enough and get it going again.

Monetary Policy Shocks in the Long Run

Expanding on the last few paragraphs, the “classical dichotomy” says that no real variable is affected by monetary policy in the long run. The exceptions are the things discussed as costs of inflation in Mankiw’s Chapter 5. Still, for moderate changes in inflation and any other moderate changes in monetary policy in the long run, start with the approximation “No real variable is affected by monetary policy in the long run.” That gives an easy answer to questions about monetary policy shocks as they show up in the Long-Run International Finance Diagram: they don’t. This includes foreign monetary policy as well as domestic monetary policy. All the variables shown in the Diagram are real. Nothing happens to any of them. (Versions of this question have appeared on many past exams.) An example of a long-run change in monetary policy would be a change in the target inflation rate. This has no effect on the real variables shown in the Long-Run International Finance Diagram.

Advanced note: The classical dichotomy has two components: Monetary Neutrality and Monetary Superneutrality. Monetary Neutrality is the idea that a single permanent change in the overall price level caused by monetary policy will have no effect on any real variable. Monetary Neutrality is expected to hold exactly, with only very trivial exceptions. Monetary Superneutrality is the idea that a permanent change in inflation that leads to a new steady level of inflation that people then get used to will have very little long-run effect on real variables. This is an approximate statement that holds for moderate changes in a central bank’s inflation target. The “costs of inflation” are some of the things that would change most in the long run with moderate changes in the inflation target.

Hyperinflation is both a very large change in inflation that would matter a lot even if it were a long-run change. And the acute stage of hyperinflation often plays out so quickly it can be thought of as happening in the short run.

The Demand for Loanable Funds

The Demand for Loanable Funds curve, D, is the horizontal sum of the Capital Flow curve, CF(r), and the Investment Demand curve, I(r). Thus, any shifts in the Demand for Loanable Funds curve are instigated by a shift in either the Capital Flow curve or the Investment Demand curve. Shifts in those two curves—which affect the Demand for Loanable Funds curve—will be discussed below.

The Supply of Loanable Funds

The Supply of Loanable Funds curve, S, shows national saving as a function of the real interest rate. National saving is the sum of saving by households, the government (federal, state and local), and firms. Each of these can spend more than what they take in, so saving can be negative as well as positive. Negative saving by the government is called a budget deficit. Some of the shocks that can shift the Supply of Loanable Funds curve are:

  • An increase in the government budget—by raising government purchases, raising transfers or cutting taxes (that don’t have a big effect on saving in other ways)—shifts S back.

  • A reduction in the government budget deficit—by cutting government purchases, reducing transfers or raising taxes (that don’t have a big effect on saving in other ways)—shifts S out.

  • Because people care about the after-tax real interest rate (or more broadly, the after-tax real rate of return), if household saving is increasing in the real interest rate, then cutting taxes on interest, dividend and capital gains income—or cutting corporate taxes so companies have more to give to their stockholders and bondholders—will raise household saving. Of course, cutting taxes on interest, dividend and capital gains income, or cutting corporate taxes, can raise the government budget deficit. So the details matter for whether a tax cut designed to raise national saving will, in fact, raise national saving. Similarly, the details matter for whether a tax increase will raise or lower national saving.

  • Current tax policy has created the institution of tax-favored retirement savings accounts. Regardless of whether the creation of tax-favored retirement savings accounts raises or lowers national saving, detailed policies about retirement savings accounts can unambiguously raise or lower national saving. In particular, automatic enrollment of employees into retirement savings accounts can raise national saving. And raising the default contribution rates can raise national saving. The government can encourage automatic enrollment and higher contribution rates (a) at a lower level by “safe-harbor” laws that an employer can’t be sued for automatically enrolling its employees in a retirement savings account certain types of funds and with a substantial contribution rate and (b) at a higher level by requiring employers to automatically enroll their employees at a substantial contribution rate. So far, the US federal government has taken step (a) but not step (b). (Note that “automatic enrollment” has an opt-out: there is a bureaucratic procedure for an employee to choose not to enroll. But if the employee does nothing, they will be enrolled.)

  • Retirement savings accounts have a penalty for taking the money out before a certain age (59.5 in the US). The government can create various exceptions that allow penalty-free withdrawal before that age. These exceptions reduce national saving but can serve other purposes. Some possible exceptions are withdrawals (a) to spend during a recession, (b) to pay large medical expenses, (c) to buy a house, (d) to pay adoption expenses, (e) when unemployed, or any combination of these and other exceptions. Allowing people to withdraw penalty-free during a recession is an interesting policy. The version of this the US government does is to loosen the rules for exceptions during a recession.

  • The government can require people to save (for example, by payroll deduction). Denmark does this.

Shocks that Start by Shifting the Same Curve the Same Way in the Short Run and the Long Run

Shifts in the CF(r), I(r) and NX(epsilon) curves happen the same way whether it is the short run or the long run.

Shocks that Shift the CF(r) Curve

  • If the level of automatic enrollment and the default contribution levels to US retirement savings accounts (such as 401(k)s) stays the same, but the default asset allocation is shifted toward more foreign assets, such as “international” or “global” or “emerging market” mutual funds, this shifts the CF(r) curve out.

  • If the level of automatic enrollment and the default contribution levels to retirement savings accounts (such as 401(k)s) stays the same, but the default asset allocation is shifted toward less foreign assets this shifts the CF(r) curve in.

  • If a foreign government raises the level of automatic enrollment raises the default contribution levels to retirement savings accounts in that foreign country or shifts the default asset allocation toward assets that are outside that foreign country, the CF(r) curve as viewed by the US shifts in. More generally, anything that a foreign government does that either encourages capital flow out of that foreign country or encourages more saving for any interest rate shifts the CF(r) curve as viewed by the US in. You can figure out the statements going in the opposite direction.

  • If a foreign government does something to shift its I(r) curve out, such as the foreign country doing an investment tax credit, this shifts the CF(r) curve as viewed by the US out, as funds go out from the US to, for example, take advantage of those investment incentives in the foreign country.

  • In general, most actions by foreign governments show up from the US point of view as shifts in the CF(r) curve. The big exception is that changes in tariffs and non-tariff trade barriers by a foreign government show up from the US point of view as shifts in the NX(epsilon curve). Always remember that an outflow from the rest of the world is an inflow (negative CF) to the US and an inflow to the rest of the world is an outflow (positive CF) from the US.

Shocks that Shift the I(r) Curve

Note: In the long run graphs,

anything that shifts the I(r) curve outward thereby shifts the Demand for Loanable Funds curve, D, outward;

anything that shifts the I(r) curve inward thereby shifts the Demand for Loanable Funds curve, D, inward.

But the I(r) curve itself shifts the same way in the short run as in the long run.

  • An investment tax credit or other tax cut that reduces the after-tax cost of capital will shift the I(r) curve out.

  • A tax increase on investment that raises the after-tax cost of capital will shift the I(r) curve back.

  • A technological change that increases (physical) domestic investment opportunities will shift the I(r) curve outward.

  • A slowdown in technological progress that reduces (physical) domestic investment opportunities will shift the I(r) curve inward.

Shocks that Shift the NX(epsilon) Curve (which is also called the Demand for Dollars Curve)

  • An increase in US trade barriers (against imports), such as tariffs, quotas and other non-tariff barriers such as ridiculously tough inspections will shift the NX(epsilon) curve outward.

  • A reduction in US trade barriers (against imports) will shift the NX(epsilon) curve inward.

  • An increase in foreign trade barriers (against US exports), such as tariffs, quotas and other non-tariff barriers such as ridiculously tough inspections will shift the US NX(epsilon) curve inward.

  • A reduction in foreign trade barriers (against US exports) will shift the US NX(epsilon) curve outward.

  • The effect of a trade deal that has both the US and foreign countries reduce trade barriers on the NX(epsilon) curve depends on the details. Some deals will shift NX(epsilon) outward, other deals will shift NX(epsilon) inwards.

  • Increased popularity of US goods abroad (either from new goods or from a shift in preferences toward US goods) will shift the NX(epsilon) curve outwards.

  • Reduced popularity of US goods abroad will shift the NX(epsilon) curve inwards.

  • Increased popularity of foreign goods in the US (either from new goods or from a shift in preferences toward foreign goods) will shift the NX(epsilon) curve inwards.

  • Reduced popularity of foreign goods in the US will shift the NX(epsilon) curve outwards.