Macroeconomics I International Group Course

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Kristin Daniel
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1 Learning objectives Macroeconomics I International Group Course Topic 4: INTRODUCTION TO MACROECONOMIC FLUCTUATIONS We have already studied how the economy adjusts in the long run: prices are flexible, all markets clear and there is full employment of labor and capital, output stays at its potential level. The aggregate price level is determined by the amount of money. Potential output is a theoretical construction that is helpful to describe how the economy evolves in the absence of frictions. But potential output must be viewed as something to which the economy converges, while current output will differ from it due to a series of frictions that impede a quick adjustment of markets. Since markets do not adjust immediately, prices are off their market clearing levels and there is over or underemployment of resources. In other words, in the short run economies adjust differently from what we have studied so far. The economy is not at the potential level but fluctuates around it. These fluctuations are a recurrent feature of market economies that last between five and eight years. These fluctuations are called business cycles and are studied in the short run macroeconomics we tackle in the next topics. 1 2

2 Learning objectives Business cycle fluctuations in the U.S. Learning objectives Business cycles: main features WE call business cycles to the observed recurrent fluctuations in production in most productive sectors. They have a similar pattern across time. These fluctuations also tend to be correlated across countries. All macroeconomic variables change over the cycle. Consumption and investment move with GDP (they are procyclical ). Investment is more volatile than GDP. Unemployment rises in slumps and falls in booms. Unemployment is countercyclical. Inflation may be procyclical or countercyclical depending on the cause of the fluctuation. Some variables move ahead of GDP and some others lag behind. The interest rate tends to be procyclical, except when the Central Bank reacts to control inflation. 3 4

3 Potential output and macroeconomic fluctuations Potential output and macroeconomic fluctuations Output and potential output (UK) Output gap (UK) 5 6

4 Fluctuations, supply and demand We shall distinguish between: The cause of fluctuations are some exogenous shocks or autonomous changes in the behavior of economic agents. The transmission of fluctuations: after these exogenous shocks all variables tend to react. All markets in the economy are influenced by these exogenous changes and the effect. Our aim is to interpret macroeconomic fluctuations as the result of market interactions in the economy. Thus we shall represent the shocks as autonomous shifts in either aggregate demand or aggregate supply. Also, the final effect of these shocks will depend on the shape of these curves, i.e., the way in which markets operate. Fluctuations, supply and demand How are the effects of shocks propagated to the main macroeconomic variables? It depends on the shape of both the aggregate demand and aggregate supply. Autonomous shifts in aggregate demand (demand shocks) affect output if the supply curve is non vertical Autonomous shifts in aggregate supply (supply shocks) affect output due to the negative slope of aggregate demand 7 8

5 The aggregate demand curve Two features of aggregate demand in the {Y, P} space Caeteris paribus, the higher the price level, he lower the aggregate demand of goods and services (from1 to 2). The aggregate demand curve is negatively sloped For a given price level, aggregate demand rises if desired spending (C, I, G) or liquidity (M) rise. From 2 to 2 The aggregate demand curve We shall study the mechanism that explains the negative slope of aggregate demand in detail in Topic 5, P rises We shall also study there the mechanisms that generate the following response: Desired spending or liquidity rise Let us try here a simple and intuitive explanation Y d falls Y d rises for a given P 9 10

6 The slope of the aggregate demand curve Can we simply apply the standard microeconomic reasoning to justify the slope of the aggregate demand curve (namely that as P rises goods and services become more expensive and their demand falls)? NO, WE CANNOT. WHY NOT? P is a relative price If P rises, the nominal incomes of productive factors (labor and capital) also rises and total demand is not affected in this way. The absolute price level does have an effect on the money market. In fact we need to bring the money market into the analysis to understand why aggregate spending falls when the aggregate price level rises. Let us consider the simplest version of the money market equilibrium. Money demand depends only on income: M P The slope of the aggregate demand curve d M = = ky P d M M P = Y P P As P rises, the real value of money is reduced, thus in equilibrium money demand must fall. This implies that fewer transactions are made, and then income falls as P rises

7 The slope of the aggregate demand curve The economic explanation. Households need cash (M) to make transactions. As P rises, agents run into a lack of liquidity, since the amount of money balances is able to buy less goods. Thus, households must reduce the amount of goods and services they demand. This explanation is easy, but not very realistic as a justification of the slope of aggregate demand. Do we really believe that consumers buy less goods to recover liquidity? The slope of the aggregate demand curve What is wrong with this reasoning? When we find ourselves short of liquidity we do not have to reduce our demand for goods and services. We can recover the desired level of liquidity by selling other financial assets. In the simplest (quantitative theory) demand for money, this possibility is assumed away since money demand is derived from the transactions motive. To fully understand the effect of prices on aggregate demand, we must consider a more complex money demand function as depending on income (transactions motive) and on the interest rate: money is an asset that may be used as a store of value, so that its demand depends also on the opportunity cost of holding money instead of other assets (bonds)

8 The slope of the aggregate demand curve The demand for real balances depends on both income (Y) and the nominal interest rate (i=r+ π e ). M P d M e = = L(, i Y ) = L( r + π, Y ) P As P rises, the supply of real balances falls. What makes households reduce their money demand to restore the money market equilibrium? Households try to restore their level of liquidity by selling bonds in the financial market. Then, the price of bonds falls and their interest rate rises. As the interest rate rises, investment demand falls. e M P,( π const.) i, r, Y L( i, Y ) P 15 The slope of the aggregate demand curve Households cash government bonds in The demand for bonds falls, their price falls and the interest rate rises Since π e is constant, the Real interest rate rises too: Investment demand falls Aggregate demand falls, income also falls; this leads to a reduction in consumption M P d = d B P B P B B P+ 1 P i B P i r I Y Y C... Y B 16

9 The economics of the aggregate demand curve When households are short of cash, they try to recover it partially by reducing their purchases of goods and partially by selling bonds. This leads to a rise in the interest rate that makes it more expensive for firms to raise funds to undertake investment projects. Some of these projects (the ones with a lower expected return) are postponed. This reduces the purchases of goods by firms too. If M increases ( excess liquidity ), households buy government bonds. This pushes bond prices up, thus reducing the rate of interest. At given prices, aggregate demand rises: the demand curve shifts rightwards. Aggregate demand shifts Since total spending has fallen so do production, employment and households incomes. This induces an additional fall in aggregate spending (consumption). 17 M M ( P ) i, Y L( i, Y ) P 18

10 If autonomous spending rises ( C, I, G), households and firms need more cash to buy the additional goods. Thus, they sell bonds, pushing government bonds up, and reducing the interest rate. At given prices, aggregate demand rises: the demand curve shifts rightwards. Aggregate demand shifts Aggregate demand and supply analysis So far we have analyzed shifts in the aggregate demand curve for a given price level. But in order to be able to say something about the final response of output we need to study how prices (i.e., the supply of goods) react when there is a change in demand. C, I, G ( P ) y Y L ( i, Y ) M P, M i L ( i, Y ) P L ( i, Y ) c te Two (extreme) examples of reactions following a rise in aggregate demand: Vertical supply curve from 1 to 2: P rises whereas Y does not change. Horizontal supply curve from 1 to 3: P does not change whereas Y rises

11 The slope of the aggregate supply curve We studied in Topic 2 the conditions under which the aggregate supply curve is vertical (i.e., aggregate output does not react to changes in aggregate prices). This happens when all prices and wages in the economy are fully flexible. This is often meant to be a long-run feature of the economy (since it takes time for prices to adjust); this is why this curve is also known as the flex price or longrun aggregate supply curve. At the other extreme we have the case in which prices are rigid, they do not react to changes in demand in the least. This is meant to be a very short-run feature of the economy, since sooner or later all firms eventually change prices when market conditions induce them to do so. Actually, the short run is better characterized by an upward sloping demand curve (something in between the two extreme cases above). This is more realistic and has to do with the fact that not all prices are either flexible or sticky. Some change faster than others, and thus the production of some firms react differently to changes in demand than others. This is what we shall discuss in Topic 6. Reaction to demand shocks: short-run and long-run. Demand shocks: autonomous shifts in the aggregate demand curve. Short-run response: the price level is unchanged (from 1 to 2). Long-run response: in time the price level reacts to excess demand (from 2 to 3)

12 Reaction top supply shocks: short-run and long-run. Reaction to supply shocks: short-run and long-run. Transitory supply shocks (labor market, oil price) do not affect long-run or potential output. Short-run response: from 1 to 2. Long-run response (accommodating demand policies): from 2 to 3. Long-run response (nonaccommodating demand policies): from 2 to 3. Permanent supply shocks (technology, labor market) do affect longrun or potential output. Short-run response: from 1 to 2. Long-run response: from 2 to 3. Accommodating demand does nothing but raise prices

13 The classical dichotomy and economic fluctuations If there is some price in the economy that is sticky or sluggish, then the aggregate supply curve is not vertical In this case we say that the classical dichotomy does not hold. Real and nominal variables are jointly determined by the interaction of all markets in the economy Both aggregate demand and supply shocks affect all variables in the economy: real wages, output, employment, the interest rate, prices, etc. Demand management macroeconomic policies (fiscal and monetary) do affect output and inflation too. What have we learned? The higher the price level, the lower the aggregate demand of goods and services. The aggregate demand curve is negatively sloped For a given price level, aggregate demand rises if desired spending or liquidity rise. If there is some price in the economy that is sticky or sluggish, then the aggregate supply curve is not vertical. The short run supply curve is horizontal or upward sloping. Changes in aggregate demand have real effects in the economy as long as aggregate supply is non vertical. Both aggregate demand and supply shocks affect all variables in the economy: real wages, output, employment, the interest rate, prices, etc. Aggregate demand shocks have real effects in the short run but only affect prices in the long run

6. The Aggregate Demand and Supply Model

6. The Aggregate Demand and Supply Model 1 Aggregate Demand and Supply Curves The Aggregate Demand Curve It shows the relationship between the inflation rate and the level of aggregate output when the