VII. Short-Run Economic Fluctuations

Transcription

1 Macroeconomic Theory Lecture Notes VII. Short-Run Economic Fluctuations University of Miami December 1,

2 Outline Business Cycle Facts IS-LM Model AD-AS Model 2

3 Outline Business Cycle Facts IS-LM Model AD-AS Model 3

4 Business Cycles Business cycles are fluctuations around trend in real GDP. A trend line is derived by drawing a path that is as close as possible to the actual level of real GDP but grows smoothly over time. 4

5 There are peaks and troughs in real GDP, a peak being a relatively large positive deviation from trend, and a trough a relatively large negative deviation from trend. A series of positive deviations from trend culminating in a peak represents a boom, whereas a series of negative deviations from trend culminating in a trough represents a recession. 5

6 The official arbiter of when recessions begin and end is the Business Cycle Dating Committee of National Bureau of Economic Research (NBER). According to an old rule of thumb, a recession is a period of at least two consecutive quarters of declining real GDP. (This rule, however, does not always hold.) Note: The shaded areas represent periods of recession. 6

7 Comovement with Business Cycles An economic variable is procyclical if its deviations from trend are positively correlated with the deviations from trend in real GDP, countercyclical if its deviations from trend are negatively correlated with the deviations from trend in real GDP, and acyclical if it is neither procyclical nor countercyclical. 7

8 8

9 9

10 10

11 In summary, consumption and investment are procyclical, but unemployment is countercyclical (in other words, employment is procyclical). In terms of the magnitude of fluctuations, consumption and employment are less variable than the real GDP, whereas investment is much more variable than the real GDP. Correlation Standard Deviation with Real GDP (% of S.D. of GDP) Real GDP Consumption Investment Employment

12 Outline Business Cycle Facts IS-LM Model AD-AS Model 12

13 IS-LM Model The IS-LM model was developed by John R. Hicks in 1937 trying to summarize the idea of John Maynard Keynes about economic fluctuations. We can view the IS-LM model as showing what causes income (GDP) to change in the short run when the price level is fixed because all prices are sticky. The IS-LM model is no longer used in modern macroeconomic studies of business cycles because it violates the microeconomic principle. However, the idea embedded in this model is still relevant, and it remains a popular framework for discussing some policy issues due to its simplicity. The two parts of the IS-LM model are the IS curve and the LM curve. IS stands for investment and saving, and the IS curve represents what s going on in the market for goods and services. LM stands for liquidity and money, and the LM curve represents what s happening to the supply and demand for money. Because the interest rate influences both investment and money demand, it is the variable that links the two halves of the IS-LM model. 13

14 The IS curve is derived by drawing the Keynesian cross, and the LM curve is derived from the theory of liquidity preference. 14

15 The Keynesian Cross We define planned expenditure (P E) as the amount households, firms, and the government would like to spend on goods and services. Assuming that the economy is closed, so that net exports are zero, we write planned expenditure P E as the sum of consumption C, planned investment I, and government purchases G: P E = C + I + G Assume that consumption C is a function of the after-tax income Y T, C = C(Y T ) where Y is total income Y and T is total tax, then we have P E = C(Y T ) + I + G Recalling that Y as GDP equals not only total income but also total actual expenditure on goods and services, we can write this equilibrium condition as Y = P E 15

16 So holding investment, government purchases, and taxes constant, the equilibrium income must satisfy the following equation: Y = C(Y T ) + I + G We can find this equilibrium income by drawing the Keynesian cross: Note that the slope of the planned expenditure line is the marginal propensity to consume (MPC), which shows how much planned expenditure increases when income rises by $1. We are assuming that MPC is less than 1 here. 16

17 An increase in government purchases G shifts the planned expenditure curve upward and increase the equilibrium income. 17

18 A decrease in taxes T shifts the planned expenditure curve upward and increase the equilibrium income. 18

19 Deriving the IS Curve So far, we have assumed that the level of planned investment I is fixed. Now let us assume that the level of planned investment I is a decreasing function of interest rate r, i.e., I = I(r), and I ( ) < 0. Then when r increases, the planned investment falls. In the Keynesian cross, this shifts the planned expenditure line downward and lowers the equilibrium income Y. 19

20 Therefore, there is a negative relationship between the interest rate and the level of income, which is summarized by the downward-sloping IS curve. 20

21 Shifting the IS Curve An increase in government purchases G shifts the planned expenditure curve upward and the IS curve outward (to the right). 21

22 The Theory of Liquidity Preference The theory of liquidity preference assumes there is a fixed supply of real money balances. That is, ( ) s M = M P P The money supply M is an exogenous policy variable chosen by a central bank, such as the Federal Reserve. The price level P is also an exogenous variable in this model because we assume a fixed price level. Next, consider the demand for real money balances. The theory of liquidity preference assumes that the quantity of real money balances demanded is negatively related to the interest rate r and positively related to income Y. That is, ( ) d M = L(r, Y ) P where L(r, Y ) in decreasing in r but increasing in Y. 22

23 The idea is that the interest rate is the opportunity cost of holding money: it is what you forgo by holding some of your assets as money, which does not bear interest, instead of as interest-bearing bank deposits or bonds. When the interest rate rises, people want to hold less of their wealth in the form of money. On the other hand, when income Y is high, expenditure is high, so people engage in more transactions that require the use of money. Thus, greater income implies greater money demand. At the equilibrium, the supply of real money balance must equal the demand. So we have M P = L(r, Y ). Remarks: Note that r is being used to denote the interest rate here, as it was in our discussion of the IS curve. More accurately, it is the nominal interest rate that determines money demand and the real interest rate that determines investment. To keep things simple, we are ignoring expected inflation, which creates the difference between the real and nominal interest rates, and assuming real and nominal interest rates always move together. 23

24 Deriving the LM Curve When income Y increases, the demand for real money balance increases, which shifts the money demand curve to the right and increases the equilibrium interest rate. Therefore, there is a positive relationship between the interest rate and the level of income, which is summarized by the upward-sloping LM curve. 24

25 Shifting the LM Curve A decrease in money supply M shifts the money supply curve to the left and the IS curve upward (to the left). 25

26 Equilibrium in the IS-LM Model In the end, we have a system of two equations in two unknowns (Y, r): Y = C(Y T ) + I(r) + G, (the IS curve) M P = L(r, Y ). (the LM curve) The solution to it tells us the equilibrium interest rate and income. Graphically, it is the intersection point between the IS and LM curves in the (Y, r) space. 26

27 An Increase in Government Purchases in the IS-LM Model 27

28 A Decrease in Taxes in the IS-LM Model 28

29 An Increase in the Money Supply in the IS-LM Model 29

30 Business Cycles in the IS-LM Model Because the IS-LM model shows how national income is determined in the short run, any shocks that shift the IS or LM curve could cause economic fluctuations, i.e., business cycles. we can group these disturbances into two categories: shocks to the IS curve and shocks to the LM curve. Shocks to the IS curve are exogenous changes in the demand for goods and services. For example, some economists, including Keynes, have emphasized that such changes in demand can arise from investor animal spirits exogenous and perhaps self-fulfilling waves of optimism and pessimism. Shocks to the LM curve arise from exogenous changes in the demand or supply of money. For example, during financial crises, people may prefer to hold more money because it is considered safer than other finical assets. Changes in money supply policy could also cause economic fluctuations as well. The policy implication of the IS-LM model is that, as we have seen in our previous analysis, policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks (e.g., by shifting back the IS or LM curve to its original location before the shocks). If policymakers are sufficiently quick and skillful (admittedly, a big if), shocks to the IS or LM curves need not lead to fluctuations in income or employment. 30

31 Outline Business Cycle Facts IS-LM Model AD-AS Model 31

32 IS-LM as a Theory of Aggregate Demand The IS-LM model tells us what is the equilibrium income/output Y when the price level P is fixed. But what if the price level is allowed to change? When price level P is higher, it shifts the LM curve upward (to the left) and the equilibrium income/output Y is lower as predicted by the IS-LM model. This implies a negative relationship between the price level and income/output, and we call the curve that summarizes this relationship the aggregate demand curve. 32

33 Shifting the Aggregate Demand Curve by Monetary Policy When money supply M is higher, for any price level P, the LM curve is shifted to the right, and the equilibrium income/output Y is higher. Thus it shifts the aggregate demand curve to the right. 33

34 Shifting the Aggregate Demand Curve by Fiscal Policy When there is an increase in government purchases G, for any price level P, the IS curve is shifted to the right, and the equilibrium income/output Y is higher. Thus it shifts the aggregate demand curve to the right. 34

35 Long-Run and Short-Run Aggregate Supply Curves The aggregate demand curve itself is not enough to pin down both the price level and the income/output. So we need another relationship between the price level and income/output to know what exactly will happen in the economy. This additional relationship is typically referred to as the aggregate supply curve. Depending on whether we are considering the economy in the long run or in the short run, the shape of the aggregate supply curve is quite different. 1. Long-run aggregate supply curve (LRAS): The classical model tells us that in the long run, the output is only determined by the amount of factors of production (capital and labor) and the available technology, regardless of the price level. This implies the aggregate supply curve should be vertical. 2. Short-run aggregate supply curve (SRAS): In the short run, if prices are sticky and therefore do not adjust to other economic changes, the price level should be fixed, and the aggregate supply curve should be horizontal. 35

36 36

37 Shifts in Aggregate Demand in the Long Run In the long run, shifts in aggregate demand only affect the price level but not the level of income/output. 37

38 Shifts in Aggregate Demand in the Short Run In the short run, shifts in aggregate demand affect the level of income/output. 38

39 Readings Chapter 3 in Williamson. Chapter 10, 11, and 12 in Mankiw. 39