Macro theory: Quick review
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1 Advanced Monetary Theory and Policy EPOS 2012/13 Macro theory: Quick review Giovanni Di Bartolomeo
2 Growth and cycle
3 Price and inflation
4 Quantitative theory in the AD/AS model Neo-classic economists: Money is a veil and monetary policy useless P LRAS An increase in M shifts AD to the In the long run, P 2 right. this raises the price level P 1 AD 2 AD 1 but leaves output the same. Y Real factors determine the Natural output Y
5 Keynes in the AD/AS model (IS/LM) Changes in the AD ( M/ i) In the long run we are all dead!!! Possible equlibrium of under-emoplyment, given the prices each point on the AD is an equilibrium of the IS/LM model P Monetary policy has real effects Prices do not change (nominal rigidity) P1=P2 AS AD 2 AD 1 Recall that the same effect on Y can be oobtained by a fiscal expansion, but this will deliver to a different compositon of Y (more C, less I), see the IS/LM model. Output changes Y1 Y2 Y
6 The policy menu: Phillips curve Taking account of prices, the goverment by expanding the aggregate demand increase the outp (reduce unemplyment) but should accept a cost in terms of higher prices (inflation) and vice versa. No free lunch!!! P AS B P 2 P 1 A Y 1 Y 2 AD 2 AD 1 Y
7 From the AD/AD to the policy menu P AS % Policy menu 106 B 6 B ,500 A 8,000 AD1 AD2 u=7% u=4% Y=8000 Unemployment rate associated to the GDP (see the Okun law) Y A Y=7500 u%
8 Policy menu in the 70s (United States) Inflation rate ( ) 10 8 C a Unemployment rate (u)
9 Something change. End of the myth? Inflation rate ( ) Unemployment rate (u)
10 No menu: Stagflation Inflation rate ( ) Unemployment rate (u)
11 Inflation rate ( ) Volcker s era (disinflation) Unemployment rate (u)
12 Greenspan s era (great moderation) Inflation rate ( ) Unemployment rate (u)
13 Supply shocks and stagflation An oil shock increases production costs, thus it shifts on the left the marginal cost curve for each level of price. P SRAS 2 SRAS 1 P 2 P 1 C A Policy options? Expansionary policy? (inflation increases) Policy contraction to reduce inflation? Not a free lunch!!!! Y 2 Y 1 AD 1 Y
14 Friedman and expectations (AD/AS model) Consider an increase of money, not all producers adjust prices (imperfect information, no one knows if the increase in demand is relative to his product or to all), output and prices increase. P LRAS SRAS 2 P 3 P 2 P 1 C A B SRAS 1 AD 2 AD 1 Y By the time, all producers revise price and SRAS moves up, long run equilibrium is reached again, but at an higher level of prices. Y 2
15 Policy in the long-run AS / AD model Phillips Curve P LRAS LR policy menu LP P 2 B P 1 AD 2 A AD 1 0 Y N Y 0 Natural unemployment rate u
16 Neo-classical economics On the empirical level, new classical theories were an attempt to explain the apparent breakdown in the 1970s of the simple inflation-unemployment trade-off predicted by the Phillips curve On the theoretical level, it argues that traditional models have assumed that expectations are formed in naive ways. Naive expectations are inconsistent with the assumptions of microeconomics Expectations are rational so adjustment is immediate. The short-run is the long-run!!! No effect for monetary policy (unless surprise but then usefulness or even counter-productive)
17 Rational expectations Naive expectations are inconsistent with the assumptions of microeconomics. If people are out to maximize utility and profits, they should form their expectations in a smarter way: Micro-foundations The rational-expectations hypothesis assumes people know the true model of the economy and that they use this model to form their expectations of the future By true model we mean a model that is on average correct in forecasting inflation When expectations are rational, disequilibrium exists only temporarily as a result of random, unpredictable shocks On average, all markets clear and there is full employment. No need for government stabilization
18 From New Classicals to RBC and NK theory The New Classical Economics challenged Keynesian theory, and stimulated the development of Real Business Cycle (RBC) and New Keynesian (NK)Theory RBC theory accepts the REH, but views cycles arising in frictionless, perfectly competitive economies with complete markets. It argues that cycles arise through the reactions of optimizing agents to real disturbances, such as random changes in technology or productivity NK theory accepts the REH, but emphasizes the importance of imperfect competition, costly or impeded price adjustments, and externalities. It argues that nominal shocks are the predominant cause of business cycles 18
19 Real Business Cycle (RBC) theory RBC theory makes the contribution of demonstrating that fluctuations in economic activity are consonant with competitive general equilibrium environments in which all agents are rational optimizers DSGE Micro-foundations (optimizing agents) Rational expectations Flexible price and wages (perfect and complete markets) RBC makes (exogenous) stochastic fluctuations in factor productivity the predominant cause of fluctuations in business activity Money does not matters the cycle is efficiently driven by the technology and other shocks
20 RBC and optimality Like New Classical Economics, the RBC theorists agree that: Agents optimize Markets clear Therefore, the business cycle is an equilibrium phenomenon, and is optimal! Coordination failures, price stickiness, waves of optimism or pessimism, or monetary or fiscal policy are not needed to explain business cycles.
21 Positive Technology Shock P LRAS 1 LRAS 2 P 1 P 2 Y N Y=F(N,K) 21
22 Why shocks have persistent effects Agents seek to smooth consumption over time. This implies that the increase in output will result in an increase in investment, and therefore the capital stock. (weak) Agents also inter-temporal substitute labor supply toward periods when real wages are higher, and away from periods when real wages have fallen. (stronger) Lags in investment (time-to-build) can result in current shocks affecting future investment and therefore future output. (stronger) Firms answer increased demand first by drawing on inventories. Once inventories are depleted, then the firms respond with production changes. If the firms face rising marginal costs, they will replenish inventories slowly, causing output changes to persist. (weak)
23 Money, credit, RBC: King-Plosser (1984) Banking firms supply financial (transactions) services A positive shock to productivity will also stimulate demand for transactions, and therefore transactions services So the volume of such services will vary with output Inside money is created Money is endogenously created in response to real sector activity Y causes M
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