Equilibrium and Shocks

Transcription

1 Equilibium and Shocks We ae now in a position to put the demand and supply sides of the model togethe. This will yield fo us the equilibium pice level, level of output, and eal inteest ate. The equilibium in the goods maket is pictued in Figue 1. If the pice level is above in Figue 1, thee will be an excess supply of goods. The excess supply of goods will put downwad pessue on pices and the pice level will fall. On the othe hand, if the pice level is below, then thee will be an excess demand fo goods and pices will ise. Thus, equilibium occus at the pice level and level of output. AS ( = e) Figue 1: Equilibium We tun to the money maket to study the inteest ate and the level of eal money balances. We aleady know that in the long un (a steady state) the eal inteest ate equals the ate of time pefeence. This means that the pice level,, detemined in the goods maket above, must

2 2 leave the supply of eal money balances at level that cleas the money maket with the eal inteest ate equal to ρ. This state in the money maket is depicted in Figue 2. ρ= e L(,, γ, π ) M s / M/ Figue 2: Equilibium in Money Maket an incease in the money supply We fist look at the effects of an unexpected incease in the money supply. Suppose the money supply inceases unexpectedly fom M s to M s '. This shifts the cuve out and to the ight. Since the change in the money supply is unexpected, we assume that incease in the pice level to ' is also unexpected. This unexpected incease in pices is intepeted by poduces as an incease in thei elative pice and they supply moe output. So, in the shot un pices and output incease in esponse to an unexpected incease in the money supply. Thus, in the shot un money is not neutal. This is shown in Figue 3. What happens to the inteest ate? To answe this question, we fist note that aggegate demand has inceased. What accounts fo this incease in desied spending? Aggegate demand depends on the steam of income, factos that affect the MK, the depeciation ate, the initial capital stock, and the uncetainty of the etun to capital. The change in income is unexpected and we assume it is taken to be tempoay, so it will have no impact on aggegate demand. None of the othe deteminants of desied spending listed above changed eithe. The only emaining

3 3 vaiable that affects aggegate demand is the eal inteest ate. Hence, the eal inteest ate must have deceased in ode to induce poduces and consumes to incease thei desied spending. AS ( = e) ' ' ' Figue 3: An incease in the money supply We can see how this incease came about in Figue 4. The incease in the money supply inceases the supply of eal money balances and this causes the eal inteest ate to fall, initially to 1. Howeve, this is not quite the end of the stoy. The pice level inceases to ' and output inceases to ' as a esult of the lowe inteest ate and these changes feedback into the money maket. The highe pice level educes the supply of eal money balances and the incease in ρ= ' 1 L(,, γ, πe) s M / M s' / M/ Figue 4: Feedback effects in the money maket

4 4 eal income inceases money demand. This causes the eal ate to dift up to '. Since we know that desied spending on goods inceased, we know the feedback effect can only patially offset the initial decline in the eal inteest ate and so ' must be less than. This state of affais cannot last. Eventually poduces will notice the incease in the pice level and expectations will adjust. As the expected pice level inceases, the shot un aggegate ' e AS(= ) AS ( = e) ' ' Figue 5: Retun to the Long Run supply cuve will shift back and to the left. Output will fall and pices will ise duing this adjustment. This etun to the long un with a pice level of and output is pictued in Figue 5. In the money maket, the incease in the pice level to etuns the level of eal money balances to M s / = M s '/ and the etun of income to etuns the money demand cuve to its oiginal position. As a esult, the inteest ate etuns to, which is the ate of time pefeence. an incease in the iskiness of the maginal poduct of capital Suppose the etun to capital becomes moe uncetain. This change may occu as the esult of political uncetainty, such as the pospect of wa o the outcome of a contested and impotant election, o it may occu as the esult of financial uncetainty, such as the fallout following a shap decline in stock pices. Whateve the cause, and incease in σ will diectly

5 5 effect investment demand. An incease in uncetainty lowes investment demand and this will shift the cuve back and to the left. This demand shock will cause the pice level to fall. Fo a given expected pice level, the decline in pices will be intepeted by poduces as a decline in AS(= e) ' ' ' Figue 6: Shock to Aggegate Demand thei elative pice and they will cutback output. The pice level falls to ' and output falls to '. This shock is shown in Figue 6. What happens to the inteest ate? The decease in the pice level inceases the supply of eal money balances and this incease will put downwad pessue on the eal inteest ate. The decline in income fom to ' educes money demand and this decline also puts downwad ρ= ' e L(,, γ, π ) s M / M s/' M/ Figue 7: Effect on the inteest ate

6 6 pessue on the eal ate. We can conclude that the eal inteest ate will decline. This discussion is pictued in Figue 7. a tempoay incease in the pice of oil James Hamilton showed that all but one ecession in the post WWII ea was immediately peceded by o coincident with a shap incease in the pice of oil. An incease in the pice of oil aises the cost of poduction and tanspotation, and may also disupt the patten of poduction. Thee ae, of couse, othe shocks, such as bad weathe, stikes, and bottlenecks, that incease the cost of poduction, but oil pice shocks usually stand cente stage in the discussion of supply shocks. An incease in the cost of poduction diven by highe oil pices will cause the AS cuve to shift back and to the left. This supply shock educes output and causes an initial shotage of goods and sevices that pushes up the pice level. The effects of this shock ae shown in Figue 8. ' AS' AS(= e) ' Figue 8: Shock to Aggegate Supply What happens to the inteest ate? The incease in the pice level will lowe the supply of eal money balances and put upwad pessue on inteest ates. The decline in income will educe money demand and put downwad pessue on inteest ates. Which effect is stonge? Since equilibium output falls to ', we know that desied spending also falls to '. Now, the

7 7 shock to oil pices is tempoay, so thee is no wealth effect on demand and we also assume that thee has been no change in the factos that affect the MK, the depeciation ate, uncetainty about the etun to capital, o the initial capital stock. Thus, the eal inteest ate is the only facto that affects desied spending that has change and so it must have inceased. This esult tells us that effect of the decline in income on money demand must be small elative to the change in the supply of eal money balances caused by the incease in the pice level. This esult is pictued in Figue 9. ' ρ= e L(,, γ, π ) M s/' s M / M/ Figue 9: Effect on the inteest ate fom a supply shock an incease in tansactions cost Shocks can also oiginate in the money maket. Fo example, an unexpected incease in tansactions cost, say as the esult of disuption in the banking system, will cause money demand to incease. This incease in money demand will cause the inteest ate to ise. The incease in the inteest ate educes consumption and investment demand and the cuve shifts back and to the left. This decline in aggegate demand causes pices to fall and, since the change in the pice level is unexpected, poduces will cut back output. A pictue of this shock to aggegate demand via the money maket looks exactly like the shock pictued in Figue 6.

8 8 A shock that oiginates in investment o consumption demand and causes aggegate demand to fall has the same impact on pices and output as an incease in tansactions cost o a decease in expected inflation. Howeve, thee is an impotant diffeence in how these shocks affect the inteest ate. A negative shock to aggegate demand fom, say, an incease in uncetainty will cause the inteest ate to fall. On the othe hand, a negative shock to aggegate demand fom, say, an incease in tansactions cost will esult in a highe inteest ate. Conclusion In the -AS model money is not neutal in the shot un. An unexpected incease in the money supply leads to a supise incease in the pice level. oduces misintepet the incease in pices as an incease in thei elative pice and incease output. Howeve, in the long un expectations adjust and money is neutal. The model also allows us to analyze shocks to the economy that oiginate in investment o consumption demand, money demand, and on the supply side of the economy. If the shock shifts the cuve, then output and pice will move in the same diection. On the othe hand, a shock fom the supply side will cause pices and output to move in opposite diections.