4 Theory of Economic Fluctuations

Transcription

1 4 Theory of Economic Fluctuations 4.1 Business Cycles 4.2 The IS-LM model 4.3 The AD-AS model 4.4 (Neo-) Classical Models of Fluctuations, 4.5 (New-) Keynesian Models of Fluctuations

2 PART 4.3 The AD-AS Model IS-LM is short-run analysis, with the price level fixed Aggregate Demand (AD) and Aggregate Supply (AS) Price Adjustment and the Attainment of General Equilibrium

3 Aggregate Demand So far, we ve been using the IS-LM model to analyze the short run, with P fixed. But a change in P would shift LM and therefore affect Y. The aggregate demand (AD) curve captures this relationship between P and Y. The AD curve is unlike other demand curves, which relate the quantity demanded of a good to its relative price; the AD curve relates the total quantity of goods demanded to the general price level, not a relative price IS-LM explains the position and slope of the AD curve

4 The Slope of the AD-Curve Why does the AD curve have a negative slope? An increase in the price level P (all else equal, including M) reduces m = M P. Given the supply of nominal balances M, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market. The LM curve shifts to the left and income falls.

5 The Slope of the AD-Curve Graphically

6 The Slope of the AD-Curve Analytically [ ] C a dy = r + I r dr MPC 1 MPC 1 MPC dt + 1 dg (IS-curve) 1 MPC dm = dm P m dp P = L y dy L r dr L r dπ e (LM-curve) We can use this to obtain the slope of the AD-curve in (Y,P)-space by setting all infinitesimals to zero except dr, dy and dp and solve for dy /dp: dy dp AD= 1 PL r (C a r + I r )m 1 MPC + Ly L r (C a r + I r ) < 0

7 Factors that shift the AD curve

8 Expansionary Fiscal Policy dy dg AD= 1 > 0 (1 MPC) + (Cr a + I r ) Ly L r

9 Expansionary Monetary Policy dy dm AD= 1 PL r (C a r + I r ) (1 MPC) + (C a r + I r ) Ly L r > 0

10 The Aggregate Supply Curve The aggregate supply curve shows how much output producers are willing to supply at any given price level The short run AS (SRAS) curve is horizontal; prices are fixed in the short run, labor market equilibrium is not required The long run AS (LRAS) curve is vertical at the full-employment level of output, as determined by equilibrium in the labor market

11 The LRAS Curve Consider aggregate production function Y = F ( + A, + K, + N) where Y here denotes real output, A is productivity, K is capital and N is labor input. Taking the total differential of this expression: dy = F A da + F K dk + F N dn where F K = F K > 0, F N = F N > 0.

12 Labor Demand From before, we know that the demand for labor is N d = ND( w, A, + K) + where w is the real wage. Taking the total differential of this expression: dn d = ND w dw + ND A da + ND K dk where ND w = ND w > 0, ND x = ND x > 0 for x = A, K.

13 Labor Supply Suppose that labor supply is given N s = NS(w) Taking the total differential of this expression: where NS w = n w > 0 dn s = NS w dw

14 The LRAS Curve Labor market equilibrium requires N d = N s, such that we have dy =F A da + F K dk + F N dn dn = ND w dw + ND A da + ND K dk dn =NS w dw (Production) (Labor Demand) (Labor Supply) Solving for dn and dw, we have ( ) dy = F K + F NND K 1 + NDw NS w dk + ( F A + + F NND A 1 + NDw NS w ) da

15 The LRAS Curve dy = ( F K + F NND K 1 + NDw NS w ) dk + ( F A + F NND A 1 + NDw NS w ) da dy does not depend dp, therefore, dy /dp = 0 and the LRAS is vertical. Productivity change: dy da = F A + F N ND A 1+ NDw NSw > 0 Change in the capital stock: dy dk = F K + F N ND K 1+ NDw NSw > 0

16 The SRAS Curve Labor market equilibrium is not required, instead dp = 0. dy =F A da + F K dk + F N dn dp =0 (Production) (Prices are fixed) Any dn may be consistent with dp = 0, and therefore any dy may be consistent with dp = 0. Firms supply any level of Y for a given P, and the SRAS curve is horizontal.

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18 General Equilibrium How markets are interlinked: LM-curve in (r, Y )-space : Asset Market Clearing IS-curve in (r, Y )-space : Goods Market Clearing AD-curve in (P, Y )-space : Asset Market Clearing+Goods Market Clearing Short-run Equilibrium: AD and SRAS intersect No labor market equilibrium and P fixed. AD curve determines Y Long-run Equilibrium: AD and LRAS intersect Labor market equilibrium and P adjusts. AS curve determines Y

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20 General Equilibrium Algebracially dy = C r a + I r MPC dr 1 MPC 1 MPC dt + 1 dg 1 MPC (IS - curve) dm P =m dp P + L y dy L r dr L r dπ e (LM -curve) 1 MPCdT + dg + PL dy = r (Cr a + I r )(dm mdp) + (Cr a + I r )dπ e 1 MPC + Ly L r (Cr a + I r ) (AD - curve) Short-run Equilibrium: dp =0 dy = MPCdT + dg + 1 PL r (C a r + I r )dm + (C a r + I r )dπ e 1 MPC + Ly L r (C a r + I r ) (Short run GE)

21 General Equilibrium Algebraically 1 MPCdT + dg + PL dy = r (Cr a + I r )(dm mdp) + (Cr a + I r )dπ e 1 MPC + Ly L r (Cr a + I r ) (AD - curve) ( ) ( ) dy = F K + F NND K 1 + NDw NS w Long-run Equilibrium: dp = PLr m dy = dk + F A + F NND A 1 + NDw NS w da ( ) [( ) 1 MPC + Ly F Cr a K + F NND K dk + + I r L r 1 + NDw NS w MPC PL r m(cr a + I r ) dg + dm m + PLr m dπe ) ( ) PLr dt + m Cr a + I r ( F K + F NND K 1 + NDw NS w dk + F A + F NND A 1 + NDw NS w da ( (LRAS - curve) F A + F NND A 1 + NDw NS w ) da (Long run GE) ]

22 Aggregate Demand Shocks Short run: Monetary Policy: M, Y, dp = 0 Fiscal Policy: T, G Y, dp = 0 Other Factors: π e, wealth, future MPK,... Y, dp = 0 Long run: Monetary Policy: M, dy = 0, dp/p = dm/m Monetary neutrality: dp/p = dm/m one percent increase in money growth dm/m leads to one percent increase in inflation dp/p. Fiscal Policy: T, G dy = 0, P Other Factors: π e, wealth, future MPK,... dy = 0, P

23 Aggregate Demand Shocks

24 Aggregate Supply Shocks Shocks to aggregate supply Technology Shocks A Y, P Shock to Labor Supply, e.g. labor force, Y, P Other shocks to costs of production, e.g. oil prices: Y, P If shocks are permanent, the effects are permanent. If shocks are transitory, the effects are transitory.

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26 Can we use the ISLM-ADAS framework to explain the behavior of output, employment and prices during oil price shocks of the 1970s (and 2000s)?

27 Oil Shocks An oil price increase is an adverse supply shocks: firms cut back on energy use and this lowers output produced for given N and K. It looks therefore just like a decrease in productivity A. Two large oil shocks in the 1970s: (permanent) and (temporary). One large oil shock (permanent or temporary?)

28 Oil Shocks What does the IS-LM/AD-AS model predict? 1. Reduction in labor demand and a decrease in employment. 2. A decrease in output Y, an increase in prices P 3. P shifts LM to the left, and the interest rate increases r 4. A decrease in consumption and investment Watch out: effects depend on how fiscal and monetary policy respond to the oil shocks.

29 Unemployment

30 Real GDP Growth

31 Consumption and Investment Growth

32 Inflation and Nominal Interest Rates

33 Real Interest Rate

34 The model fits the observations quite well, except for the real interest rate The real interest rate did not rise during the oil price shock (though it did during the shock) It could be that people expected the oil price shock to be permanent In that case the real interest rate would not necessarily rise because of an increase in π e (LM shifts right) and reductions in future expected MP K and households expected future income (IS shifts left). If so, people s expectations were correct, since the shock was permanent, while the shock was transitory.

35 The 2001 Recession Three (potential) contributing factors: 1. Stock Market Decline Household wealth C, IS shifts left 2. Corporate accounting scandals (Enron, Worldcom,...), added to stock market decline, discouraged investment C,I, IS shifts left 3. 9/11: fall in consumer and business confidence C,I, IS shifts left Model prediction: Y, C, I, r, P

36 Real GDP Growth

37 Consumption and Investment Growth

38 Real Interest Rate

39 Inflation and Nominal Interest Rates

40 The 2001 Recession Policy response to the 2001 recession: Fiscal Policy Stimulus, shifts IS curve right tax cuts in 2001 and 2003 spending increases: airline industry bailout, NYC reconstruction, Afghanistan war Monetary Policy Expansion, shifts LM curve right Policy intervention had intended effects: recession was short and mild.