EC 205 Macroeconomics I. Lecture 19

Transcription

1 EC 205 Macroeconomics I Lecture 19

2 Macroeconomics I Chapter 12: Aggregate Demand II: Applying the IS-LM Model

3 Equilibrium in the IS-LM model The IS curve represents equilibrium in the goods market. r LM The LM curve represents money market equilibrium. r 1 The intersection determines the unique combination of and r that satisfies equilibrium in both markets. 1 IS

4 Policy analysis with the IS-LM model r LM We can use the IS-LM model to analyze the effects of r 1 fiscal policy: G and/or T monetary policy: M 1 IS

5 An increase in government purchases 1. IS curve shifts right 1 by 1 MPC G causing output & income to rise. 2. This raises money demand, causing the interest rate to rise which reduces investment, so the final increase in is smaller than 1 G 1 MPC r 2 r 1 r LM IS 1 IS 2

6 A tax cut Consumers save (1-MPC) of the tax cut, so the initial boost in spending is smaller for ΔT than for an equal ΔG and the IS curve shifts by MPC 1 MPC T so the effects on r and are smaller for ΔT than for an equal ΔG. 2. r 2 r 1 r LM IS 2 IS 1

7 Monetary policy: An increase in M 1. ΔM > 0 shifts the LM curve down (or to the right) 2. causing the interest rate to fall r 1 r 2 r LM 1 LM 2 3. which increases investment, causing output & income to rise. 1 2 IS

8 Interaction between monetary & fiscal policy Model: Monetary & fiscal policy variables (M, G, and T) are exogenous. Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interaction may alter the impact of the original policy change.

9 The Central Bank s response to ΔG > 0 Suppose the government increases G. Possible CB responses: 1. hold M constant 2. hold r constant 3. hold constant In each case, the effects of the ΔG are different

10 Response 1: Hold M constant If the gov t raises G, the IS curve shifts right. r LM 1 If the CB holds M constant, then LM curve doesn t shift. r 2 r 1 Results: 2 1 r r2 r1 1 2 IS 1 IS 2

11 Response 2: Hold r constant If the gov t raises G, the IS curve shifts right. To keep r constant, the CB increases M to shift LM curve right. r 2 r 1 r LM 1 LM 2 Results: IS 1 IS 2 r 0

12 Response 3: Hold constant If the gov t raises G, the IS curve shifts right. r LM 2 LM 1 To keep constant, the CB reduces M to shift LM curve left. r 3 r 2 r 1 Results: IS 1 IS 2 r r3 r1

13 Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Fed holds money supply constant Fed holds nominal interest rate constant Estimated value of Δ/ΔG Estimated value of Δ/ΔT

14 Digression: Macroeconomic Goals Internal balance describes the macroeconomic goals of producing at potential output (at full employment ) and of price stability (low inflation). An unsustainable use of resources (overemployment) tends to increase prices; an ineffective use of resources (underemployment) tends to decrease prices. Volatile aggregate demand and output tend to create volatile prices. Price level movements reduce the economy s efficiency by making the real value of the monetary unit less certain and thus a less useful guide for economic decisions. Internal balance became more popular especially after WW2

15 Macroeconomic Goals (cont.) Taylor Rule: i t =p t + r t * + a p (p t - p * t ) + a y (y t - y t ) Equivalently r t =r t * + a p (p t - p * t ) + a y (y t - y t ) Very popular rule of thumb in central banking Divine Coincidence: stabilizing inflation also stabilizes the distance of output (Olivier Blanchard and Jordi Gali) Alternative versions exist (asset prices, future uncertainty, into RHS)

16 Macroeconomic Goals (cont.)

17 Shocks in the IS-LM model IS shocks: exogenous changes in the demand for goods & services. Examples: stock market boom or crash change in households wealth ΔC change in business or consumer confidence or expectations ΔI and/or ΔC

18 Shocks in the IS-LM model LM shocks: exogenous changes in the demand for money. Examples: a wave of credit card fraud increases demand for money. more ATMs or the Internet reduce money demand.

19 IS-LM and aggregate demand So far, we ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift LM and therefore affect. The aggregate demand curve (introduced in Chap. 10) captures this relationship between P and.

20 Deriving the AD curve r LM(P 2 ) Intuition for slope of AD curve: r 2 LM(P 1 ) P (M/P ) r 1 IS LM shifts left r P 2 1 I P 2 P 1 AD 2 1

21 Monetary policy and the AD curve The Fed can increase aggregate demand: r r 1 LM(M 1 /P 1 ) LM(M 2 /P 1 ) M LM shifts right r I r 2 P 1 2 IS at each value of P P 1 AD AD 1

22 Fiscal policy and the AD curve Expansionary fiscal policy ( G and/or T) increases agg. demand: r r 2 r 1 LM IS 2 T C IS shifts right P 1 2 IS 1 at each value of P P AD 2 AD 1

23 IS-LM and AD-AS in the short run & long run Recall from Chapter 10: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run equilibrium, if then over time, the price level will rise fall remain constant

24 The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing to fall. r LRAS LM(P 1 ) IS 1 IS 2 P LRAS P 1 SRAS 1 AD 1 AD 2

25 The SR and LR effects of an IS shock r LRAS LM(P 1 ) In the new short-run equilibrium, P P 1 LRAS IS 2 IS 1 SRAS 1 AD 1 AD 2

26 The SR and LR effects of an IS shock r LRAS LM(P 1 ) In the new short-run equilibrium, IS 1 IS 2 Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down P P 1 LRAS SRAS 1 AD 1 AD 2

27 The SR and LR effects of an IS shock r LRAS LM(P 1 ) LM(P 2 ) IS 1 IS 2 Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down P P 1 P 2 LRAS SRAS 1 SRAS 2 AD 1 AD 2

28 The SR and LR effects of an IS shock r LRAS LM(P 1 ) LM(P 2 ) This process continues until economy reaches a long-run equilibrium with P LRAS IS 2 IS 1 P 1 SRAS 1 P 2 SRAS 2 AD 1 AD 2

29 Example: Analyze SR & LR effects of ΔM a. Draw the IS-LM and AD-AS diagrams as shown here. r LRAS LM(M 1 /P 1 ) b. Suppose the CB increases M. Show the short-run effects on your graphs. IS c. Show what happens in the transition from the short run to the long run. P LRAS d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? P 1 SRAS 1 AD 1

30 Chapter Summary 1. IS-LM model a theory of aggregate demand exogenous: M, G, T, P exogenous in short run, in long run endogenous: r, endogenous in short run, P in long run IS curve: goods market equilibrium LM curve: money market equilibrium

31 2. AD curve Chapter Summary shows relation between P and the IS-LM model s equilibrium. negative slope because P (M/P ) r I expansionary fiscal policy shifts IS curve right, raises income, and shifts AD curve right. expansionary monetary policy shifts LM curve right, raises income, and shifts AD curve right. IS or LM shocks shift the AD curve.

32 Macroeconomics I Chapter 14: Aggregate Supply and the Short-run Tradeoff Between Inflation and

33 Introduction In previous chapters, we assumed the price level P was stuck in the short run. This implies a horizontal SRAS curve. Now, we consider two prominent models of aggregate supply in the short run: Sticky-price model Imperfect-information model

34 Introduction Both models imply: agg. output natural rate of output a positive parameter actual price level expected price level Other things equal, and P are positively related, so the SRAS curve is upward-sloping.

35 The sticky-price model Reasons for sticky prices: long-term contracts between firms and customers menu costs firms not wishing to annoy customers with frequent price changes Assumption: Firms set their own prices (e.g., as in monopolistic competition).

36 The sticky-price model An individual firm s desired price is: where a > 0. p = P + a( - ) Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price before they know how P and will turn out: p = EP + a(e - E )

37 The sticky-price model p = EP + a(e - E ) Assume sticky price firms expect that output will equal its natural rate. Then, p = EP To derive the aggregate supply curve, first find an expression for the overall price level. s = fraction of firms with sticky prices. Then, we can write the overall price level as

38 The sticky-price model P = s[ep] + (1- s)[p + a( - )] price set by sticky price firms price set by flexible price firms Subtract (1-s)P from both sides: sp = s[ep] + (1- s)[a( - )] Divide both sides by s : (1- s)a P = EP + ( - ) s

39 The sticky-price model P = EP + (1- s)a s ( - ) High EP High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices. High High P When income is high, the demand for goods is high. Firms with flexible prices set high prices. The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Δ on P.

40 The sticky-price model P = EP + (1- s)a s ( - ) Finally, derive AS equation by solving for :

41 The imperfect-information model Assumptions: All wages and prices are perfectly flexible, all markets are clear. Each supplier produces one good, consumes many goods. Each supplier knows the nominal price of the good she produces, but does not know the overall price level.

42 The imperfect-information model Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level. Supplier does not know price level at the time she makes her production decision, so uses EP. Suppose P rises but EP does not. Supplier thinks her relative price has risen, so she produces more. With many producers thinking this way, will rise whenever P rises above EP.

43 Summary & implications P LRAS P EP P EP P EP SRAS Both models of agg. supply imply the relationship summarized by the SRAS curve & equation.

44 Summary & implications Suppose a positive AD shock moves output above its natural rate and P above the level people had expected. Over time, EP rises, SRAS shifts up, EP2 and output returns to its natural rate. P P SRAS equation: ( P EP) EP 3 3 P 2 P EP LRAS 1 SRAS 2 2 SRAS 1 AD 2 AD 1

45 Inflation, Unemployment, and the Phillips Curve The Phillips curve states that π depends on expected inflation, Eπ. cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate supply shocks, ν (Greek letter nu ). E ( u u n ) where ν > 0 is an exogenous constant.

46 Deriving the Phillips Curve from SRAS (1) ( P EP) (2) P EP (1 )( ) (3) P EP (1 )( ) (4) ( P P ) ( EP P ) (1 )( ) 1 1 (5) E (1 )( ) n (6) (1 )( ) ( u u ) n (7) E ( u u )

47 Comparing SRAS and the Phillips Curve SRAS: ( P EP) Phillips curve: E ( u u n ) SRAS curve: Output is related to unexpected movements in the price level. Phillips curve: Unemployment is related to unexpected movements in the inflation rate.

48 Adaptive expectations Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. A simple version: Expected inflation = last year s actual inflation Then, P.C. becomes E 1 n 1 ( u u )

49 Inflation inertia n 1 ( u u ) In this form, the Phillips curve implies that inflation has inertia: In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate. Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set.

50 Two causes of rising & falling inflation n 1 ( u u ) cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up. demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up.

51 Graphing the Phillips curve In the short run, policymakers face a tradeoff between π and u. E π E ( u u n ) 1 The short-run Phillips curve n u u

52 Shifting the Phillips curve People adjust their expectations over time, so the tradeoff only holds in the short run. E 2 E 1 π E ( u u n ) E.g., an increase in Eπ shifts the short-run P.C. upward. n u u

53 The sacrifice ratio To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year s real GDP that must be foregone to reduce inflation by 1 percentage point. A typical estimate of the ratio is 5.

54 The sacrifice ratio Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year s GDP: GDP loss = (inflation reduction) x (sacrifice ratio) = 4 x 5 This loss could be incurred in one year or spread over several, e.g., 5% loss for each of four years. The cost of disinflation is lost GDP. One could use Okun s law to translate this cost into unemployment.

55 Rational expectations Ways of modeling the formation of expectations: adaptive expectations: People base their expectations of future inflation on recently observed inflation. rational expectations: People base their expectations on all available information, including information about current and prospective future policies.

56 Painless disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small: Suppose u = u n and π = Eπ = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible. If the announcement is credible, then Eπ will fall, perhaps by the full 4 points. Then, π can fall without an increase in u.

57 Calculating the sacrifice ratio for the Volcker disinflation 1981: π = 9.7% 1985: π = 3.0% Total disinflation = 6.7% year u u n u-u n % 6.0% 3.5% Total 9.5%

58 Calculating the sacrifice ratio for the Volcker disinflation From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%. Okun s law: 1% of unemployment = 2% of lost output. So, 9.5% cyclical unemployment = 19.0% of a year s real GDP. Sacrifice ratio = (lost GDP)/(total disinflation) = 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation.

59 The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3-8).

60 An alternative hypothesis: Hysteresis Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. Negative shocks may increase u n, so economy may not fully recover.

61 Hysteresis: Why negative shocks may increase the natural rate The skills of cyclically unemployed workers may deteriorate while unemployed, and they may not find a job when the recession ends. Cyclically unemployed workers may lose their influence on wage-setting; then, insiders (employed workers) may bargain for higher wages for themselves. Result: The cyclically unemployed outsiders may become structurally unemployed when the recession ends.

62 Chapter Summary 1. Two models of aggregate supply in the short run: sticky-price model imperfect-information model Both models imply that output rises above its natural rate when the price level rises above the expected price level.

63 2. Phillips curve Chapter Summary derived from the SRAS curve states that inflation depends on expected inflation cyclical unemployment supply shocks presents policymakers with a short-run tradeoff between inflation and unemployment

64 Chapter Summary 3. How people form expectations of inflation adaptive expectations based on recently observed inflation implies inertia rational expectations based on all available information implies that disinflation may be painless

65 Chapter Summary 4. The natural rate hypothesis and hysteresis the natural rate hypotheses states that changes in aggregate demand can only affect output and employment in the short run hysteresis states that aggregate demand can have permanent effects on output and employment