Keynesian Matters Source:

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1 Money and Banking Lecture IV: The Macroeconomic E ects of Monetary Policy: IS-LM Model Guoxiong ZHANG, Ph.D. Shanghai Jiao Tong University, Antai November 1st, 2016

2 Keynesian Matters Source:

3 Road Map IS-LM Model Keynesian Cross commodity market: IS curve money market: LM curve IS-LM and monetary policy Aggregate Demand and Aggregate Supply liquidity preference and aggregate demand long run and short run aggregate supply AD-AS and monetary policy Dynamic Aggregate Demand and Aggregate Supply dynamic IS curve Philips curve adaptive expectation Taylor rule and Taylor principal

4 Keyesian Cross Planned expenditure: consumption planned investment government spending net export Actual expenditure: consumption investment = planned investment + unexpected inventory investment government spending net export The economy is at equilibrium when planned expenditure equals actual expenditure.

5 Consumption function In Keynes s view, consumption is determined by dispensable income: C = C 0 + mpc Y d, where C 0 is autonomous consumption, mpc is marginal propensity to consume, and Y d = Y T is dispensable income. Keynes believed that mpc must be between 0 and 1. Is it still true today? What will happen if mpc is heterogeneous?

6 Multipliers Taking the interest rates as given, multipliers that measure output s response to exogenous shocks can be calculated from the Keynesian cross: Y = C 0 + mpc (Y T )+I + G + NX. private spending multiplier (C 0 and I): government spending multiplier (G): government tax multiplier (T): net export multiplier (NX): 1 1 mpc 1 1 mpc 1 1 mpc mpc 1 mpc

7 Commodity Market: IS Curve IS curve originates from the notion that planned investment is negatively related to the interest rate: Y = C 0 + mpc (Y T )+I(r)+G + NX. interest rate shifts the planned expenditure in the Keynesian cross and in turn a ects the aggregate output; interest rate here is the real interest rate; therefore we have a downward sloping IS curve

8 Money Market: LM Curve LM curve originates from Keynes liquidity theory of money: ( M P )d = L(Y,i). money demand is negatively related to textcolor[rgb]1.00,0.00,0.00nominal interest rate and positively related to aggregate income; therefore for a given money supply, aggregate income and nominal interest rate are positively related; Fisher equation: i = r + e, which gives a one-to-one relationship between nominal and real interest rates given economic agents expectation on future inflation to be constant; therefore we have a upward sloping LM curve

9 Exogenous Shocks that A ect IS-LM Equilibrium Exogenous shocks that right-shift the IS curve: increase in autonomous consumption (wealth e ect) increase in investment that not driven by lower interest rate (animal spirit, technology progress) expansionary fiscal policy shock increase in net export (technology progress; preference shock; trade policy shock) Exogenous shocks that right-shift the LM curve monetary policy shock liquidity preference shock

10 Fiscal Policy vs Monetary Policy in IS-LM When money demand is not elastic with respect to interest rate (vertical LM curve), monetary policy is e ective while fiscal policy is ine ective; When money demand is extremely elastic with respect to interest rate (liquidity trap), fiscal policy is e ective while monetary policy is ine ective; Generally the more sensitive money demand is with respect to interest rate, the more e ective fiscal policy is compared to monetary policy.

11 IS-LM and Aggregate Demand Rising price level lowers real money supply (nominal money supply is given) and hence shifts the LM curve to the left; Left-moving LM curve cause a lower equilibrium aggregate income in the IS-LM curve; Therefore we have an aggregate demand curve that describe a negative relationship between price level and aggregate income; Factors that shift the aggregate demand curve: factors that shift the IS curve shift the aggregate demand curve at the same direction; factors that shift the LM curve shift the aggregate demand curve (except for the price level) shift the aggregate demand curve at the same direction.

12 Aggregate Supply Long-run aggregate supply curve is vertical (it s determined by factor endowments and technology); Short-run aggregate supply curve is upward sloping (wage and price stickiness); Factors that shift the short run aggregate supply curve: labor market friction; financial market friction; other production cost shocks (oil price, etc.)

13 Dynamic IS Curve Similar as the IS curve, a dynamic IS curve also portraits a negative relationship between the real interest rate and aggregate income: Y t = Ȳt (rt )+ t Ȳ t: natural output r t: real interest rate : natural interest rate t:demandshock

14 Fisher Equation Fisher equation relates nominal interest rate and real interest rate: r t = i t E t t+1 r t: ex ante real interest rate i t t+1: ex post real interest rate

15 Philips Curve Philips curve relates inflation and aggregate income: t = E t 1 t + (Y t Ȳ t)+ t Firms form their expectation on future inflation when setting prices; When actual output exceeds natural output, labor market is tightened, production cost is raised, and therefore price becomes higher; t:supplyshock

16 Adaptive Expectation Adaptive expectation is the simplest form of expectation formation: E t t+1 = t just simply a short-cut: in real macro we use rational expectation equilibrium (REE).

17 Taylor Rule and Taylor Principal A common way to characterize monetary policy response is to use a form of Taylor rule: i t = t + + t( t t )+ Y (Y t Ȳ t)+u t t : inflation target (not exactly inflation targeting) u t: monetary policy shock t > 0, Y > 0 Taylor Principle: 1+ t > 1

18 Taylor rule: US Experience =2.0, t =0.5, Y =0.5, t =2.0

19 Dynamic AD-AS A dynamic aggregate demand and aggregate supply model: Y t = Ȳt (rt )+ t r t = i t E t t+1 t = E t 1 t + (Y t Ȳ t)+ t E t t+1 = t i t = t + + t( t t )+ Y (Y t Ȳ t)+u t After some algebra we can eliminate the expectation and solve the model into two equations: dynamic aggregate supply u t: dynamic aggregate demand t = t 1 + (Y t Ȳ t)+ t Y t = Ȳt 1+ ( t t ) t + 1+ u t.

20 Long Run Economic Growth

21 Supply Shock

22 Demand Shock

23 Growth vs Inflation

24 Taylor Principal