Macroeconomics: Fluctuations and Growth

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1 Macroeconomics: Fluctuations and Growth Francesco Franco 1 1 Nova School of Business and Economics Fluctuations and Growth, 2011 Francesco Franco Macroeconomics: Fluctuations and Growth 1/43

2 Outline 1 Aggregate output 2 The Short Run Introduction Goods Markets Financial Markets Connecting Goods and Financial Markets Francesco Franco Macroeconomics: Fluctuations and Growth 2/43

3 GDP Measuring output National Income and product accounts were put together at the end of WWII (Simon Kuznets, Richard Stone). Example Blackboard 2 firms (See Blanchard et al. p16) Francesco Franco Macroeconomics: Fluctuations and Growth 3/43

4 GDP Measuring output Definitions 1 Gross Domestic Product is the value of final goods and services produced in the economy during a given period 2 GDP is the sum, of value added in the economy during a given period 3 GDP is the sum of incomes in the economy during a given period Francesco Franco Macroeconomics: Fluctuations and Growth 4/43

5 GDP Measuring output Figure: GDP by type of income Francesco Franco Macroeconomics: Fluctuations and Growth 5/43

6 GDP Measuring output Figure: GDP by type of income Francesco Franco Macroeconomics: Fluctuations and Growth 6/43

7 GDP Measuring output Figure: GDP by type of income Francesco Franco Macroeconomics: Fluctuations and Growth 7/43

8 GDP Measuring output Beyond GDP? A lot of e orts to incorporate measures of well-being, envornmental quality, check Francesco Franco Macroeconomics: Fluctuations and Growth 8/43

9 GDP Real versus Nominal Nominal GDP is the sum of the quantities of final goods produced times their current price. GDP increases for: 1 the production of most goods increase over time 2 the prices of most goods increase over time (correcting for quality) Real GDP is denoted by Y Francesco Franco Macroeconomics: Fluctuations and Growth 9/43

10 GDP Real versus Nominal Figure: Real Versus Nominal Francesco Franco Macroeconomics: Fluctuations and Growth 10/43

11 GDP Real versus Nominal 2 goods and deflator Figure: GDP with more than one good Francesco Franco Macroeconomics: Fluctuations and Growth 11/43

12 Unemployment rate Definitions employment is the number of people who have a job unemployment is the number of people who do not have but are looking for one labour force is the sum of unemployed and employed unemployment rate is the ratio of the number of unemployed to the number of people in the labour force Francesco Franco Macroeconomics: Fluctuations and Growth 12/43

13 Unemployment rate Figure: Unemployment rate Francesco Franco Macroeconomics: Fluctuations and Growth 13/43

14 Inflation rate Definition Inflation is a sustained rise in the general level of prices, the price level 1 The GDP deflator: average price of goods produced in the economy 2 The Consumer Price index: average price of goods consumed by population Francesco Franco Macroeconomics: Fluctuations and Growth 14/43

15 Inflation rate Figure: Inflation in the Euro area Francesco Franco Macroeconomics: Fluctuations and Growth 15/43

16 Business Cycles Shocks Figure: Real GDP growth Francesco Franco Macroeconomics: Fluctuations and Growth 16/43

17 Business Cycles Shocks Figure: Employment Growth Francesco Franco Macroeconomics: Fluctuations and Growth 17/43

18 Goods market Figure: The composition of GDP, EU 15, 2008 Francesco Franco Macroeconomics: Fluctuations and Growth 18/43

19 IS Goods Markets in a closed economy with price fixed Aggregate Demand Z : Z C(Y, T, W )+I(r, e )+G. C : is consumption from Households depends on income Y, taxes T and wealth W I: investment depends on the real interest rate r, expected profits e G : public expenditure Francesco Franco Macroeconomics: Fluctuations and Growth 19/43

20 Consumption Francesco Franco Macroeconomics: Fluctuations and Growth 20/43

21 Consumption A first carachterization The keynesian consumption function C = c 0 + c y Y D, Y D = Y T, T = t y Y. c 0 is autonomous consumption 0 < c y < 1 is called the marginal propensity to consume out of disposable income Francesco Franco Macroeconomics: Fluctuations and Growth 21/43

22 IS Derivation on the blackboard Figures on the blackboard 1 Goods Market equilibrium. 2 interest rate change. 3 Goods market equilibrium for every interest rate. Francesco Franco Macroeconomics: Fluctuations and Growth 22/43

23 IS Definition The IS schedule describes the equilibrium value of output associated with any value of the interest rate. To find it impose equilibrium in Goods Market: Y = Z 1 Y = 1 c y (1 t y ) Multiplier:mm 5 6 c 0 + I(r, e )+G Autonomous Spending=Ā(r) Francesco Franco Macroeconomics: Fluctuations and Growth 23/43

24 IS Any change in the size of the multiplier will change the slope of the IS. For example, a rise in the propensity to consume will increase the multiplier, making the IS flatter. Any change in the interest sensitivity of investment will lead to a consequential change in the slope of the IS curve: a less interest-elastic investment function will be reflected in a steeper IS curve. Any change in autonomous consumption or in government expenditure will cause the IS curve to shift by the change in autonomous spending times the multiplier. A change in the variable e in the investment function also shifts the IS. Francesco Franco Macroeconomics: Fluctuations and Growth 24/43

25 IS multiplier A feature of the model of the goods market is that quantities adjust through the multiplier process to take the economy to a stable short-run equilibrium. Example A fall in investment leads to a contraction of output until the level of income has fallen to the extent required to make saving equal to the lower level of investment: Y = I + c y (1 t y ) I +[c y (1 t y )] 2 I +... = I + mm mm 1 2 I + I +... mm mm = mm ú I Francesco Franco Macroeconomics: Fluctuations and Growth 25/43

26 IS Employment In the short run we the assumption is that to change production firms have to change employment N (we will have an exercise with inventories) Y = N in fact before employment is a ected inventories are likely to change first. Francesco Franco Macroeconomics: Fluctuations and Growth 26/43

27 LM How do you allocate your wealth W? Simplification only 2 assets: Money M and Bonds B Portfolio allocation, M can be used for transactions (proxied by Y )whileb gives a nominal interest rate i Francesco Franco Macroeconomics: Fluctuations and Growth 27/43

28 LM Money demand or liquidity demand (real): M d P = L(Y, i) A rise in the level of income, holding the interest rate unchanged, will raise the demand for money A rise in the interest rate, holding the level of income unchanged will lower the demand for money. Francesco Franco Macroeconomics: Fluctuations and Growth 28/43

29 LM A first hint at selfulfilling prophecies Equilibrium in Bonds Market determine their price P B.The interest rate is then derived, for example a T-Bill with face value 100 has an interest rate: i = 100 P B P B. Speculative motive (Keynes). Expectations drive financial markets and that shifts in expectations have a self-fulfilling character. If bondholders suddenly believe that the interest rate will be higher in the future than they had previously believed, they will expect capital losses and will sell their bonds, driving bond prices down and interest rates up the expectation of a rise in the interest rate is fulfilled. Francesco Franco Macroeconomics: Fluctuations and Growth 29/43

30 LM Money Supply The central bank controls the money supply M s. Change Supply with Open Market Operations. Francesco Franco Macroeconomics: Fluctuations and Growth 30/43

31 LM Financial Markets Equilibrium Figures on the blackboard 1 Financial Markets equilibrium. 2 income rate change. 3 Money market equilibrium for every income level. Francesco Franco Macroeconomics: Fluctuations and Growth 31/43

32 LM Financial Markets Equilibrium Definition The LM is the schedule that shows the equilibrium value of interest rate associated with any value of output. Equilibrium determination M d P = Ms P, L(Y, i) = Ms P. Francesco Franco Macroeconomics: Fluctuations and Growth 32/43

33 LM Financial Markets Equilibrium Any rise in the transactions velocity as the result of financial innovation (e.g. introduction of credit cards, development of non-bank financial institutions) will rotate the to the right (clockwise), making it flatter. A more interest sensitive demand for money, reflecting the fact that small changes in the interest rate will have large e ects on the portfolio mix between money and bonds, will produce a flatter LM curve. Francesco Franco Macroeconomics: Fluctuations and Growth 33/43

34 LM Financial Markets Equilibrium An increase in the money supply will shift the curve to the right, since at any level of output, a higher money supply will require lower interest rate to bring money demand into line with the higher supply. A change in the price level. For a given interest rate, with a higher price level, the available transactions balances can only finance a lower amount of output. The LM-curve shifts to the left. Francesco Franco Macroeconomics: Fluctuations and Growth 34/43

35 IS-LM Scope Model to explain how the level of output and employment is determined by the level of aggregate demand in the short run Short-run equilibrium of the economy as a situation in which both the goods and the financial markets are in equilibrium The IS refers to the goods market, in fact 1 good. The LM to the money market, in fact 2 assets: money and bonds Francesco Franco Macroeconomics: Fluctuations and Growth 35/43

36 IS-LM Scope We can analyze Shifts in consumption or investment, changes in fiscal policy, i.e. in government expenditure or taxation Shifts in money demand, changes in monetary policy, e.g. in the money supply Francesco Franco Macroeconomics: Fluctuations and Growth 36/43

37 IS-LM The real interest rate The real interest rate is defined in terms of goods and the nominal interest rate in terms of money: 1 + r t =(1 + i t ) P t P e t+1 Using the definition of expected inflation fi e t = Pe t+1 P t P t, 1 + r t = (1 + i t) (1 + fi e t ), i ƒ r + fi e t Francesco Franco Macroeconomics: Fluctuations and Growth 37/43

38 IS-LM Nominal rigidity Short run with constant P = r = i Adjustment in Financial markets more rapid than in goods markets Hicks synthesis of General Theory Francesco Franco Macroeconomics: Fluctuations and Growth 38/43

39 IS-LM Fiscal Expansion Higher government spending will generate higher aggregate demand and a higher output level. Higher incomes will mean a higher demand for money but since monetary policy is unchanged (i.e. the LM curve remains fixed), a higher interest rate will be required in the new equilibrium to dampen the asset demand for money Francesco Franco Macroeconomics: Fluctuations and Growth 39/43

40 IS-LM Fiscal Expansion The rise in government spending produces excess demand for goods and results in unplanned inventory decumulation. If the rise in demand is sustained,then employment is increased. The economy moves from A to B The rise in real income associated with higher output boosts the transactions demand for money, with the result that there is excess demand for money balances at B. Bonds are sold, causing the bond price to fall and the interest rate to rise Francesco Franco Macroeconomics: Fluctuations and Growth 40/43

41 IS-LM Fiscal Expansion The rise in the interest rate dampens the excess demand for goods by reducing investment demand nevertheless, at C there remains excess demand owing to increased consumption associated with the multiplier e ects of the rise in government spending Output and employment rise further (C to D). The adjustment process continues until the new equilibrium at is attained. The full multiplier expansion of output (A to A ) does not occur because when there is a fiscal expansion without any change in the money supply, the increase in the interest rate causes a fall in interest-sensitive spending Francesco Franco Macroeconomics: Fluctuations and Growth 41/43

42 Summary IS-LM is the first analytical framework that allows us to think of Business Cycles but lacks behavioral microfoundations Dynamics and Stocks treatment are not entirely satisfactory but they do work Francesco Franco Macroeconomics: Fluctuations and Growth 42/43

43 Readings I W. Carlin and David Soskice. Macroeconomics Imperfections, Institutions and Policies. Oxford, 2008, Chapter 2, paragraphs1-4. Olivier Blanchard, Alessia Aminghini and Francesco Giavazzi Macroeconomics, a European Perspective. Prentice Hall, 2010, chapters 2-3. Francesco Franco Macroeconomics: Fluctuations and Growth 43/43

Chapter 10 Aggregate Demand I CHAPTER 10 0

Chapter 10 Aggregate Demand I CHAPTER 10 0 1 CHAPTER 10 1 2 Learning Objectives Chapter 9 introduced the model of aggregate demand and aggregate supply. Long run (Classical Theory) prices flexible output