MPRA Munich Personal RePEc Archive Macroeconomic Theory and Policy (2nd Edition) David Andolfatto Simon Fraser University 1. January 2008 Online at http://mpra.ub.uni-muenchen.de/6403/ MPRA Paper No. 6403, posted 19. December 2007 17:56 UTC
MACROECONOMIC THEORY & POLICY 2nd Edition David Andolfatto Simon Fraser University 2008
The expression P N i=1 bd i represents the world s trade balance position. Now, let s think about this for a second. What must the world trade balance position sum up to (assuming that there is no interplanetary trade)? Clearly, it must adduptozero. That is, for every country with a positive trade balance, there must be some other country in the world with a negative trade balance. For an arbitrary interest rate R, the world trade balance is not likely to be equal to zero. For example, if we interpret s D and x D in Figure 7.4 as the world supply and demand for loanable funds, then the world would desire to import goods from other planets. The distance between point A and point B represents an excess demand for loanable funds in the world financial market. In such a circumstances, it seems plausible to suppose that a competition for loanable funds will put upward pressure on the real interest rate. One might expect such pressure to move the interest rate to a point R at which the world supply and demand for loanable funds is equated; i.e., NX NX s D (R,y 1i,y2i) = x D (R,z 2i ). (42) i=1 That is, in the context of Figure 7.4, the equilibrium interest rate would be determined by the intersection of the two curves s D and x D. What this analysis suggests is that the real interest is likely to be influenced by how rapidly the world economy is expected to grow. We know, for example, that the 1970s was a decade characterized by a slowdown in world economic growth. In the context of our model, we might think of this as a general decline in z 2i across most (but not necessarily all) countries. The effect of such a growth shock would be to depress the world demand for investment and increase the world supply of saving. Both effects would serve to put downward pressure on the interest rate. Of course, the converse would be true in the event of a positive growth shock. 5. The IS Curve In the previous section, I described a theory that is distinctly neoclassical in flavor. For economists trained in the conventional wisdom, such a theory can be thought of as, at best, describing how economies function in the longrun (whatever this means). In the short-run, things appear to work very differently. Let me try to explain. It is a neoclassical view that prices serve as equilibrating variables. An example of what is meant by this phrase is to consider the discussion surrounding equation (42). The idea there was that if s D 6= x D, then the interest rate (a price) would move (by the magic of market forces ) to equilibrate the supply and demand for loanable funds. Likewise, in Chapter 2, the view there was that if n S 6= n D, then the real wage (a price) would move to equilibrate the supply and demand for labor. i=1 163
It was an insight of Keynes (and touched upon by Malthus) that an economy s equilibrating variables may not be prices; rather they may be quantities. To give you an example of what is meant by this, consider a closed economy with: s D (R, y 1,y 2 )=x D (R, z 2 ). (43) The neoclassical view is to see this equality holding by an appropriate adjustment in R. Butwhatif,insteadofmovementsinR, the equilibrium between saving and investment occurs through an adjustment in y 1 (a quantity variable)? According to this interpretation then, we should view R and z 2 as exogenous variables (y 2 is frequently viewed as exogenous as well, even though we have demonstrated above the dependence of y 2 on R and z 2 ). If this is the case, then equation (43) can only be brought to hold with equality by adjustments in y 1. How might this adjustment process be thought to occur? One way to think of the adjustment process is as follows. In a closed economy (without government purchases), the aggregate demand for output today is given by: AD c D 1 (R, y 1,y 2 )+x D (R, z 2 ). This aggregate demand function is decreasing in R and increasing in y 1. Next, we have the aggregate supply of output given by: AS y 1. So far, all of this is consistent with the neoclassical model. The point of departure is in the next step. The neoclassical model assumes that the AS is determined through price adjustment in the current period factor market; in this case, y 1 = z 1 f(k 1 ). The equation AS = AD then determines R ; i.e., z 1 f(k 1 )=c D 1 (R,y 1,y 2 )+x D (R,z 2 ). In contrast, the Keynesian model assumes that the (short-run) AS is independent of price adjustments in the current period factor market (imagine, for example, that factor prices are sticky for some unexplained reason). In this case, the Keynesian model simply assumes that factors are supplied to meet the demands of producers; and that producers simply supply output to meet the aggregate demand for output; i.e., y 1 = c D 1 (R, y 1,y 2 )+x D (R, z 2 ). Figure 7.5 depicts these two different ways in viewing the AS relationships. 164
FIGURE 7.5 The Keynesian Cross y 1 AS = y 1 (Keynesian) B AD(y 1,R L ) AD(y 1,R H ) zf(k) 1 1 C AS (Neoclassical) A 0 45 0 y*(r ) 1 H y*(r) 1 L y 1 In Figure 7.5, point C depicts the neoclassical equilibrium. While I have not drawn it, you can imagine an AD curve passing through point C with interest rate R. Figure 7.5 also depicts two AD relationships associated with two interest rates R H >R >R L. That is, a high interest rate depresses the aggregate demand for output; while a low interest rate stimulates the demand for output. The supply of output is imagined to response passively to whatever the demand for output turns out to be. Point A depicts the Keynesian equilibrium for a high interest rate; and point B depicts the Keynesian equilibrium for a low interest rate. Notice that the equilibrium level of output is a decreasing function of the interest rate. This negative relationship y 1(R) is called the IS Curve; see Figure 7.6. 54 While there is reason to doubt whether this Keynesian analysis accurately reflects Keynes own interpretation (he never derived an IS curve; this is something that Hicks invented much later), there can be little doubt that the IS curve reflects conventional wisdom. The basic idea is that the level of GDP in the short-run at least is largely determined by the demand for output (with supply reacting passively to fulfil this demand). You can see clearly how this view has permeated everyday language. For example, both Statistics Canada and the Bank of Canada regularly refer to measured GDP as aggregate demand. 54 IS stands for Investment-Saving. Note that the IS curve can alternatively be derived from equation (43). That is, the expression AS = AD is equivalent to equation (43). 165
FIGURE 7.6 The IS Curve y 1 A y*(r) 1 L C zf(k) 1 1 AS (Neoclassical) y*(r ) 1 H B IS(R) 0 R L R* R H R In Figure 7.6, points A and B are said to reflect a short-run disequilibrium. In an ideal world, prices (in this case, the real interest rate) would move the economy quickly to its long-run neoclassical equilibrium at point C. But since prices are not reliable equilibrating variables, this process may take a long time. In the meantime, the actual level of GDP (demand) may deviate from its long-run potential (neoclassical) level. The difference between actual GDP (demand) and potential GDP (long-run supply) is commonly referred to as the output gap. Since natural economic forces cannot be trusted to close the output gap quickly, there appears to be a role for government policy to help things work more smoothly. 6. Policy Implications (Conventional Wisdom) The conventional view is that the business cycle is ultimately caused by wild fluctuations in aggregate demand, stemming primarily from the demand for investment. These fluctuations are typically thought of as stemming from psychological factors (animal spirits) that lead to volatile movements in private sector expectations. But whether this is true or not need not concern us here. We may, in particular, assume that expectations change for good (fundamental) reasons; for example, an exogenous change in z 2 (the expected productivity 166
of future capital). In the neoclassical model, an exogenous increase in z 2 generates an increase in investment demand. In a closed economy, the effect of this increase in demand for output leads to an increase in the interest rate (leaving current GDP unchanged). 55 The higher interest rate suppresses current consumer demand (which is what allows more of the current GDP to be diverted toward the construction and purchase of new capital goods). In the Keynesian model, an exogenous increase in z 2 also generates an increase in investment demand. However, the increase in aggregate demand does not result in (an immediate) increase in the interest rate. Instead, the increase in demand is simply met by an increase in current production. That is, this positive demand shock results in a positive output gap. The economy appears to be overheating; see Figure 7.7. FIGURE 7.7 Aggregate Demand Shock y 1 y* 1 C B zf(k) 1 1 AS (Neoclassical) A H IS(R,z 2 ) 0 R* R H L IS(R,z 2 ) R In Figure 7.7, the initial long-run equilibrium is depicted by point A. The effect of the aggregate demand shock (z2 H >z2 L ) is to shift the IS curve up. In the neoclassical model, the increase in demand results in an increase in the 55 The neoclassical model can be extended, for example, by endogenizing capacity utilization. In this case, the increase in investment demand will lead firms to increase the supply of current GDP by utilizing capital more intensively. Greater utilization also implies an increase in the demand for labor and hence, and increase in the real wage. 167
real interest rate; so that the economy moves from point A to point B. In the Keynesian model, the increase in demand results in an expansion in current period GDP; so that the economy moves from point A to point C. It is natural to suppose that if the market cannot be relied upon to equilibrate the market, then perhaps the government can. In fact, this latter view is exactly the one adopted by central banks around the world. The basic idea is very simple. An exogenous increase in aggregate demand results in a positive output gap. A positive output gap implies that the current demand for output is outpacing the current long-run supply of output. To a central bank, the primary concern associated with a positive output gap is that since demand exceeds supply, the result is likely to be inflationary pressure. To combat the inflationary pressures that result from an overheating economy, the central bank must try (by whatever means at its disposal) to increase the real rate of interest. By acting in this manner, the central bank can cool off the excess aggregate demand (i.e., move the economy from point A to point B, instead of point C). Of course, the opposite would be true in the event of a negative aggregate demand shock. In this case, the central bank would be motivated to cut the real rate of interest. Failure to do so would result in a negative output gap and deflationary pressure. 7. Summary Capital is a durable asset that augments the economy s productive capacity. While capital depreciates in value as it is used in production, it may also be augmented with investment. Since current investment translates into future capital, investment constitutes a form of domestic saving. The demand for domestic investment depends primarily on the opportunity cost of investment (the real rate of interest) and the expected productivity of future capital. Changes in either of these factors is likely to influence the level of domestic investment demand. An economy s trade balance is determined by the difference between domestic saving and investment. When desired domestic saving exceeds domestic investment demand, the excess saving is exported (in exchange for foreign bonds). When desired domestic saving falls short of domestic investment demand, the difference is made up by imports (in exchange for domestic bonds). A negative trade balance is not necessarily the sign of a weak economy. It may, for example, reflect high expectations over the future return to investing domestically. In a closed economy, well-functioning financial markets ensure that the real rate of interest adjusts to equate the supply and demand for loanable funds. An alternative view, however, argues that price variables do not adjust quickly enough to bring balance in the supply and demand for loanable funds. If this is the case, then quantity variables may serve as the economy s equilibrating variables. The effect of various types of shocks would then imply the inefficient 168
movement in quantities (like GDP), rather than the efficient movement in prices (like the real interest rate). This latter view appears to describe the conventional wisdom. In particular, central banks around the world appear to view their role as governors of the interest rate. 169