Putting the Economy Together

Putting the Economy Together Topic 6 1

Goals of Topic 6 Today we will lay down the first layer of analysis of an aggregate macro model. Derivation and study of the IS-LM Equilibrium. The Goods and the Money Markets (Mostly a Review). Construction of the AD curve. Construction of the Short-Run Aggregate Supply (SRAS) curve. Classical approach to supply. Start discussing examples. Likely to shift to next week as well. 2

IS-LM Equilibrium r LM = f(m, P, π e ) IS = f(g, PVLR, taxes, A f ) 3

Note on the IS-LM Equilibrium Remember: ou can always see the problem as a system of 2 equations. Sometimes having an analytical representation of the problem helps. One simplified example is the following IS-LM system: = c( - T) + I(r) + G IS M/P = L(, r + π e ) LM Where c is the marginal propensity to consume out of disposable income (assumed constant here) and I is a negative function of the real interest rate. ou can graph the two equations as in the previous slide in the (,r) space. Note: See Appendix 9.A in the text to have an analytical representation of our IS-LM Model. 4

Understanding IS-LM: Brief Roadmap. At the point of crossing of IS and LM the equilibrium interest rate and desired output that simultaneously satisfy goods and money markets are determined. We will now study how the endogenous variables in our model ( and r) change when we change exogenous variables like the money supply (M) and government spending (G). That is, if I change M or G what are the new and r that satisfy the IS=LM condition? We then relax the assumption that the price level is fixed and we show that the IS-LM model implies a negative relationship between the price level and national income. The IS-LM model provides a theory of the slope and position of the aggregate demand curve (AD). 5

Understanding the IS-LM Equilibrium: M increasing Suppose M increases. r LM = f(m 0 ) M increases LM = f(m 1 ) r e 0 r 1 1 r z z IS = f(g) * 1 6

Understanding the IS-LM Equilibrium: G increasing Suppose G increases. * = f(n*,k,a) r G increases LM = f(m,p,π e ) 1 r 1 r e 0 z IS = f(g 1 ) IS = f(g 0 ) * 1 z 7

Understanding the IS-LM Equilibrium: P decreasing Suppose P decreases. r LM = f(p 0 ) P decreases LM = f(p 1 < P 0 ) r e 0 r 1 1 r z z IS = f(g) * 1 8

The Aggregate Demand Curve ou may not have realized it yet,but we just derived an aggregate demand curve! The AD curve is drawn in (, P) space. It represents how the demand side of the economy responds to a change in prices. On the previous slide, we just did this! As P decreases (holding everything else fixed - including M), M/P will increase. As real money balances increase, interest rates will fall, Investment will rise and will rise. Prices affect the demand side of the economy through interest rates (and consequently investment). 9

The AD: The Intuition (1) 1. IS_LM Equilibrium This point shows the values of output and real interest rates that contemporaneously satisfy the Money Market and the Goods Market equilibrium. The aggregate quantity of output demanded is determined where IS and LM intersect. r 0 P P 0 LM IS This point shows the relation between the aggregate quantity of goods demanded and the price level. 0 10

The AD: The Intuition (2) 1. IS_LM Equilibrium An increase in prices from P to P 1 shifts the LM curve to the left because of a reduction in real money supply. The IS and LM now intersect at a point of lower output and higher interest rates. r 1 LM 1 r 0 1 0 2. Aggregate Demand P LM IS The aggregate quantity of output demanded falls to 1 and real interest rates increase to r 1. P 1 P AD 1 0 11

The AD: The Detail (1) 1. Liquidity-Money M s /P 2. IS_LM Equilibrium LM r 0 r 0 L d IS M 0 /P M/P 0 P P This point shows the relation between the aggregate quantity of goods demanded and the price level. 0 12

1. Liquidity-Money The AD: The Detail (2) r 0 r 0 2. IS_LM Equilibrium M s /P LM r 1/2 r 1 1/2 LM Notice: at this point the goods mkt is not in equilibrium. L d ( 0 ) IS M 0 /P 1 M 0 /P An increase in prices from P to P 1 shifts the LM curve to the left because of a reduction in real money supply. M/P P 0 3. Aggregate Demand P P 1 1 AD 1 0 13

The AD: The Detail (3) 1. Liquidity-Money 2. IS_LM Equilibrium M s /P LM r 1/2 r 1 1/2 1 r 1 r 1 r 0 r 2 0 0 LM L d ( 1 ) L d ( 0 ) IS M 0 /P 1 M 0 /P M/P 1 0 3. Aggregate Demand P The aggregate quantity demanded drops from 0 to 1 shifts liquidity demand too. The equilibrium in the Money Market is restored at real rate r 1. P 1 P 1 0 AD 14

The Aggregate Demand Curve (Cont.) Changes in prices do not affect consumption (consumption is only affected by PVLR - or real wages - if wages change 1 for 1 with prices (W/P is constant), PVLR will not change. The AD curve comes directly from the IS-LM equilibrium. So, in essence, the AD curve is a representation of BOTH the IS curve AND the LM curve. 15

What Shifts the AD curve? Remember - the AD curve represents the demand side of the economy: d = C d +I d +G+NX Anything that causes the IS curve to shift to the right, will cause the AD curve to shift to the right (both the IS curve and the AD curve represent the demand side of the economy). Anything that causes the LM curve to shift to the right (except price changes) will cause the AD curve to shift to the right. A change in prices will cause the LM curve to shift - but, will cause a movement along the AD curve. Example: Nominal money (M) increases, r will fall, I will increase, AD will shift right. With changes in money: LM shifts right Move along the IS curve Interest rates fall I increases AD shifts right. 16

Example 1: Shifting the AD curve increasing G P G increases P 0 AD AD 1 0 1 Suppose prices are held fixed (at P 0 ). Suppose that G increases and the Fed does not change M. This implies that M/ P 0 will not change (i.e., the LM curve is fixed). An increase in G will shift out IS curve. This will cause to increase. An increase in G will lead to an increase in, holding P fixed. The AD curve will shift right! 17

Example 1: Shifting the AD curve increasing G 1. IS-LM Equilibrium An increase in G shifts the Is curve to the right because for every level of output savings are lower and r is higher. The IS and LM now intersect at a point of higher output and higher real interest rates. r 1 r 0 0 1 2. Aggregate Demand P LM IS 1 IS The aggregate quantity of output demanded increases to 1 for the same P 0 and the real interest rate increases to r 1. P 0 0 1 AD AD 1 18

Example 2: Shifting the AD curve increasing M P M increases P 0 AD AD 1 0 1 Suppose prices are held fixed (at P 0 ). Suppose that G does not change and the Fed increases M. This implies that M/ P 0 will increase (i.e., the LM curve moves right). The IS curve does not move. An increase in M will lead to an increase in, holding P fixed. The AD curve will shift right! 19

Market 3: The Supply Side (a review) Labor Market Review: N s (PVLR,taxes,value of leisure, population) W 0 /P 0 N* What is set in this market: N* (and real wages). N d (A,K) 20

Some Definitions In Short Run (N adjusts, but it need not be at N*, K is fixed!) Nominal Wages are Sticky (although firms can adjust prices). W is fixed, but not W/P (because firms can adjust P) K by definition is fixed! Because Wages are sticky in the Short Run, the labor market can be in disequilibrium i.e. labor demand not equal to labor supply (cyclical unemployment can occur). In the Long Run (N adjusts to N*, K is fixed). W adjusts. We will be at N* (labor market is in equilibrium), but capital still does not adjust. (K is fixed! This assumption is OK is capital stock moves slowly). Note: In Really Long Run (Growth - N adjusts to N* and K is not fixed!) Capital can adjust, labor market is in equilibrium. See our Topic 2 on economic growth. For the following analysis always consider K fixed. 21

Aggregate Supply Curve in the Long Run (LRAS) In the Long Run, the labor market always clears! (We are at N*) Define: LRAS (full employment level of output) gives the level of output * associated with N*: * = A F(K, N*, Raw Materials). Note Slight Modification (inclusion of raw materials) LRAS Curve is vertical at * - the potential level of GDP. * is the level of output generated when the economy employs N*. Also know as the FE (full employment) line. (w/p) e = the real wage in labor market equilibrium N* = hours worked in labor market equilibrium What shifts the Long-Run AS Curve: N* or A (by definition K is fixed in long run) 22

The Long-Run AS Curve P LRAS * 23

Notes on the Potential Level of GDP (*) and LRAS The Equilibrium level of is not necessarily optimal: Tax distortions can mean * is lower than is economically efficient. Equilibrium just means balance between private costs and benefits (in this case to household supply of labor and firm demand for labor). At an equilibrium, there is no incentive for people to change their behavior. The Equilibrium is not constant: Changes to A, K and N* change *, and hence shift the LRAS. * trends upward in most countries (because A and K and population grow over time - shifting out N*). Many economists believe its growth rate is fairly stable. 24

Aggregate Supply Curve in the Short Run (SRAS) The Short-Run Aggregate Supply Curve (the relationship between output and prices) in the short run is positive. If firms get a demand shock, they may chose to produce more (at a given fixed nominal wage) to satisfy demand. To take advantage of the higher demand, firms may raise prices (optimally) which drives down W/P. The lower real wages causes firms to optimally hire more labor - causing output to increase. NOTE: N d has not shifted!!!!!! Firms decide to meet the increase in demand for their product by hiring more workers because of the lower real wage (as prices increase). In short run, firms remain on their labor demand curve, while workers are off their labor supply curve temporarily (workers have little bargaining power, options in the short run). In the Short Run there is disequilibrium in the labor market! NOTE: The text assumes a different SRAS Firms always produce to meet demand. See chapter 9 for details. 25

The Short-Run AS Curve (SRAS) - The Intuition 1. Labor Demand Curve 4. Short Run Aggregate Supply N s W/P 0 W/P 1 As prices increase, W/P falls N d P 1 P 0 N 0 N 1 2. Production Function 0 3. 45 degree line 1 1 0 0 N 0 N 1 0 26 1

Aggregate Supply in the Short Run (Part 1) W 0 /P 0 W 0 /P 1 1 N* N 0 N s N d Assume an increase in demand temporarily forces firms to produce more than the fullemployment level at the current wage and prices. This forces workers to work more than they wish. 27

Notes on AS in Short Run (Part 1) If firms get a positive demand shock (demand for goods increase), firms will raise prices and keep labor costs fixed. This will reduce real wages causing firms to hire more labor and produce more. The Short-Run AS Curve Slopes Upwards Because and increase in prices reduces real wages and causes firms to higher more workers and consequently to produce more. Consequence, N > N* and > * and U < U* U = current unemployment rate U* = Natural Rate of Unemployment (only frictional and structural, no cyclical unemployment) See text for a discussion of the utilization rate of labor (and capital). 28

More Notes on AS in Short Run (Part 1) What Shifts the SRAS curve? SRAS=F(A,K,N,rawmaterials). Kisfixed A is exogenous (ie, I tell you when changes) Raw materials is the new twist. Anything that effects the nominal price of raw materials will effect the quantity of raw materials purchased and will shift the short run AS. For every given labor and capital - if the price of raw materials get more expensive, firms will produce less (ie, oil prices). Nominal wages will adjust between the short run and the long run - that will cause the SRAS to shift between the short run and the long run! For our discussion - only input prices (nominal wages and nominal oil prices) and technology will shift the SRAS! Higher costs of production means SRAS will shift in! 29

The Expenditure - Output Equilibrium (AD, AS) P LRAS * = f(n*,k,a) SRAS(1) = f(input prices) P e AD = f(g,pvlr,taxes, f,m,π e ) * 30

Effect of an increase in input prices (cost of production) on SRAS P LRAS * = f(n*,k,a) SRAS = f(input prices 1 ) SRAS = f(input prices 0 ) P e AD = f(g,pvlr,taxes, f,m,π e ) * 31

The Self-Correcting Mechanism Let us focus on SRAS(1). It has a better link to the labor market. When the economy is in short-run disequilibrium ( short-run not equal to *), the economy will naturally move towards *. Reason: Labor market will eventually clear. The reason that does not equal * is because N does not equal N*. As soon as the labor market clears, we will be back at N*. How does the labor market eventually clear? Workers will not continue to work off their labor demand supply for long periods of time. 32

The Self-Correcting Mechanism (Cont.) When N > N*, workers will be working more than their desired amount and will require the firm to raise nominal wages (W) so as to compensate them for their additional effort. Doing so, will cause labor market to clear. But, if W increases, the SRAS will shift in (the cost of production has increased). The exact opposite will work when N < N*. As the labor market starts to clear, the SRAS will adjust to bring us back to *. 33

Notes on the SRAS(2) Some Macroeconomists (starting from Keynes) had the notion that prices are fixed in the short run. This is a second type of SRAS. It is costly to keep changing your prices when faced with every given shock. As a result, prices in the market tend to change slowly. Think about the price of milk at Dominick s. Macro conditions are changing all the time and the price of milk - over the last 1/2 year has been about $1.79 per quart. In this case - firms keep prices and wages fixed and just meet demand by requiring workers to work a little harder sometimes and a little less hard during other times. This is how they meet changes in demand without changing prices. It adds a dimension to our problem: utilization rate of labor (and an associated concept: labor hoarding). In this case - the labor market isn t really in equilibrium at all in the short run. In such a case - prices are fixed SRAS is horizontal. NOTE: We will work with both the upward sloping (short run) and the horizontal (instantaneous) SRAS curves. 34

The Expenditure - Output Equilibrium (AD, AS) P LRAS * = f(n*,k,a) SRAS(2) = P e P e AD = f(g,pvlr,taxes, f,m,π e ) * 35

The IS-LM Equilibrium: The Overview 1. Investment-Saving 3. Labor Market S d N s r 0 W 0 /P I d N d I 0 2. Liquidity-Money I, S N 0 IS_LM Equilibrium N M s /P LM r 0 r 0 L d IS M 0 /P M/P 0 36

Notice where Real and Nominal Shocks Operate 1. Investment-Saving: Real 3. Labor Market: Real S d N s r 0 W 0 /P I d N d I 0 I, S 2. Liquidity-Money: Nominal M s /P N 0 IS_LM Equilibrium N LM r 0 r 0 L d IS M 0 /P M/P 0 37

r The IS-LM Equilibrium: A Positive Money Supply Shock (Nominal) (1) 1. Investment-Saving 3. Labor Market S d N s r 0 W 0 /P I d N d r I 0 2. Liquidity-Money M s /P M s /P I, S N 0 IS-LM Equilibrium N LM LM r 0 r 0 L d IS M 0 /P M/P 0 38

r 0 The IS-LM Equilibrium: Positive Money Supply Shock (2) r 1. Investment-Saving 3. Labor Market S d = 0 -C d -G r 1 S d = 1 -C d -G Temporary increase in demand. r C d + G + I d 0 2. Liquidity-Money M s /P M s /P I d I, S W 0 /P r 0 N 0 N 1 IS-LM Equilibrium N s N d An increase in demand temporarily forces firms to produce more than optimal at the current wage and prices, forces Nworkers to work more than they wish. LM LM r 1 L d L d ( 1 ) IS M 0 /P M/P 0 1 39

The IS-LM Equilibrium: Positive Money Supply Shock (3) 1. Investment-Saving 3. Labor Market r S d S d I d W 0 /P W 1 /P 1 N s N d At this point firms raise prices, and workers demand higher wages. r 2. Liquidity-Money M s /P M 1 /P I, S N 0 N 1 IS-LM Equilibrium LM N LM r 0 r 0 r 0 L d L d ( 1 ) IS M 0 /P = M 1 /P 1 M/P 0 1 40

Neoclassical Approach to AD-AS Money neutrality in the Long Run. However the Short Run is very short. Prices and wages are assumed to adjust quickly and markets are in equilibrium. This approach faces two main empirical obstacles. 1) Disequilibrium in the Labor Market (i.e. Unemployment is > 0 and counter-cyclical). 2) Money has real effects in the short run (Money is non-neutral to real outcomes even Friedman admits it and leads the cycle increasing M s increases above *). Can we match these two facts and maintain that there is no sluggishness in prices and wage adjustments? 41

Neoclassical Approach (Cont.) Solution to 1: Unemployment is justified by search frictions and reallocation of workers to new business or industries. This requires time and produces unemployment. Solution to 2: Misperceptions theory (Friedman and Lucas). Because of costs in collecting information concerning the nature of price changes in the economy, agents may be fooled by nominal shocks into considering aggregate price hikes as increases in relative prices of the goods they produces (shock to the demand of the goods they produce) and hence they supply more goods. However if changes in money supply (and hence prices) are expected all the information will be immediately incorporated and no mistake will be made (rational expectations). 42

The Neoclassical SRAS Curve: Misperceptions Theory (Lucas) P SRAS P e * SRAS = prices adjust instantaneously but the aggregate quantity of output supplied rises above the full-employment level, *, when the aggregate price level is higher than expected. 43

Misperceptions Theory: Unanticipated change in Money Supply P LRAS SRAS 2 1 P e 0 AD * 1 The unanticipated monetary shock produces an increase in the realized price level different from what expected. This tricks some of the producers to interpret the price increase as an increase in their relative price and produce more. Hence the temporary non-neutrality at 1. 44 AD

Misperceptions Theory: Anticipated change in Money Supply P LRAS SRAS 2 P e 0 AD * The anticipated monetary shock produces an increase in the realized price level equal to what expected. No producer interprets the price increase as an increase in his relative price and nobody produces more. Hence the neutrality of money and the jump at 2. 45 AD

Let the Fun Begin! Examples and rules - bring lots of extra pages - we are going to do lots of examples! Why did the 1991 recession occur? How about the 1975 recession, why did it occur? How about the 1982 recession, why did it occur? What if I wanted to run for president? Suppose I had control of the Money Supply - what could I do in the short run? What about the long run? What did the tech boom in the 1990s do to the economy? Why did Greenspan RAISE interest rates in 2000? What was he thinking? 46

Let s Start Analyzing These Problems Start with short-run effects! 1. We look at the Demand Side of the Economy A. Did IS or LM change? B. Did AD change? 2. We, then, look at the Supply Side - Did SRAS change? We ignore the labor market in the short run. 3. The long run is all about the labor market. For the long run (and *) we need to figure out what happens in the labor market! In the long run - we always end up at * and * is determined in the labor market. 47