Outline for ECON 701's Second Midterm (Spring 2005)

Outline for ECON 701's Second Midterm (Spring 2005) I. Goods market equilibrium A. Definition: Y=Y d and Y d =C d +I d +G+NX d B. If it s a closed economy: NX d =0 C. Derive the IS Curve 1. Slope of the IS Curve is derived by calculating the derivative, dr/dy, from the Goods Market Equilibrium condition (holding all else constant) 2. Factors that increase C d and I d, other than changes in r or Y, shift the IS curve right as does an increase in G 3. Can use calculus to calculate how much and in what direction the IS curve shifts when a particular factor changes II. The Money market A. Demand for money 1. Factors that influence M d a. The scale variable is income (or sometimes consumption) b. The opportunity cost of holding money is the spread between the interest rate on a non-monetary asset (e.g. bonds) and the rate on money (e.g. bank deposits) c. Relative liquidity of money d. Relative risk of money e. Financial innovations and technological innovations can affect the relative costs and benefits of using money, and can create completely new ways to conduct transactions (e.g. when debit cards were developed to make immediate withdrawals from a bank account) 2. Baumol-Tobin model of money demand 3. The elasticities of a money demand function B. Money supply 1. Broad measures of M M1=currency+demand deposits+other checkable deposits+travelers checks M2=M1+MMDA+MMMF+small time deposits+passbook savings accounts Weighted Monetary Aggregates come from multiplying a measure of moneyness times the dollar amount and then summing these products over all various types of assets that are liquid (it turns out that the moneyness of an asset is inversely related to its interest rate) 2. Monetary base (currency + reserves) 3. Money multiplier (M/MB) 4. Tools of monetary policy (1) Open market operations (2) discount lending (borrowed reserves) (3) reserve requirements

How is each tool used to affect the money supply? 5. Non-policy factors that affect the money supply (1) currency to deposits ratio (2) excess reserves to deposits ratio How does each non-policy factor affect the money supply? C. The LM curve 1. Derived from money market equilibrium, yielding a positive relationship between Y and r 2. Factors that shift the LM curve a. Factors that increase M d (excluding changes in r or Y) will shift the LM curve to the left b. Factors that increase in the money supply cause the LM curve to shift to the right (can arise from changes in policy tools or from changes in non-policy money supply factors) 3. Slope of the LM curve: comes from solving for the derivative, dr/dy, from the money market equilibrium 4. Can use calculus to calculate how much and in what direction the LM curve shifts when a factor changes 5. LM is a good model of the money market when a central bank implements monetary policy by controlling the money supply 6. The IS-LM model has for a long time been one of the most popular models for explaining how Y and r are affected by changes in factors from the goods market and the money market. D. However, most central banks today implement monetary policy by controlling an interest rate 1. If a central bank holds real rates constant, then a. Money demand movements are fully accommodated by central bank changes in the money supply (1) in this case money supply changes in the same direction and by exactly the same amount as money demand (2) thus, the LM curve moves back to its original position (i.e. before the increase in money demand occurred) (3) this keeps r and Y from changing b. Non-policy changes in money supply are fully off-set by central bank changes that leave the money supply unchanged (1) in this case monetary policy counteracts the change in money supply caused by some private sector factor (2) again the LM curve returns to its original position (i.e. before the money supply change from a non-policy source) (3) again this keeps r and Y from changing c. In each case the Fed keeps the LM curve in its original position by eliminating movements of the LM curve caused by changes in money demand or by non-policy changes in money supply d. Conclusion: when central banks hold the real rate constant they

may perfectly shield output from all changes in money demand (excluding a change in Y) and all non-policy changes in the money supply e. One problem: Holding the real rate constant exacerbates the output effect from a shift in the IS curve. This is easily seen from the IS- LM graph. Thus a policy of holding the interest rate constant could cause output to be pushed far away from its desired level 2. The Taylor Rule provides a better way of characterizing the way monetary policy behaves in countries that implement policy through interest rates * * * * a. i= r +π + f Y (Y Y ) + f π ( π π ) where * denotes a targeted level for r, Y or π and f Y and f π could each be equal to ½ b. Using with the Fisher equation ( i=r+π e ) and assuming expected future inflation is equal to the inflation target (e.g. because the central bank established a credible inflation rate target), we can write the Taylor Rule as: * * * r = r + f Y (Y Y ) + f π ( π π ) Or: * * * r = f0 + fyy + f ππ where f0 = r fyy + fππ These are equivalent algebraic characterizations of the MP Curve c. Commonly accepted targets for policy variables: (1) for Y *, full employment output (a.k.a. the natural level of output) (2) for r *, the natural real rate of interest (defined as the real rate at which the goods market is in equilibrium and output is at its full employment level) (3) for π *, a small positive rate, typically in the range from 1% to 3% (A little inflation is thought better than a little deflation) d. From the equations for the Taylor rule, we see that it yields a positive relationship between the real rate and real output. Thus this equations slopes upward just like the LM curve. However, most of the money supply and money demand factors that shift the LM curve don t shift the MP curve III. The IS-MP model A. This model is particularly useful at analyzing the short-run, which is often used to describe the condition of the economy before inflation adjustment leads to the economy general equilibrium. B. Graph the model C. Factors that shifts the IS curve D. Factors that shift the MP curve 1. Changes in policy targets

2. Changes in the rate of inflation E. This model is used to analyze what happens in the short-run to r and Y when any of the factors changes. F. We looked at an example of policy coordination in the mid-1990s. The US economy did not go into a recession even though the Federal government had implemented policies to reduce budget deficits (by increasing taxes and reducing spending). One reason was because the Fed, under Greenspan, dropped interest rates quickly once these contractionary fiscal policies were implemented G. We also looked at the case of adverse animal spirits where people and firms expect future output to be lower they reduce desired consumption and desired investment, shifting the IS curve to the right and causing output and real interest rate to fall. IV. Aggregate demand relationship A. Derive the inverse relationship between Y and π such that Goods Market is in equilibrium and the Fed is operating on its MP curve B. Can be derived graphically from the IS-MP model or by equations C. Factors that shift the ADΠ curve 1. Factors that shift the IS curve right shift ADΠ right 2. Factors that shift the MP Curve right shift ADΠ right (except for any changes in π) V. Aggregate supply side of the economy A. Long-run aggregate supply 1. Determines the amount of output produced in general equilibrium. This is called full employment output or the natural output level 2. General equilibrium (GE) occurs when all markets clear simultaneously. This requires: a. Goods market equilibrium (IS) b. Central bank conducting policy according to its policy rule (MP) c. Labor market equilibrium B. Short-run aggregate supply 1. Indicates the way prices respond in the short run to a change in market conditions 2. Various theories about this adjustment have been developed. They can be grouped into the following two general categories: a. Classical theory, where prices and wages adjust rapidly to get to GE b. Keynesian theory, where prices and wages are slow to adjust to conditions and therefore it takes longer to bring about GE VI. Labor market equilibrium A. Classical View: Labor Market is a Perfectly Competitive Market

1. Firms and workers take wages as given 2. Labor Market Equilibrium: Labor Supply=Labor Demand 3. Wages and prices adjust rapidly to keep the economy operating at (or near to) full employment, which is when labor market equilibrium occurs 4. Unemployment is caused by search and matching frictions, problems particularly relevant in labor markets a. Unemployed people are looking for a job (not in labor force people are not looking for a job and not employed) and even some employed workers are looking for a new job b. Firms search for workers to fill job openings which are known as vacancies c. Time and other real resources are used up trying to match the best person to a job vacancy 5. In equilibrium, there is unemployment, called natural unemployment, which comes from frictional and structural sources a. Frictional unemployment: A short-term matching problem (1) there are firms with job openings and people who are able and willing to immediately start working on these jobs (2) in most cases it takes no more than a few months to fill these openings b. Structural unemployment: A long-term matching problem (1) for workers with a particular set of skills there are either (a) no jobs at all OR (b) no jobs that require these skills in a specific region of the country (2) possible solutions to this kind of unemployment (a) (b) (c) if there are no jobs anywhere in a given field, a person may change occupation. This nearly always requires learning new skills which is costly in terms of expenses and time used to acquire a new skill with no jobs of a particular type in a particular region, a person may choose to relocate to a part of the country where these jobs are found. Relocation has significant costs (both the pecuniary costs associated with planning and implementing a move, and non-pecuniary costs such as being farther away from family, friends and surroundings you are familiar with) rather than relocate and/or learn new skills, a person may choose to wait until demand for their skills returns to the region where they live. (3) no matter which choice is made (a, b or c) a person will be unemployed for a considerable amount of time. Hence this type of unemployment persists for quite a while (4) A related problem to structural unemployment is underemployment. Underemployment means when

someone is significantly over-qualified for a certain job (E.g. a nuclear physicist in Russia who drives a cab to make his income). Underemployment of high skilled workers creates structural unemployment for low-skilled workers as the high-skilled take jobs away from the lowskilled B. A Keynesian Labor Market Model: Efficiency Wage Theory 1. Imperfectly competitive labor markets a. Firms choose the real wage, they don t take the wage as given b. Firms optimally choose W/P and N to maximize their profits c. Effort is positively affected by the real wage (W/P) and by the aggregate unemployment rate (u): e=e(w/p,u) d. Effort is a positive factor in production, it serves to complement labor input: 1 Y A K α α = (N e) e. A firm takes the aggregate unemployment rate as given when choosing the amount to employ and the wage to pay f. In addition to there being a cost of paying workers a higher wage there is also a benefit to increasing wages; With higher wages workers give more effort and so produce more output-per-hour g. The labor demand curve that results from the efficiency wage theory is essentially the same as before, with the real wage set equal to the marginal product of labor: W (1 )AK N e 1 = α P α α α (1) here increased effort raises the MPN (2) to simplify the analysis, however, we ignore the effects of effort on marginal products and production. The reason: Correct qualitative answers to questions are obtained when we ignore these effort effects, and it is mathematically tedious to keep track of most effects when we permit effort to change both u and W/P. The effort effects are crucial in deriving the wage setting (WS) curve. (3) it is easy to show that we are able to re-write the previous labor demand function in precisely the same way as we had done earlier in class (i.e. when effort was not a factor in production): d (1 )Y N = α W P h. There is a new condition called the wage setting curve (or the efficiency wage curve). The Wage Setting (WS) curve is an inverse relationship between W/P and u. The firm sets the real

wage to maximize profits, choosing a real wage that gets the optimal amount of effort from workers. (Technically, this wage maximizes the effort per dollar of wage payed) i. Labor Supply is still relevant. There are no changes to labor supply from our previous theoretical analysis and discussions 2. Source of natural unemployment in the Keynesian labor market model a. Frictional and structural unemployment are still important b. Firms pay wages higher than in the Classical equilibrium, and therefore they employ fewer workers. This is an additional source of equilibrium unemployment not found in Classical theories. c. The basic idea is that firms may obtain higher profits by paying higher wages, but higher wages reduce the demand for labor and so unemployment increases d. In addition to differences in the long-run, there are important differences between Classical and Keynesian theories in terms of the speed an economy adjusts to its long-run position. Keynesian economists believe this adjustment takes a long time due to relatively sticky wages and prices. Classical economists believe the adjustment is fairly rapid because wages and prices are quick to bring the economy back to general equilibrium. C. Graphical model of Keynesian labor market equilibrium 1. N d is shifted by factors that affect MPN (primarily A and K) 2. L S is shifted by any factor that affects labor supply (except W/P) a. increase in value of assets reduces L S b. increase in income from assets reduces L S c. increase in tax on labor income reduces L S d. increase in tax on non-labor income increases L S e. Demographic factors that raise the labor force participation rate or raise the population also will raise aggregate labor supply 3. WS is shifted by: a. factors that affect the wage bargaining position of firms relative to workers are (1) the unemployment compensation program (2) how prevalent are unions (3) how much firms are taxed by the government when they fire a worker b. Shifts in the labor supply curve: A shift in the labor supply curve causes the WS curve to shift in the same direction (1) WS is a function of u (and other factors like those above) (2) given a particular level of the labor supply, the WS curve indicates the relationship between W/P and N (3) If L and N are logarithms of labor supply and demand, respectively, then there is a simple relationship between the unemployment rate L and N: u = L-N. (And in empirical

work, economists almost always take logarithms of these and many other variables that tend to grow over time) (4) Given this linear in logarithms relationship, the WS curve must shift by precisely the same amount and in precisely the same direction when labor supply shifts. To see this, consider what happens when labor supply increases. If the WS curve did not shift, then there would now be a larger gap between the WS and L s curves for every level of the real wage. Since this gap reflects the unemployment rate, this would mean that an increase in labor supply was affecting the relationship between real wage and unemployment. But we don t want this to occur because the factors that shift labor supply are generally not the same as the factors that affect the wage setting relationship. To make this relationship between W/P and u stay the same, the WS curve to shift in the same direction and by the same amount as the labor supply curve shifts. D. The Keynesian labor market equilibrium model determines how a shift in each of these 3 curves affects: 1. full employment level of employment 2. equilibrium real wage 3. natural rate of unemployment VII. Long-Run Aggregate Supply is determined by the Full Employment Output level (Y FE ) A. This is obtained by combining the production function with B. Primary factors in production 1. Full employment level of employment (N FE ) a. Assume effort effects on output are small compared with the employment effects on output b. This assumption guarantees that output goes up when employment increases, which is what we see in the data c. If the effort effects were not small, it would be more difficult to show that full employment output goes up when equilibrium employment goes up, although that would still be true 2. Capital stock (K) 3. Technology (A)