Review: Markets of Goods and Money

TOPIC 6 Putting the Economy Together

Demand (IS-LM) 2

Review: Markets of Goods and Money 1) MARKET I : GOODS MARKET goods demand = C + I + G (+NX) = Y = goods supply (set by maximizing firms) as the interest rate increases, I and C fall and the demand for goods falls IS curve is downward sloping 2) MARKET II : MONEY MARKET money demand = L d (Y, r + π e ) = M s /P = money supply (set by the Fed) as output increases, money demand increases and the interest rate has to increase to bring the demand back to the supply LM curve is upward sloping IS-LM EQUILIBRIUM = EQUILIBRIUM IN BOTH MARKETS I and II 3

IS-LM Equilibrium r LM = f(m,p,π e ) r e IS = f(g,pvlr,taxes,a f ) Y e Y 4

Summary: Shifts of IS and LM 1) What shifts the IS curve to the right? higher expected income or wealth higher PVLR higher C higher conusmer confidence higher PVLR higher C higher Tr or lower T (if the Ricardian equivalence fails) higher C higher expectations about A f higher MPK f higher I higher business confidence higher MPK f higher I lower δ or mm, or lower t K lower adjusted user cost of K higher I higher G 2) What shifts the LM curve to the right? Higher nominal money supply higher M s /P Lower prices higher M s /P higher h π e higher h I and hence lower money demand d 5

Short Run SHORT RUN: equilibrium given by intersection of IS and LM When aggregate demand for goods rises, assume that firms are willing to hire more workers in the short run to produce the extra output and meet the expanded demand LONG RUN: also labor market is in equilibrium and Y* = f(n*,k,a) (full employment) In the long run, if there is higher demand, firms will increase prices until they hire the optimal amount of workers and produce the potential level of output. For now: focus on the short run analysis and fix prices 6

IS-LM Equilibrium r Y* = f(n*,k,a) LM = f(m,p,π e ) Money Market r e Labor Market Goods Market IS = f(g,pvlr,taxes,a f ) Y* Y 7

Fall in private demand: a recession r LM r e IS Y * 1) Direct reduction in C and I due to credit crunch 2) Fall in consumer and business confidence 3) Fall in financial wealth (NPVLR) Y 8

Fighting the recession: Monetary Policy r LM r e IS Y * Y Expansionary Monetary Policy by the Fed: M s increases Recall: prices are fixed for now. 9

When Monetary Policy does not work 1) Vertical IS Curve firms don t respond much to interest rate changes if they think that the banking system is frozen The effect of an expansionary monetary policy is dampened d 1) Horizontal LM Curve Liquidity Trap Nominal interests rates are bounded at zero Lower bound on r is equal to ππ e and the Fed cannot reduce it further! This is what is happening now in the US and what happened in Japan in the late 1990s Read Krugman s Babysitting the Economy (From Week 1) 10

r Vertical IS IS LM r e Y * Y What if Ms increases? 11

Liquidity Trap r LM r e -π e Y * IS Y 12

Fighting the Recession: Fiscal Policy r LM r e IS Y * Y If monetary policy does not work fiscal stimulus: G increases 13

Short Run versus Long run! Conventional Definition: SHORT RUN: Prices are sticky LONG RUN: Prices adjust Traditional debate in Macroeconomics on the length of the Short Run! Classical economists: prices adjust fast Keynesian economists: prices adjust slowly Basic Distintion: Business Cycle: focus on the short run Growth: focus on the long run 14

Long Run The short run equilibrium is an equilibrium in the sense that the aggregate quantity of goods produced is equal to the quantity demanded It is not an equilibrium in the sense that to meet the aggregate demand of goods, firms have to produce more (or less) output than their potential level Y*! Y* is the level of output that maximizes firms profits. Hence, firms are producing more (or less) than what they would like. This will induce at some point firms to change prices. If M increases, firms will start to increase prices up to the point that M/P is the same as before, so that the demand is equal to Y*! 15

Review: Monetary Policy in the Short Run SHORT RUN: P are fixed r LM r e IS Y * As M increase, money holders have more money than what they need and increase the demand for bonds and decrease r. This increases I and C. Y 16

Monetary Policy in the Long Run LONG RUN: prices adjust and back to the general equilibrium r LM r e IS Y * In the long-run, monetary policy has no effect! Y 17

Money Market (Short run / Long run) The effectiveness of Monetary Policy will depend on how sticky prices are r 0 0 M s1 /P 1 M s0 /P 0 M s1 /P 0 M s0 /P 0 = M s1 /P 1 M1 > M0 P1 > P0 r 1 r z 1 z M d = L d (Y*) M d = L d (Y1) M/P 18

Monetary Neutrality Consensus: after some economic disturbance prices will eventually restore the economic general equilibrium Disagreement on the speed of this adjustment! Classical economists: prices adjust immediately Money is Neutral! Keynesian economists: prices are sticky Money is neutral only in the long run, it is non-neutral in the short run! 19

Review: Fiscal Policy in the Short Run Suppose G increases (The extent of the outward shift in IS depends on Ricardian Equivalence!) Y* = f(n*,k,a) r LM = f(m,p,π e ) r * As r increases, private I and C are somehow crowded out IS = f(g 0 ) Y* Y 20

Fiscal Policy in the Long Run If fiscal policy doesn t affect Y*, then prices will rise and LM shifts in. Y* = f(n*,k,a) Inflationary pressures r LM = f(m,p,π e ) r * IS = f(g 0 ) Y* Output is unchanged and G has crowded out C and I (through higher r) Y 21

Demand and Supply (AD-AS) AS) 22

Aggregate Demand Curve (AD) So far we have kept the prices constant. What happens to aggregate demand d if Prices increase? The AD curve is drawn in {Y,P} space. It represents how the demand side of the economy responds to a change in prices. As P decreases (holding everything else fixed), M s /P increases. As the supply of real money balances increase to have an equilibrium in the money market interest rate needs to fall, and hence from the equilibrium in the good market, I and C rise! Prices affect the demand side of the economy through interest rates. Recall: prices do not affect C (if wages change 1 for 1 with prices 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. 23

Constructing the AD Part 1 r Suppose P increases from P 0 to P 1 LM r 0 IS Y 0 Y 24

Constructing the AD Part 2 P P 1 P 0 AD Y 1 Y 0 Y 25

What Shifts the AD curve? As the IS, the AD curve represents the demand side of the economy: Y = C+I+G+NX Anything that causes the IS curve to shift to the right cause the AD curve to shift to the right Anything that causes the LM curve to shift to the right (except price changes) causes the AD curve to shift to the right. Example: Nominal money (M) increases, r will fall, I will increase, AD will shift right. With increase in money: LM shifts right Move along the IS curve Interest rates fall C and I increase AD shifts right. A change in prices cause the LM to shift, but cause only a movement along the AD curve. 26

Example: Temporary Increase in G 27

The Supply Side Labor Market Review: N s (PVLR,taxes,value of leisure, population) W 0 /P 0 N d (A,K) N* What is set in this market: N* (and real wages). 28

Aggregate Supply Curve in the Long Run (LRAS) In the long run, the labor market clears and we are at N*! The full employment level of output is the level of output Y* associated with N*: Y* = A F(K, N*, Raw Materials) Define LRAS = long run aggregate supply is a curve vertical at Y* (or FE line) In the long run, the labor market clears and (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 or Raw Materials Assume K is fixed, if I do not specify otherwise. 29

The LRAS Curve P LRAS Y Y* 30

Notes on the Potential Level of GDP (Y*) The Equilibrium i level l Y* is not necessarily optimal: Tax distortions ti can mean Y* 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 Y*, and hence shift the LRAS. Y* 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. 31

Long-run Equilibrium Equilibrium is a point of attraction for the economy: Most macroeconomists believe that, in the absence of shocks, the economy would reach equilibrium i after perhaps 5 years. Thus the economy is in equilibrium in the long run (after 5 years). Is the economy ever in long run equilibrium? Given that shocks are always hitting, the economy is not likely to be in long run equilibrium at any point in time. Yet the force of attraction of equilibrium keeps the economy hovering around the equilibrium. Why is the long run equilibrium point attractive? Because at this point the labor market clears. Away from Y* workers are not on their labor supply curve (and firms may be off their labor demand curve). Maximizing behavior by workers and firms push the economy towards long run equilibrium. Shocks push the economy away temporarily. 32

Aggregate Supply: Short Run versus Long Run 1) Really Long Run: labor market is in equilibrium,n=n*, and K=K* 2) Long Run: the labor market is in equilibrium (N=N*) but K is fixed 3) Short Run: labor market is not in equilibrium and K is fixed: cyclical unemployment may occur (N adjusts, but it need not be at N*, K is fixed) 1. Version 1: Firms cannot adjust prices nor wages, that is, all prices are sticky! Firms are always willing to produce extra output to meet the increased demand 2. Version 2: nominal wages are sticky. Then W is fixed, but not W/P! Firms can change somehow prices in the short run in reaction to changes in demand, but cannot change wages 33

SRAS: Version 1 Some Macro Economists believe that prices are fixed in the short run. 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 (price of milk at Dominick s!) 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. This is what we have assumed so far, when we were working with the IS- LM framework keeping P as fixed. In this case - the labor market isn t really in equilibrium at all in the short run. Concept is called efficiency wages - pay workers a slight premium because they realize that sometimes they work real hard and others they do not. In such a case - prices are fixed.. SRAS is horizontal 34

AD-AS Equilibrium (Version 1) P Y* = f(n*,k,a) SRAS(1) =P e P e AD = f(g,pvlr,taxes,y f,m,π e ) Y* Y 35

SRAS: Version 2 The Short Run Aggregate Supply Curve (the relationship between output and prices) in the short run is positive SRAS is upward sloping! If there is a positive demand shock, firms 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. However, N d has not shifted! Firms decide to meet the increase in demand for their product by hiring more workers because of the lower short run real wage. 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). there is disequilibrium in the labor market! 36

The SRAS Curve (Version 2) 1. Labor Demand Curve 4. Short Run Aggregate Supply W/P 0 W/P 1 As prices increase, W/P falls P 1 P 0 N 0 N 1 Y 0 Y 1 2. Production Function 3. 45 degree line Y 1 Y 0 Y 0 N 0 N 1 Y 0 Y 1 37

Labor Market Disequilibrium N s W 0 /P 0 W 0 /P 1 N d N* N 38

Notes on SRAS (Version 2) If firms get a positive demand shock (demand for goods increase), firms will raise prices, but wages stay fixed. Hence real wages will decline making firms willing to hire more labor and produce more. SRAS Curve Slopes Upwards because an increase in prices reduces real wages and causes firms to higher more workers and hence to produce more. Hence, N > N* and Y > Y* and U < U* U = current unemployment rate U* = Natural Rate of Unemployment (only frictional and structural, no cyclical unemployment) In our model lu* U*=0! 39

AD-AS Equilibrium (Version 2) P Y* = f(n*,k,a) SRAS(2) = f(input prices) P e AD = f(g,pvlr,taxes,y f,m,π e ) Y* Y 40

What Shifts the SRAS We will work with both the horizontal (Version 1) and the upward sloping (Version 2) SRAS curves. What Shifts any SRAS curve? SRAS = F(A, K, N, rawmaterials). K is fixed an increase in A shifts the SRAS down anincreaseinpriceofraw materials shifts the SRAS up. For given labor and capital, a if the price ceofraw materials ae asgetmore oeexpensive, firms will produce less Moreover, 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! 41

IS-LM versus AD-AS The IS-LM and the AD-AS models are equivalent! Two different representations: (Y, r) and (Y, P) They are based on the same economic assumptions and give the same answers Why bother? Very useful to think to different models for different questions! (e.g. International Borrowing or Lending vs Inflation and Unemployment) 42

The Self Correcting Mechanism When the economy is in disequilibrium for a while (Y not equal Y*), the economy will naturally move towards Y*. Reason: Labor market will eventually clear. The reason that Y does not equal Y* 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. 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, as W increases, the short run AS will shift in (higher cost of production). The exact opposite will work when N < N*. As the labor market starts to clear, the SRAS will adjust to bring us back to Y*. 43

Monetary Neutrality with AD-AS P Y* = f(n*,k,a) M increases P e SRAS(2) =P e AD = f(g,pvlr,taxes,y f,m,π e ) Y* Y Y1 > Y* then firms will eventually increase their prices up to the point that output demanded = Y*! 44

Classical Economists Classical Economist believe that adjust instantaneously This implies that money is neutral, that is, monetary shocks do not affect real variables Evidence: money is very procyclical! Sometimes it can be reverse causation (Money demand depends both on current and on expected future output!) However, more recently there is consensus that money is non-neutral! neutral! A classic study is A Monetary History of United States, 1867-1960 by Milton Friedman and Anna Schwartz. Their findings: 1) Money is procyclical 2) The interrelation between monetary and economic changes has been stable 3) Monetary changes have often had independent origin, they have not been simply a reflection of changes in economic activity (gold discoveries, changes in monetary institutions, ) 45

The Misperceptions Theory (Friedman, Lucas) A theory to explain an upward sloping aggregate supply, with classical principles Extra assumption: producers have imperfect information about the general price level. Hence, they sometimes can misinterpret changes in the general price level as changes in the relative prices of the goods that they yproduce. Even though prices are not slow to adjust, the aggregate supply curve can be upward sloping in the short run and money can be non-netural! netural! The aggregate quantity of output supplied rises above the potential level when aggregate price level is higher than expected. 46

The Misperceptions Theory: Intuition Consider a bakery owned and operated by a single baker Then the price of bread is the baker s nominal wage and the price of bread relative to the general price level is his real wage! Imagine the baker sees that the price of bread goes up. There can be two situations: 1) The price of all goods went up 2) The price of bread went up relative to the price of other goods If the price of bread goes up by 5% and the baker expects all prices to go up by 5%, then he believes that his real wage does not change! If the price of bread goes up by 5% and the baker expects all prices to go up by 3%, then he thinks that his real wage went up and increases the production of bread! 47

The Misperceptions Theory: Intuition (continued) Everybody thinks the same! The amount of output produced will depend on the actual general price level compared to the expected general price level If actual prices are higher than expected producers are fooled into thinking that the relative price of their own goods increased A possible representation: Y = Y* + b*(p P e ) Output exceeds its potential level when prices are higher than expected! In the long run people learn what happens to prices and change their expectations accordingly (P = P e )! 48

Unanticipated Changes in M are non-netural! According to the Misperception Theory, unanticipated changes in monetary policy have real effects in the short run. The reason: producers are fooled! Anticipated changes in monetary policy do not have real effects because the SRAS shifts accordingly. Are monetary policy good? Not clear because if agents have rational expectations, ti they will predict that the monetary authority will react to shocks and there will be no unexpected monetary policies! 49

Unanticipated Increase in M Money is non-neutral in the short run! P LRAS SRAS 1 P e 1 Y* Y 1 AD1 Y 50

Money is neutral! Anticipated Increase in M P LRAS SRAS 1 P e 1 Y* Y 1 AD1 As M increases the AD shifts to the right but also expected prices increase! Y 51

Real Business Cycle (RBC) What really drives the business cycle? Kydland and Prescott developed the RBC theory that argues that real shocks to the economy are the primary cause of business cycle. Real shocks are shocks that affect the production function, the size of the labor force, the spending and savings decisions, Nominal shocks are shocks to money supply or demand In particular the RBC theory refer to productivity shocks The RBC theory is consistent with our IS-LM and AD-AS models. A negative productivity shock (A decreases) has two effects: 1) reduces MPN and hence the demand for labor and N* 2) Decreases Y* directly Both effects make Y* to decrease (LRAS) and hence LM has to adjust! 52

Real Business Cycle (RBC) 53

Real Business Cycle: Facts Consistent with the following stylized facts: 1) Continuous productivity shocks generate recurrent fluctuations 2) Employment will move procyclically 3) Real Wages will be higher in booms 4) Average labor productivity is procyclical Fact 4 is crucial: with no productivity shocks, the expansion of employment during booms will tend to reduce average labor productivity because of diminishing marginal returns! Fact against trbc: inflation tends to slow down during or immediately after recessions (is this evidence controversial?) For RBC theory a negative shock is associated with inflation! 54

Real Business Cycle: Calibration 55

To sum up: what is an Equilibrium? Short run equilibrium: AD = SRAS and IS = LM (ignore FE) The Labor Market need not be in equilibrium We need not be at the potential level of GDP Long run equilibrium: AD = SRAS = Y* and IS = LM = Y* and N d = N s = N* In the long run, by definition, we will move to Y*. In the long run, by definition, iti the labor market will clear. 56

How do we analyze the effects of shocks? Start with short run effects! 1. I look at the Demand Side of the Economy A. Did IS or LM change? B. Did AD change? 2. I, then, look at the Supply Side - Did SRAS change? I ignore the labor market in the short run. The long run is all about the labor market. For the long run (and Y*) I figure out what happens in the labor market! In the long run - we always end up at Y* and Y* is determined in the labor market (along with A). 57