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Model of aggregate demand and aggregate supply

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Long run: prices flexible, output determined by factors of production & technology, unemployment equals its natural rate Short run: prices fixed, output determined by aggregate demand, unemployment negatively related to output

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The Keynesian cross

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Closed economy model; income determined by expenditure. I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment

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Consumption function

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C = C(Y - T)

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Government policy variables

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G = G[bar], T = T[bar]

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Investment

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I = I[bar] -> exogenous

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Planned expenditure

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PE = C(Y-T) + I[bar] + G[bar] Slope of PE line = MPC I and G are exogenous, so the only component of (C + I + G) that changes when income changes is consumption. A one-unit increase in income causes consumption & therefore the PE to increase by the MPC.

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Equilibrium condition for the Keynesian cross

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Actual expenditure = planned expenditure Y = PE

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Graphing the equilibrium condition for the Keynesian cross

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PE on vertical axis Y on horizontal axis 45 degree line

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An increase in government purchases and the Keynesian cross

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At Y1, an unplanned drop in inventory causes firms to increase output, and income rises toward a new equilibrium At any value of Y, an increase in G by the amount deltaG causes an increase in PE by the same amount. At Y1, there is an unplanned depletion of inventories because people are buying more than firms are producing (PE > Y)

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Solving for delta Y

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Y = C + I + G delta Y = delta C + delta I + delta G = delta C + delta G = MPC x delta Y + delta G (because delta C = MPC x deltaY) (1 - MPC) x delta Y = delta G. Solve for Y: delta Y = (1/(1-MPC)) x delta G

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Government purchases multiplier

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The increase in income resulting from a $1 increase in G. In this model, delta Y/delta G = (1-(1/MPC) Example: If MPC = 0.8, then delta Y / delta G = (1/(1-0.8)) = 5 An increase in G causes income to increase by 5 times as much

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Why the government purchases multiplier is greater than 1

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Initially, the increase in G causes an equal increase in Y; that is, delta G = delta Y. But an increase in Y -> an increase in C, which further increases Y, which further increases C, etc. So the final impact on income is much bigger than the initial delta G.

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An increase in taxes

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Initially, tax increases reduce consumption (by a measure of MPC x delta T) and therefore PE (does not affect I and G, as they are exogenous). So firms reduce output, and income falls toward a new equilibrium. At Y1, there is now an unplanned inventory buildup. See book for an example about a decrease in taxes

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Solving for delta Y with an increase in taxes

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delta Y = (-MPC/(1-MPC)) x delta T

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Tax multiplier

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The change in income resulting from a $1 increase in T delta Y/delta T = (-MPC/(1-MPC)) If MPC = 0.8, tax multiplier is: delta Y/delta T = (-0.8/(1-0.8)) = (-0.8/0.2) = -4 -The tax multiplier is negative because a tax increase reduces C, which reduces income. -The tax multiplier is greater than one (in absolute value) because a change in taxes has a multiplier effect on income. -The tax multiplier is smaller than the government spending multiplier because consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

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An increase in planned investment and the Keynesian cross

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At Y1, there is an unplanned drop in inventory so firms increase output and income rises toward a new equilibrium.

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The IS curve

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A graph of all combinations of r and Y that result in goods market equilibrium i.e. actual expenditure (output) = planned expenditure Equation of the IS curve: Y = C(Y - T[bar]) + I(r) + G[bar]

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A decrease in interest rate and the IS curve

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A decrease in r leads to: An increase in I -> an increase in PE -> an increase in Y

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Why the IS curve is negatively sloped

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The fall in interest rate motivates firms to increase investment spending, which drives up the total planned spending (PE). To restore equilibrium in the goods market, output Y must increase.

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Fiscal policy and the IS curve

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-An increase in G At any value of r, an increase of G -> an increase in PE -> an increase in Y, so the IS curve shifts to the right. The horizontal distance of the IS shift equals delta Y = (1/(1-MPC))delta G.

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How an increase in taxes shifts the IS curve

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-An increase in T At any value of r, an increase in T -> a decrease in C -> a decrease in PE, so the IS curve shifts left. The horizontal distance of the IS shift is equal to delta Y = (-MPC/(1-MPC)) delta T

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The theory of liquidity preference

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The interest rate is determined by the money supply and the money demand -Money supply: assume a fixed supply of money balances because P is fixed by the short-run assumption and M is an exogenous policy variable. Thus, M/P is a vertical line. -Money demand: demand for real money balances in (M/P)^d = L(r). Money demand depends negatively on the nominal interest rate.

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Equilibrium in theory of liquidity preference

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The interest rate adjusts to equate the supply and demand for money M[bar] / P[bar] = L(r)

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How the Fed raises the interest rate

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To increase r, Fed reduces M This is monetary tightening

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Effects of monetary tightening on nominal interest rates

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Short run -Model: liquidity preference (Keynesian) -Prices: sticky -Prediction: delta i > 0 Long run -Model: Quantity theory, Fisher effect (classical) -Prices: flexible -Prediction: delta i < 0

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The LM curve

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The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. Equation for the LM curve: M[bar]/P[bar] = L(r,Y) -LM curve is upward sloping because an increase in income raises money demand. Since the supply of real balances is fixes, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.

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How a change in M shifts the LM curve

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When the Fed reduces M, the vertical distance of the shift tells us what happens to the equilibrium interest rate associated with a given value of income. Interest rates rise; LM shifts upward. Same happens if consumers use cash more frequently - money demand will increase, and LM shifts upward as the real money market curve shifts outward.

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Short run equilibrium of the IS-LM model

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The short run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y = C(Y - T[bar]) + I(r) + G[bar] M[bar]/P[bar] = L(r, Y)

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The Big picture

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The Keynesian cross -> IS curve Theory of liquidity preference -> LM curve IS curve + LM curve -> IS-LM model IS-LM model -> aggregate demand curve Aggregate demand curve + aggregate supply curve -> model of aggregate demand and aggregate supply -> explanations of short-run fluctuations

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Equilibrium in the IS-LM model

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The IS curve represents the equilibrium in the goods market Y = C(Y - T[bar]) + I(r) + G[bar] The LM curve represents money market equilibrium M[bar]/P[bar] = L(r,Y) Intersection of IS and LM determines the unique combination of Y and r that satisfies equilibrium in both markets

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An increase in government purchases and the IS-LM model

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-IS curve shifts right by (1/(1-MPC))delta G, causing output and income to rise -This raises money demand, causing the interest rate to rise, which reduces investment, so the final increase in Y is smaller than (1/(1-MPC))delta G

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A tax cut and the IS-LM model

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Consumers save (1-MPC) of the tax cut, so the initial boost in spending is smaller for deltaT than for an equal deltaG. The IS curve shifts by 1. (-MPC/(1-MPC))delta T 2. ...so the effects on r and Y are smaller for delta T than for an equal delta G IS shifts outward and interest rates rise

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An increase in M and the IS-LM model

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DeltaM > 0 shifts the LM curve down (to the right), causing interest rates to fall, which increases investment, causing output & income to rise

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The Fed's response to deltaG > 0

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If Congress increases G, Fed can hold M constant, hold r constant, or hold Y constant. The effects on delta G are different each time.

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Increase in G, Hold M constant

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-If Congress raises G, the IS curve shifts right. If Fed holds M contant, LM curve doesn't shift. Result: delta Y = Y2 - Y1 (Y shifts right) delta r = r2 - r1 (r shifts up)

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Increase in G, Hold r contant

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If Congress raises G, the IS curve shifts right. To keep r constant, Fed increases M to shift LM curve to the right. delta Y = Y3 - Y1 delta r = 0

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Increase in G, Hold Y constant

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If Congress raises G, the IS curve shifts right. To keep Y constant, Fed reduces M to shift LM curve left. delta Y = 0 delta r = r3 - r1

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IS shocks

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IS shocks: exogenous changes in the demand for goods & services. Examples: stock market boom or crash (change in households' wealth, delta C); change in business or consumer confidence or expectations (delta I and/or delta C)

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LM shocks

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LM shocks: exogenous changes in the demand for money Examples: a wave of credit card fraud increases demand for money; more ATMs or the Internet reduce money demand

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Effect of a housing market crash on the IS-LM model

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IS shifts left, causing r and Y to fall. C falls lower due to lower wealth/income; I rises because r is lower; u rises because Y is lower (Okun's law)

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Effect of an increase in money demand on the IS-LM model

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LM shifts left, causing r to rise and Y to fall C falls lower due to lower income; I falls because r is higher; u rises because Y is lower (Okun's law)

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Causes of US recession of 2001

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1. Stock market decline (-> decrease in C) 2. 9/11 (lower spending, IS curve shifts left) 3. Corporate accounting scandals (Enron, WorldCom) Fiscal policy response: shift IS curve right (tax cuts, spending increases) Monetary policy response: shift LM curve right (causing interest rates to fall)

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What is the Fed's policy instrument?

answer

-The Fed targets the federal funds rate, or the interest rate banks charge one another on overnight loans. The Fed changes the money supply and shifts the LM curve to achieve its target.

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Why does the Fed target interest rates instead of the money supply?

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1. Easier to measure than the money supply 2. Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.

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Deriving the AD curve

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Downward sloping Slope of AD curve: increase in P -> decrease in M/P -> LM shifts left -> increase in r -> decrease in I -> decrease in Y

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Monetary policy and the AD curve

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The Fed can increase aggregate demand: increase in M -> LM shifts right -> decrease in r -> increase in I -> increase in Y at each value of P

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Fiscal policy and the AD curve

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Expansionary fiscal policy (increase in G and/or decrease in T) increases aggregate demand: decrease in T -> increase in C -> IS shifts right -> increase in Y at each value of P

question

IS-LM and AD-AS in the long and short runs

answer

In the short run equilibrium, if Y > Y[bar], then over time, the price level will rise In the short run equilibrium, if Y < Y[bar], then over time, the price level will fall In the short run equilibrium, if Y = Y[bar], then over time, the price level will remain constant

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The SR and LR effects of an IS shock

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A negative IS shock shifts IS and AD left, causing Y to fall. In the new short run equilibrium, Y < Y[bar]. Overtime, P gradually falls, causing SRAS to move down, and M/P to increase (which causes LM to move down). This process continues until economy reaches a long-run equilibrium with Y = Y[bar].

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Short run effects of an increase in M on the IS/LM and AD models

answer

LM and AD shift right r falls, Y rises above Y[bar]. Overtime, P rises, SRAS moves upward, M/P falls, LM moves leftward. New long run equilibrium: P higher, all real variables back at their initial values. Money is neutral in the long run.

question

Great Depression and IS curve

answer

Spending hypothesis -Asserts that the Depression was largely due to an exogenous fall in the demand for goods & services - a leftward shift of the IS curve. Output and interest rate both fell, which is what a leftward IS shift would cause. -Reasons why: stock market crash -> exogenous decrease in C. Drop in investment, contractionary fiscal policy

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Great Depression and LM curve

answer

Money hypothesis -Asserts that the Depression was largely due to a huge fall in the money supply -Severity due to deflation due to the fall in M -Evidence: M1 fell by 25% 2 problems with hypothesis -P fell even more, so M/P actually rose slightly -nominal interest rates fell, which is opposite of what a leftward LM shift would cause The effects of falling prices -Decreasing P -> increasing M/P -> LM shifts right -> increase in Y -Pigou effect: decrease in P -> increase in M/P -> consumers' wealth increases -> increase in C -> IS shifts right -> increase in Y The effects of falling prices -The destabilizing effects of expected deflation -> decrease in E(pi) -> increase in r for each value of i -> decrease in I because I = I(r) -> planned expenditure and aggregate demand decrease -> income and output decrease The destabilizing effects of unexpected deflation (debt deflation theory) -decrease in P (if unexpected) transfers purchasing power from borrowers to lenders -> borrowers spend less, lenders spend more -> if borrowers' propensity to spend is larger than lenders', then aggregate spending falls, the IS curve shifts left, and Y falls

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Why another depression is unlikely

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-M would not be allowed to fall so much -Taxes should not be raised and spending should not be cut in a contraction -Federal deposit insurance makes widespread bank failure unlikely -Automatic stabilizers make fiscal policy expansionary during an economic downturn (i.e. income tax falls, unemployment insurance)

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Important factors of 2008 crisis

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-In 2009, real GDP fell and u approached 10% -Important factors: early 2000s Fed interest rate policy, subprime mortgage crisis, busting of house price bubble, falling stock prices, failing financial institutions, declining consumer confidence

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Aggregate supply model

answer

Y = Y[bar] + alpha(P - EP) Aggregate output = natural rate output + a positive parameter (actual price level - expected price level) Y and P are positively related, so the SRAS curve slopes upward

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Sticky price model

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Reasons for sticky prices -Long term contracts between firms and customers, menu costs, firms not wishing to annoy regulars Assumption: firms set their own prices (e.g. firms have some market power)

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Sticky price model: individual firm's desired price

answer

p = P + alpha(Y - Y[bar]) where alpha > 0 Two types of firms: those with flexible prices (which set prices as above) and firms with sticky prices, which follow: p = EP + a(EY - EY[bar]) Assume sticky-price firms expect that output will equal its natural rate. Then, p = EP. s = fraction of firms with sticky prices P = s[EP] + (1 - s)[P + alpha(Y - Y[bar]), where EP is the price set by sticky-price firms and the second bracket is price set by flexible price firms. P = EP + ((1-s)a/s)(Y - Y[bar]) High EP -> High P. If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices. High Y -> High P. When income is high, the demand for goods is high. Firms with flexible prices set high prices. The greater the fraction of flexible-price firms, the smaller is s and the bigger the effect of delta Y on P. Y = Y[bar] + alpha (P - EP)

question

Imperfect information model assumptions

answer

All wages and prices are perfectly flexible and markets clear. Each supplier produces one good, consumes many goods. Each supplier knows the nominal price of the good she produces, but does not know the overall price level. Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level. Supplier does not know the price level at the time she makes her production decision, so uses EP. Suppose P rises but EP does not: supplier thinks her relative prices has risen so she produces more. With many producers thinking this way, Y will rise whenever P rises above EP.

question

Why the SRAS curve is bow shaped

answer

At low levels of output, there are lots of unutilized and under-utilized resources available, so it is not terribly costly for firms to increase output, and therefore firms do not require a big increase in prices to make them willing to increase output by a given amount. In contrast, at very high levels of output, when unemployment is below the natural rate and capital is being used at higher than normal intensity levels, it is relatively costly for firms to increase output further. Hence, a larger increase in prices is required to make firms willing to increase their output.

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SRAS equation

answer

Y = Y[bar] + alpha (P - EP) A positive AD shock moves output above its natural rate and P above the level people had expected. Overtime, EP rises, SRAS shifts up, and output returns to its natural rate.

question

Phillips curve

answer

States that inflation depends on expected inflation (Epi), cyclical unemployment (the deviation from the actual rate of unemployment from the natural rate), supply shocks v Pi = Epi - beta(u - u'') + v where beta > 0 is an exogenous constant

question

Comparing SRAS and Phillips curve

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SRAS: output is related to unexpected movements in the price level Phillips curve: unemployment is related to unexpected movements in the inflation rate

question

Adaptive expectations

answer

An approach that assumes people form their expectations of future inflation based on recently observed inflation. Simple version: expected inflation - last year's actual inflation: Epi = pi(subscript -1) Then P.C. becomes pi = pi(subscript -1) - beta(u - u^n) + v

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Inflation intertia

answer

Phillips curve implies that inflation has inertia -In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate -Past inflation influences expectations of current inflation, which in turn influences the wages & prices people set

question

Two causes of rising & falling inflation

answer

-Cost-push inflation: inflation resulting from supply shocks. Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up -Demand-pull inflation: inflation resulting from demand shocks. Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up

question

Graphing the Phillips curve

answer

In the short run, policymakers face a tradeoff between inflation and u. People adjust their expectations overtime, so the tradeoff only holds in the short run. Pi on vertical axis, u on horizontal Epi + v as vertical axis intercept u as horizontal axis intercept

question

The sacrifice ratio

answer

To reduce inflation, policymakers can contract aggregate demand, causing unemployment to rise above the natural rate. The sacrifice ratio measures the percentage of a year's real GDP that must be forgone to reduce inflation by 1 percentage point. A typical estimate of the ratio is 5. Example: to reduce inflation from 6 to 2 percent, must sacrifice 20 percentage points: 4 (inflation reduction) x 5 (sacrifice ratio) = 20 The cost of disinflation is lost GDP, can use Okun's law to translate this to unemployment Lost GDP/total disinflation Okun's law: 1% of unemployment = 2% of lost output

question

Types of expectations

answer

Ways of modeling the formulation of expectations: -Adaptive expectations: people base their expectations of future inflation on recently observed inflation -Rational expectations: people base their expectations on all available information, including information about current and prospective future policies. Proponent of rational expectations believe sacrifice ratio may be very small

question

Natural-rate hypothesis

answer

Changes in aggregate demand affect output and unemployment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model

question

Hysteresis

answer

The long-lasting influence of history on variable such as the natural rate of unemployment Negative shocks may increase u^n, so economy may not fully recover

question

Why negative shocks may increase the natural rate (hysteresis)

answer

-The skills of the cyclically unemployed may deteriorate and they may be unable to find a job when the recession ends -Cyclically unemployed workers may lose their influence on wage setting; then, insiders (employed workers) may bargain for higher wages for themselves -Result: the cyclically unemployed "outsiders" may become structurally unemployed when the recession ends

question

Arguments for active policy

answer

-Recessions cause economic hardship for millions of people -The model of aggregate demand and supply shows how fiscal and monetary policy can respond to shocks and stabilize the economy

question

Arguments against active policy

answer

Policies act with long and variable lags, including: -Inside lag: the time between the shock and the policy response. Takes time to recognize a shock; takes time to implement policy, especially fiscal policy -Outside lag: the time is takes for policy to affect the economy If conditions change before policy's impact is felt, the policy may destabilize the economy

question

Automatic stabilizers

answer

-Policies that stimulate or depress the economy when necessary without any deliberate policy change -Designated to stimulate or depress the economy when necessary without any deliberate policy change -Examples: income tax, unemployment insurance, welfare

question

Forecasting the macroeconomy

answer

Because policies act with lags, policymakers must predict future conditions. Two ways: -Leading economic indicators (LEI) - data series that fluctuate in advance of the economy -Macroeconomic models - large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies -Forecasts are often wrong; one reason why some economists oppose policy activism

question

The Lucas critique

answer

Forecasting the effects of policy changes has often been done with models estimated with historical data. Such predictions are not valid if the policy change alters expectations in a way that changes the fundamental relationships between variables. -Example: prediction: an increase in the money growth rate will reduce unemployment. The Lucas critique points out that increasing the money growth rate may raise expected inflation in which case unemployment would not necessarily fall -It is hard to identify shocks in data -It is hard to tell how outcomes would have been different had actual policies not been used

question

Policy conducted by rule

answer

Policymakers announce in advance how policy will respond in various situations and commit themselves to following through -Arguments for rules: 1. distrust of policymakers and the political process (misinformed politicians, politicians' interests sometimes not the same as the interests of society) 2. the time inconsistency of discretionary policy. Definition: a scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. Destroys credibility and reduces effectiveness of policies. Example: to encourage investment, gvt announces it won't tax income from capital, but once factories are built, gvt reneges

question

Policy conducted by discretion

answer

As events occur and circumstances change, policymakers use their judgement and apply whatever policies seem appropriate at the time

question

Monetary policy rules

answer

-Constant money supply growth rate (advocated by monetarists, stabilizes aggregate demand only if velocity is stable) -Target growth rate of nominal GDP (automatically increases money growth whenever nominal GDP grows slower than targeted; decreases money growth when nominal GDP growth exceeds target) -Target the inflation rate (automatically reduce money growth whenever inflation rises above target rate; practiced by many central banks but allowed a little leeway)

question

Central bank independence

answer

A policy rule announced by central bank will only work if the announcement is credible. Credibility depends in part on degree of independence of central bank.

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