Intermediate Macroeconomics

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Short Run Macroeconomics

Labour markets + unemployment

Macroeconomic adjustment

long-run macroeconomics

open economy macroeconomics

aggregate output - measured through national income accounts - Key measures: GDP and GDI

GDP

(1) trade value of final goods and services (2) total value added (3) total income (wages and profits)

nominal GDP = sum of quantities * prices denominated in dollars

real GDP = sum of quantities * constant prices

IS Approach

Demand for goods + services

Z = C + I + G + X - M

Consumption function

Money Demand

(1) demand increasing in level of transactions; transactions

proportional to nominal income $Y ≡ P Y

(2) demand decreasing in opportunity cost i of holding money

Md = Py × L(i)

Shifts in Money Demand/money supply

Increase in nominal income increases equilibrium Money Demand

Reserve Bank changes money supply by “open market operations” expansionary, buy bonds with money, M increases, i falls contractionary, sell bonds for money, M falls, i rises

The balance sheet of Reserve Bank

– assets of Reserve Bank are its bond holdings

– liabilities are money stock issued

leverage ratio ≡

total assets / equity

Leverage magnifies risk and return to shareholders of the bank

Classic bank runs. Rumours cause depositors to converge on

bank, demand money back

Modern bank runs. Short-term debt (wholesale funding, etc)

plays role of demand deposits

IS- LM CURVES

Any point on the IS curve is consistent with equilibrium in the

goods market

Any point on the LM curve is consistent with equilibrium in

financial markets

• Each curve is an aggregate equilibrium relationship, not analogous

to micro demand and supply curves

• General equilibrium achieved at intersection of IS and LM curves

Fiscal expansion and general equilibrium

Decrease in taxes from T to T', shifts IS curve to right from IS to IS' . Leads to

increase in the general equilibrium level of output from Y to Y' and interest rates

from i to i' . Movement along LM curve.

Increase in output increases demand for money, puts upward

pressure on interest rates. Since supply of money is unchanged,

interest rates have to rise to equalise money demand and supply

• Position of LM curve unchanged. Movement along LM curve

• Typically, rise in interest rate effect not enough to offset fall in

taxes, so in new general equilibrium where output is higher

Monetary expansion and general equilibrium

Position of LM curve changes. Shifts down following increase in

money supply from M to M' • Increase in money supply puts downward pressure on interest rates

• Position of IS curve unchanged. Movement along IS curve

• Fall in interest rates increases investment and so demand for

goods, output rises from Y to Y' • Rise in output shifts out demand for real money, tends to mitigate

extent of interest rate fall

Unlike fiscal policy, with monetary policy we can be sure what

happens to each of the components of output

Following an expansion M to M'

– fall in i increases investment I and hence output Y

– increase in Y increases disposable income and hence consumption C

– multiplier effect reinforces increase in Y

Monetary / Fiscal Policy Interactions

interest rate setting

how does Reserve Bank set some target i = i0?

* if output Y is high, money demand is high, upward pressure on i

* increase money supply M to keep at target i = i0

– in practice setting i is generally easier than setting M

IS-LM Model

Shifts in IS curve (EQm Goods market) - Investment Savings

For given interest rate i demand Z(Y, i) is increasing in output Y Z(Y, i) ≡ C(Y, T) + I(Y, i) + G

– increase in Y increases consumption C(Y, T)

– increase in Y increases investment I(Y, i)

Consider increase in taxes from T to T' – disposable income falls, consumption falls, demand for goods falls – equilibrium output falls at any given interest rate – IS curve shifts in (to the left)

Decrease in taxest , shifts IS curve to right from IS to IS0

Any exogenous shock (change in G, consumer confidence, etc) that

for given interest rate i reduces Y causes IS curve to shift in.

- Contractionary fiscal policy, e.g., increase in T or fall in G, shifts whole IS curve in

to the left.

Shifts in LM Curve (EQm Financial markets) - liquidity money

Equilibrium in financial markets when money demand equals

money supply

M = P *Y L(i)

In real terms M/P = Y L(i)

LM curve drawn for given monetary policy M and price level P

Changes in M or P will shift whole LM curve

Consider increase in nominal money from M to M' – real money rises from M/P to M0/P

– equilibrium interest rate i falls for any given real output Y

– LM curve shifts down

Decrease in nominal money

– real money falls

– equilibrium interest rate rises for any given real output

– LM curve shifts up

• Increase in P equivalent to fall in M. Much more on this later

(“macroeconomic adjustment”).

Shocks that increase supply of real money M/P (for given Y ) shifts whole LM curve down • Shocks that decrease supply of real money M/P shifts whole LM curve up

Howard-Macfarlane policy mix I, 1996–2002

Rudd-Stevens policy mix, 2008–2009

Comparative effects of monetary or fiscal stimulus depend on

slopes of IS and LM curves

Slopes determine whether a given policy mostly changes interest

rates i or mostly changes output Y

Fiscal Policy Effects

LM curve is steep when money demand is very interest-insensitive (e.g., if money demand does not depend on i)

• If so, it takes a large increase in interest rates to equate money

demand and money supply (i.e., it takes large increase in i to keep

money demand from increasing)

• Large increase in interest rates leads to fall in investment demand

• If LM is vertical, complete crowding out. Interest rates i increases

but fall in I completely offsets fiscal stimulus

Monetary Policy Effects

IS curve is steep when investment demand is very

interest-insensitive

• If so, a given increase in M reduces i but this leads to small

increase in investment demand I and a small increase in output Y

• Comparative effectiveness of monetary and fiscal policy determined

by relative interest-sensitivities of money demand and investment

demand

• Explains why monetary policy can be ineffective and economy can

get stuck in a liquidity trap

Liquidity trap

Nominal interest rates cannot fall below i = 0. At the zero bound money and bonds

are perfect substitutes (people are indifferent). Increasing money supply has no

effect on the nominal interest rate.

For low levels of output, the LM curve is flat, with i = 0. For higher levels of

output, the LM curve is upward sloping.

Labour market

Civilian population (non-institutional, working age 15+)

Number of people potentially available for civilian employment

Labor force L - Sum of those either working or looking for work. Those neither

working nor looking for work are out of the labor force

Participation rate

Ratio of labor force to civilian population

•

Unemployment rate u

Ratio of unemployed to labor force, u = U/L

(1) “fluid ” labor market, many separations and many hires

(2) “sclerotic ” labor market, few separations and few hires

Even if overall unemployment rate is the same, differences in labor

market flows will be apparent in

– compositions of short and long-term unemployment

– responses to unexpected shocks

job separations sNt

job finding fUt

When unemployment is high, the proportion of the unemployed finding jobs is low.

Job finding rate ft is pro-cyclical.

When unemployment is high, higher proportion of workers lose their jobs.

Separation rate st is counter-cyclical.

Unemployment Duration

Recall that expected unemployment duration is 1/f where f is the

job finding rate

• In a recession, labor market is more slack, f(θ) falls, and so

unemployment duration 1/f(θ) rises

• In a boom, labor market is tighter, f(θ) rises, and unemployment

duration 1/f(θ) falls

• Opposite implications for expected duration of a vacancy, 1/q(θ)

Derivation of AD curve

When the price level increases from P to P

0

, the Reserve bank raises the interest

rate through open market sales of bonds to reduce the nominal money supply.

Therefore the LM curve shifts up to LM’. The new equilibrium is at A'

Shifts in the AD demand

Increase in government spending G increases output Y at given price level P, shifts

AD curve to the right. A decrease in price target P

T

(i.e., a monetary contraction)

decreases output at given price level, shifting the AD curve to the left.

AGGREGATE SUPPLY

Production function gives output Y in terms of employment N

Y = AN (for given labour productivity A)

Prices equal to marginal cost

P = W/A

Wage setting, workers ask for wages W that depend on expected

prices and current output Y

W = P

e F(Y )

Given an expected price level Pe , an increase in output Y will leads to an increase in price level P. If the price level is equal to the expected price level P = Pe , then output is equal to the natural level Y = Yn.

SHORT RUN

Short run equilibrium takes expected prices P

e as given

• Value of P

e determines position of short run AS curve

Over time, economy P

e adjusts in response to prevailing conditions

CONTRACTIONARY MONETARY POLICY

A permanent decrease in the price target PT • Monetary policy is set according to the interest rate rule • Change in policy implies

– Reserve Bank increases the interest rate i

– AD curve shifts left, Y falls for each P level

Decrease in price target P

T

shifts AD curve left. In short run, output and price

level decrease to point A0

. There Y

0

NEUTRALITY OF MONEY

Over time, price level P decreases and effects of monetary

contraction on output Y and interest rate i dissipate

• Implied expansionary or contractionary monetary policy has no

effect on output in long run

Instead, change in monetary policy absorbed by change in price

level

• In long run equilibrium, P = P

e = P

T and i = in and Y = Yn. From LM curve

M / P

= L(Yn, in)

(note money stock adjusts endogenously)

In short run, contraction leads to

– increase in interest rates i and decrease in output Y

In long run

– output bounces back to natural level Y = Yn

– interest rates i fall back to in

– prices and price expectations settle at new lower level

P0 = P

e0

= PT

DEFICIT REDUCTION

Decrease in budget deficit G down to G0

initially decreases output as AD shifts in.

Fall to G0

reduces natural interest rate in. Over time, output returns to the natural

level and P returns to unchanged PT

In long run, composition of output different after deficit reduction

• Consumption C unchanged, since output Yn and taxes T

unchanged

• Government purchases G lower at G' • Therefore investment I must be higher than before deficit

reduction by amount equal to fall in G

– investment is “crowded in”

• Since investment has to rise, in has to fall to i'n

. Deficit reduction

leads to decrease in interest rate and increase in investment

In short run, deficit reduction leads to

– decrease in output Y and decrease in interest rates i

In long run

– output bounces back to natural level Y = Yn in output, i falls

further to i'n

, investment increases to I(Yn, i'n

).

PHILIP's Curve DOUBTS

Friedman (1968) and Phelps (1968) questioned any supposed

policy tradeoff between inflation π and unemployment u

Negative relation between unemployment u and inflation π held till

the 1960s

But then began to break down

(i) persistent inflation incorporated into expected inflation

(ii) oil price shocks

DYNAMIC AS CURVE

Limitations of Static Models

Inadequate treatment of - distinction between nominal and real interest rates - expectations and dynamics

static models are difficult to relate to policy discussions - crouched in terms of output gaps, inflation vs. expected inflation, transitory vs. persistent shocks, impact vs. dynamic effects, policy rules

nominal interest rate, it, expressed in terms of claims to currency

real interest rate, rt, expressed in terms of claims to a basket of real goods (CPI basket)

SHORT RUN Equilibrium

The intersection of the DAD and DAS curves determines the SR equilibrium

CALCULATING IMPACT EFFECTS

permanent vs. persistent vs. transitory

RULES VS. DISCRETION In Macro policy making

Rule

– goals and instruments announced in advance

– central bank commits to a contingent plan

Discretion

– policy makers evaluate events in real time

– optimise sequentially

Flexibility creates problem of incredible policy announcements

• Central bank cannot make private sector believe it will do the right

thing and keep inflation low

• There may be advantages to taking options “off the table”

– key difference between single-agent optimisation and a game

• But absolute commitment to a rule difficult to achieve in practice

ECONOMICS GROWTH FACTS

• In the short- and medium-run fluctuations dominate

• But in the long-run, trend growth dominates

Long-run growth – sustained increase in real output over time – driven by supply-side considerations

**technological progress

population growth and demographics, labor supply

physical and human capital accumulation

Output per person is real GDP divided by population

• Living standards depend on output per person, not total output

Living standards have increased significantly since 1950

• Growth rates of output per person have decreased since mid-1970s

Convergence: levels of output per person across (these) countries

have become closer

Countries that had a lower level of output per person in 1950 have typically grown

faster since then.

Aggregate Production

Depends on state of technology or productivity

• Higher technology, higher is output for any given level of inputs

• State of technology A given by set of “blueprints” defining range of

products and techniques available to produce them

Growth comes from capital accumulation K and technological

progress A • We will see that because of diminishing returns, capital

accumulation alone cannot sustain growth

• Sustained growth requires sustained technological progress

SOLOW (1956) NEOCLASSICAL GROWTH MODEL

Based on two important long run relationships

(i) amount of capital determines output produced (per period)

(ii) amount of output determines saving and investment (per period)

savings rate on output

Saving rate has no effect on long-run growth rate of output per

worker

(ii) But saving rate determines long-run level of output per worker

– consider two countries with savings rates s1 > s0

– in long-run, both will grow at same rate

– country with s1 will have higher level of output per worker

(iii) Increase in s will lead to higher growth of output per worker in

short-run, not forever. Boost to growth will fade away as economy

converges to new, higher, steady-state level of output per worker

An increase in the saving rate leads to an increase then decrease in consumption per

worker in steady state. If s = 0, then C = 0. But if s = 1, then C = 0 too.

Intermediate value sG maximises C [the “golden rule ”].