CHAPTER 1

INTRODUCTION TO FLUCTUATIONS

KEYNESIAN ECONOMICS

MASTER EPP – MACRO 2

2010

Yann ALGAN

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1.INTRODUCTION

How does the economy react to economic shocks in the short-run ?

• Recurrent fluctuations in the short run around the long-run trend

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GDP growth rate in France since WWII

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• Recurrent crisis:

Financial and Economic Crisis 2008-2009

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Puzzle: how has the subprime crisis led to an economic crisis?

• Initial loss on subprime: 250 billions $• Loss output: 4,600 billions $• Loss financial assets 2007-2008: 26,400 billions $

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Opacity and Complexity of Subprime markets

• ABS: Asset Backed Security: package of credits• CDO: Collaterized Debt Obligation: pooling with less risky assets

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Source IMF 2009, Precentage change

8Source: IMF 2009, Percentage change

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• Global interactions between markets and countries

Percentage change

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Okun Law

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The end of decoupling

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• Prices of goods : the return of deflation?

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Financial assets

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Confidence Index

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Fluctuations and macroeconomic policies

• What role for monetary policies ?

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• What role for fiscal stimulus ?

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Basic framework: keynesian economicsShort-run analysis with price and wage rigidities

Shortage of demand on the product market Output is driven by aggregate demand

Shortage of demand on the labor marketInvoluntary Unemployment

Animal Spirits and State intervention

Basic framework: IS/LMHicks (1937), based on the General Theory Keynes (1936)Static model with rigid prices and shortage of demand

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Illustration of the relevance of price rigidity

Menu costs on the goods market

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Wage contracts

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2. Product Market

2.1 Components of aggregate demand

Components of GDP• Consumption (C): largest component (2/3 of GDP)• Private investment (I) : • Public investment (G)• Net exports (X – M)

Simplification ISLM: closed economyY = C + I + G

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Decomposition of growth in Europe

Decomposition of growth in France

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2.2 Behaviors

Consumption

Disposable income: (+)

= Income - TaxYD = Y-T

Interest rate i : (-)- Trade-off consumption-saving- Debt of households (ex. Subprime crisis)

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Simplification

Role of income and marginal propensity to consume

C = C (YD) où YD = Y-T

• Ex.:

C = c0 + c1. YD

• Empirically: marginal propensity to cosume on average between .3 and .5, but close to 1 for borrowing constrained people

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Investment

DefinitionFlows of spending to increase capital stock: component of aggregate demand in the short run. Highly volatile

French case

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- Aggregate demand : role of anticipations and animal spirits

- Interest rate: cost of borrowing or trade-off with financial assets:

I = I ( Y , i )+ -

Determinants

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Fiscal spending

• Budget constraint

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Evolution of French public debt

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2.3 Product market equilibrium : IS

Aggregate demand

Z = C (Y-T) + I(Y,i) + G

Equilibrium on the product market

• Total output Q is equal to total income Y and to aggregate demand ZAccountability definition of GDP

Q = Y=Z

Y = Z = C(Y-T) + I(Y,i) + G IS relationship

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• Causal relationship for Keynes:In case of price rigidity and demand shortage : Z Y

Alternative representation of the equilibrium IS

• Total savings : S(Y-T) = Y – T – C(Y-T)

• Equality savings and investment

S(Y-T) = I(Y,i) + G - T

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Example

One gets

(where )

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Illustration 45° diagram

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IS curve

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Basic Keynesian Multiplier

Impact of a fiscal stimulus?

Basic answer regardless of financial market

Ex.:

MechanismIf G increases by 1 $, Z increases by 1 $, so does output and incomeThis yields extra demand, output, and income of , leading to an increase in demand by …..

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Impact of a tax cut?

If

An increase in public spending is more efficient than a tax cut

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Illustration

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3. Financial market equilibrium

3.1 Money demand

Basic trade-off - Real balances: liquid but no return- Financial asset (bonds here): illiquid but yields a return

Basic relationship- MD increases with income Y : transaction motives- decreases with interest rate i : speculation motives

⇒ MD / P = Y. L(i) : Money demand(+, -)

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3.2 Equilibrium on the money market

Equilibrium:

- Money supply : M/ P - Targeted by the Central Bank: Ex M3 target for the ECB (interest rate targeting)

- Equilibrium : M/P= MD / P or M/P = Y. L(i)

LM relationship: All (Y,i) compatible with money market equilibrium

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LM curvePositive relationship between Y and i on the money market

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Illustration of an increase in money supply

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4. Macroeconomic Equilibrium

IS-LM equilibriumSimulatenous equilibrium on the product and money market

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Monetary integration

Equilibrium on the product market depends on the money market

- Money demand for transaction

- Interest rate influences Investment (and consumption in a more general framework)

Interaction between the product maket and the money markets is at the core of the non-neutrality of money

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Involuntary unemploymentLabor market activity driven by aggregate demand

Situation of unemployment:Equilibrium employment is determined by labor demand side

Aggregate demand drives production and thus labor demand

Z Y N (ex. production Y=N)

Unvoluntary unemployment: • Unemployment due to the lack of aggregate demand on the productmarket and not from too high wages !

• Equilibrium: no spontaneous adjustment of the markets through prices,adjustment by shortage of quantities

Room for State intervention

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5. Economic policies

Assessment of the impact of demand policies in the IS-LM framework

Basic framework : static, no anticipations, price stickiness

But good starting point for the short run

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5.1 Fiscal Policy

Example: decrease in G or increase in T

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Interaction with monetary markets and crowding out effect

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Positive effect in the short run…

…but vanishes over time . Why ? Next chapter : AD/AS model

Impact of an increase by 1% of fiscal spendings

What is the size of the multiplier ?

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Case study: the Barro – Krugman argument

Robert Barro: Government spending is not free lunch

• How can we identify the causal effect of fiscal shock ? • Potential instrument: military spendings (WWI, WWII, Vietnam war)

• Barro estimates 0,8: crowding out effet

Paul Krugman : War and Non-Remembrance

The problem with war is …war

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How ambitious and efficient are the current fiscal stimulus?

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How efficient is the French stimulus plan ?

Conclusion: what will happen with the withdrawal of fiscal stimulus?

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5.2 Monetary Policy

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Illustration

Increase by 1% of the FED interest rate (or money contraction)

Decrease in Z (lower I and C)

Decrease in Y Decrease in N

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Higher u …little effect on prices

IS/LM relevant in the short run

…But price adjustment in the long run (next chapter)

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Financial crisis and Monetary Policy

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5.3 Policy Mix

Example: FED policy during the financial crisis

Inverse Example: German reunification