chapter 5: short-run economic...

Outline History Trends vs. Fluctuations IS and LM SRE NRU LRE Dynamics Policies Fluctuations Conclusions

Chapter 5:Short-run economic fluctuations

Econ206 - Francesc Ortega


Outline

1. A bit of history2. Long-run trend versus short-run fluctuations3. The IS and LM curves4. Short-run equilibrium5. The Natural rate of unemployment6. Long-run equilibrium7. Dynamics8. Fiscal and monetary policy9. Economic fluctuations

Reading: Chapters 9, 10 and 11 (Mankiw 6e or 7e)


The Keynesian Theory

• The Great Depression and the resulting hugeunemployment caused many economists to question theusefulness of the neoclassical theory.

• In 1936, English economist John Maynard Keynes wroteThe General Theory of Employment, Interest, and Money.In it, he proposed a new way to analyze the economy.

• With the Great Recession in 2008-2009 Keynesian theorywas at the forefront of the policy discussion. It prescribes arole for monetary and fiscal policy to accelerate therecovery.


The Keynesian Theory

• In neoclassical economics output is supply-determined:Y = AF (K ,L).

• Keynes proposed that low aggregate demand isresponsible for the low income and high unemploymentthat characterize economic downturns.

• In the short run the level of income and output (Y) isdetermined by the desire to spend by households, firms,the government (and net exports).

• Thus the fundamental problem during recessions is thatspending is too low.

• Only in the long run income and output are supply-sidedetermined.


Long-run trends

• In neoclassical theory supply always equals demand inall markets.

• The neoclassical model is our theory behind thelong-run trends in macroeconomic variables.

• Output (real GDP) always at its potential level and “fullemployment".

• Full employment: the unemployment rate is at its long-runlevel (the natural rate of unemploymentu around 5%).

Yt = F (Kt ,Lt)

Lt = (1 − u)LFt


Short-run fluctuations

• Obviously, output and employment not always at their fullpotential.

• E.g. US employment and real GDP were much lower in2009.Q2 than in 2008.Q2 despite no reductions in theamount of capital and labor available for production.

• The economy is constantly hit by (positive or negative)shocks, which push it above or below the long-run trend.

• The economy needs some time to absorb these shocksand return to its long-run trend.

• What prevents the economy from returning immediately toits long-run trend?


Price rigidities

• Prices (including nominal wages) are sticky. It takestime for firms to change their prices for a variety of reasons.

• Consider a 5% drop in the money supply. In long run, noeffects on real variables. Simply a 5% reduction in allprices (including nominal wages).

• But firms do not change their prices or cut workers’ wagesimmediately.

• As we shall see, price rigidities imply that the reduction inthe money supply will have real effects in the short run.Employment and real GDP will fall!

• Once all prices adjust, employment and real GDP will goback to their long-run values, as predicted by theneoclassical theory.


The 1994 Alan Blinder study• Firms surveyed about their price adjustment decisions

1. The typical firm adjusts prices only once or twice a year.2. About 10% of firms adjust more often. About the same

amount adjust less often.3. Main reasons given for delaying adjusting prices:

• Coordination failure (60%). They are waiting forcompetitors to do it first.

• Menu costs (30%). It is costly to relabel and print newbrochures.

• Nominal contracts (35%). Price has been fixed withcustomers for a period of time.

• Implicit contracts (50%). Tacit agreement (with customersor other firms) to stabilize prices.


New framework: the IS and LM model

• Let us introduce a new framework to think about theeconomy. The IS (investment=saving) and LM(liquidity=money) model.

• Designed to think about short-run fluctuations. Embodiesthe essence of Keynesian economics.

• Underneath the new diagram lie the markets we alreadyknow.

• But in the short-run factor (labor) markets are sluggishbecause of price rigidities.


The IS curve• Given (G,T , I), the IS curve is the collection of pairs (Y , r)

such that supply equals demand in the loans & creditmarket (and in the goods market).

• We now introduce exports X and imports. Let net exportsbe NX = X − M. Assume exogenous NX .

• The demand for loans in the economy is given by I + NX .• Both Investors and the Rest of the world demand loans to

purchase current US output. Supply equal demand in theloans and credit market:

S(Y , r) = I(I, r) + NX

• Recall S(Y , r) = SP(Y , r) + T − G. Hence, supply equaldemand in the goods market as well:

C(Y − T , r) + I(I, r) + G + NX = Y


IS slope

• Graphical derivation of the IS curve in Figure 1• Movements along the IS. An increase in Y shifts the

savings curve to the right. As a result, r falls. Hence, the ISslopes down.


IS position

The IS curve shifts to the right if:1. Government purchases (G) increase.2. Taxes (T ) fall. In both cases we have a shift to the left of

the savings curve.3. Investors’ optimism about the future (animal spirits, I)

increases. This is a shift of the investment function(demand for loans) to the right.

I(I, r) = I − br , for any b>0

4. Net exports (NX ) increase.


The LM curve

• Given (Ms,P, πe), the LM curve is the collection of pairs

(Y , r) such that supply equals demand in the market forreal money balances.

Ms

P= L(Y , r + πe)


LM slope

• Graphical derivation of the LM curve in Figure 3• Movements along the LM. An increase in Y shifts the

demand for real money balances to the right. As a result, rrises. Hence, the LM slopes up.


LM position

The LM curve shifts to the right if:1. The money supply (Ms) increases.2. The price level (P) falls. In both cases we have an increase

in the supply for RMB.3. Increase in future expected inflation (πe). In this case the

demand for RMB falls.


Short-run equilibriumDefinition

• The key feature: the price level if fixed in the short-run.• Given (Ms,G,T , I,NX , πe), a short-run equilibrium is a

vector (Y ∗, r∗,P∗) such that:1. The loans & credit and the goods markets clear i.e. the IS

condition holds.2. The market for real money balances (liquidity) clears i.e.

the LM condition holds.3. The price level is fixed: P∗ = P.

• Note that factor markets need not clear in a short-runequilibrium. So the unemployment rate may be above orbelow the NRU.


Short-run equilibrium

• Note that we have two equations for two unknowns (Y,r)

Y = C(Y − T , r) + I(I, r) + G

Ms

P= L(Y , r + πe)

• The solution is denoted by (Y ∗, r∗)• Graphically, this is the intersection of the IS and LM

curves. Note that the position of the LM(P) is a function ofthe given price level P.

• Note that changes to factor endowments will not affect theshort-run level of output!


The NRU

• Define the natural rate of unemployment as the long-runaverage unemployment rate. We will denote it by u.

• Over the last fifty years the natural rate of unemployment inthe US has been around 5%. Why is the NRU above zero?

• Search and matching frictions. Dale Mortensen, ChrisPissarides, Peter Diamond got the Noble prize for this.

• It takes time for a worker to find an acceptable job.Workers pickiness depends on how generousunemployment benefits are.

• Likewise it takes time for a firm to find an acceptableworker. How picky firms are depends on how costly it is tofire a worker if he turns out to be a “lemon". Also dependson workers’ skills.


Labor market institutions and the NRU

• Why the natural rate of unemployment is higher in Europe(around 10%) than in the US?

• Many European countries had overly generousunemployment benefits. Over the last decade they havebeen redesigning them to fix the incentive problems.

• The US has lower firing costs. So firms are quicker tohire workers when the economy gets out of a downturnthan European firms.


The problem with Long-term unemployment

• Several analysts have warned about the dangers of notbeing aggressive against unemployment.

• A serious argument is based on skills depreciating whileout of work.

• If a worker can’t find work for several years his skillsbecome obsolete and the worker becomes lessemployable.

• Long-term unemployment can turn into a higher NRU!


Short-run fluctuations

• Define Y = F (K ,L) as the full-employment level ofproduction. This is the equilibrium output in theneoclassical model.

• Recall that “full employment" means L = (1 − u)LF , whereu is the NRU and LF is the labor force.

• Compare to the SRE level of production Y ∗ = F (K ,L∗).• Negative shocks push output and employment below their

full-employment levels. That is, Y ∗ < Y and L∗ < L.• Positive shocks have the opposite effect: Y ∗ > Y and

L∗ > L.• When L∗ < L, the unemployment rate is above the NRU.


Long-run equilibriumDefinition

• The key feature: all markets clear.• Given (Ms,G,T , I, πe), a long-run equilibrium is a vector(Y ∗, r∗,P∗) such that:

1. The loans & credit and the goods markets clear i.e. the IScondition holds.

2. The market for real money balances (liquidity) clears i.e.the LM condition holds.

3. Factor markets clear. That is, we have full employment:Y ∗ = Y = F (K ,L). So the unemployment rate equals theNRU.

• This is exactly the neoclassical model, but with newdiagrams.


Long-run equilibrium

• The level of production and use of factors of productiongiven by Y = F (K ,L).

• The price level and the real interest rate are the solution tothe following system:

Y = C(Y − T , r) + I(I, r) + G

Ms

P= L(Y , r + πe)

• The solution is denoted by (P∗, r∗)• Graphically, the LRE is the intersection of three curves:

the IS, the LM, and Y .• Everything we know about the neoclassical model applies

to the long-run equilibrium of the model we have here.


Finding the LREthe 3 steps again

1. Market clearing in the factor markets determines the levelof output: Y = F (K ,L)

2. Given Y , market clearing in the loans and credit marketdetermines the real interest rate. This is the intersectionbetween the IS curve and Y .

3. Given (Y , r∗), market clearing in the RMB marketdetermines the price level:

P∗ =Ms

L(Y , r∗ + πe)


Dynamics

• Suppose the economy is at a short-run equilibrium belowfull employment.

• At the current price level P0, the IS and LM(P0) intersect ata level of real income Y0 < Y .

• Point A in Figure 5.• Is the economy going to remain at this point? No. This is

not a long-run equilibrium.


Self-adjustment

• After some time the price level in the economy will beginto adjust.

• Where is the economy going to head to? Let us find thelong-run equilibrium from our initial situation. Follow thesacred 3 steps.

• The economy will travel from A to B in Figure 5.• In words, through a process of deflation the economy

returns to full employment.• Deflation increases the supply for RMB, which lowers

the interest rate.• The declining interest rates spur consumption and

investment, bringing the economy back to fullemployment.


What’s going on?

• Consider a situation where the economy has a level ofoutput below its long-run level. That is, unemployment isabove the NRU.

• What brings the economy back to full employment?• Unemployment is relatively high. This puts downward

pressure on wages. As wages fall, firms’ costs also fall,allowing them to cut the prices of their goods.

• As more firms cut their prices, the price level graduallyfalls. This increases the supply of real money balances.

• As a result, real interest rates fall, spurring consumptionand investment.


Fiscal policy

• Suppose economy starts off at full employment. Considernow an increase in government purchases (used forgovernment consumption).

• The IS shifts to the right.• Figure 6 depicts the SRE (given P0) and the LRE.

Y r PInitial equil. Y r0 P0

SRE Y1 > Y r1 > r0 P0

LRE Y r2 > r1 P1 > P0


• In the short run (while the price remains rigid), output andthe real interest rate both rise. Investment falls. Ambiguouschange in Consumption. But drop in C+I smaller thanincrease in G.

• As the price adjusts upward, the LM shifts to the left.This pushes up the real interest rate and reduces output.Both investment and consumption are falling now.

• Comparing the initial and final LRE, the drop inprivate-sector spending is exactly equal to the increase ingovernment purchases. Complete crowding out.

• The long-run effects of expansionary fiscal policy:inflation and complete crowding out.


Monetary policy

• Suppose economy starts off at full employment. Considernow an increase in the money supply.

• The LM shifts to the right.• Figure 7 depicts the SRE (given P0) and the LRE.

Y r PInitial equil. Y r0 P0

SRE Y1 > Y r1 < r0 P0

LRE Y r2 = r0 P1 > P0


• In the short run (while the price remains rigid), outputrises and the real interest rate falls. Spurs investment andconsumption.

• As the price adjusts upward, the LM shifts to the left.This pushes up the real interest rate and reduces output.Both investment and consumption are falling now.

• Comparing the initial and final LRE, identical consumption,investment, RGDP, and real money balances. Theneutrality of money.

• The long-run effects of expansionary monetary policy:inflation.


Demand shocks

• A well-known fact of business cycles is that investment ishighly volatile (compare to consumption or GDP).

• In part this is due to the constant arrival of news about thefuture that affect investors’ optimism. When becomingmore pessimistic, they will reduce current investment.

• In Keynes’ words, an important driver of investment areanimal spirits.

I(r) = I − br , for any b>0

• A reduction in consumers’ confidence has similar effects.


A loss of confidenceLaisser-faire

• Suppose the economy starts off at a LRE. Now investorsbecome pessimistic, shifting the IS to the left.

• In the short run, output and the interest rate fall.• The laisser-faire LRE: the price level will fall, shifting the

LM to the right until we go back to full employment.Increase in real money balances.

• The adjustment process (deflation) may be slow. For along time economy below full employment.


Stabilization policiesFiscal stimulus

• In theory, the government can provide for a faster return tofull employment.

• Consider the SRE, with price level P0. Figure 8.• The government can use expansionary fiscal policy to shift

the IS to the initial point (increasing purchases or cuttingtaxes). The price level remains at P0.

• Potentially faster than waiting for deflation to do the job.


Stabilization policiesMonetary expansion

• The Fed can also deliver a faster return to full employment.• Consider the SRE, with price level P0. Figure 8.• The Fed can increase the money supply. This will shift the

LM to the right while the price level remains at P0.• Increase in real money balances.• Again it is fast since we do not need to wait for deflation to

do the job.


Demand shocksSummary Figure 8

Y r PInitial LRE Y r0 P0

SRE Y1 < Y r1 < r0 P0

LRE LF Y r2 < r1 P1 < P0

LRE FP Y r0 P0

LRE MP Y r2 < r1 P0

Note: LF stands for laissez-faire, FP stands for fiscal policy andMP stands for monetary policy.


Supply shocks

• Anything that affects Y = AF (K ,L).• Natural disasters (reduce K or L), shocks to Total Factor

Productivity (e.g. reflecting changes in the price of energy),and so on.

• Suppose the economy is at a LRE with full employment Y 0.• Negative supply shock occurs.• No immediate effects.• Increase in the price level shifts LM to left until output

equals Y 1 < Y 0.• Long-run effects: inflation and falling output.


Supply shocksStabilization policy

• Suppose Fed wants to move economy back to initial outputY 0.

• Increase in money supply. New LM(P1,M1).• Temporarily, it works.• Eventually, another inflation wave shifts LM(P2,M1) back

to Y 1.• Similarly if government uses fiscal stimulus to maintain

initial output Y 0.


Supply shocksSummary Figure 9

Y r PInitial LRE Y0 r0 P0

SRE Y0 r0 P0

LRE LF Y1 < Y0 r1 > r0 P1 > P0

LRE MP Y1 < Y0 r1 > r0 P2 > P1

Note: LF stands for laissez-faire, FP stands for fiscal policy andMP stands for monetary policy.


In a nutshell

• The economy is constantly being hit by positive or negativeshocks. Some affect the aggregate demand, others thefull-employment output.

• In the short run, rigidities in prices. Income isdemand-determined.

• After some time the price level adjusts and market forcesbring back supply equal to demand in all markets. Theeconomy goes back to full employment, as described bythe neoclassical model.


Policy advice

• Importantly, fiscal and monetary policy can in theory beused to stabilize the economy and shorten recessions.

• In practice, some challenges:1. The appropriate response depends on the nature of the

shock (supply versus demand shocks). Often not known atthe time.

2. In addition, delayed effects of fiscal and monetary policies.Hard to figure out the right amount of stimulus.

3. One should also keep in mind that the consequences ofcurrent policies for long-run economic growth. E.g. avoidsustained crowding out of investment.

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