macroeconomics in the world economy: theory and ... in the world economy: theory and applications...

Macroeconomics in the World Economy:Theory and Applications

Topic 6: Putting It All Together

Dennis Plott

University of Illinois at ChicagoDepartment of Economics

http://blackboard.uic.edu

Spring 2014

Plott (ECON 221) Spring 2014 1 / 28

http://blackboard.uic.edu

Outline

1 Topic 6: Putting It All Together


Goals & Readings

Goals

Derivation and study of the IS−LM equilibrium. The Goods and theMoney Markets (mostly a review).Construction of the aggregate demand (AD) curve.Construction of the Short-Run Aggregate Supply (SRAS) curve.Define Short-Run equilibrium and Long-Run equilibrium.Analyze demand and supply shocks.Discuss and demonstrate examples.

Readings

Abel, Bernanke, Croushore (2013) Chapters 8-11


Note on the IS−LM Equilibrium

Remember: you can always see the problem as a system of two

equations.

Sometimes having an analytical representation of the problem helps.

One simplified example is the following (closed) IS−LM system:

(IS) Y = MPC · (Y −T)+ I(r)+G

(LM)M

P= L(Y ,r+πe)

Where MPC is the marginal propensity to consume out of disposable

income (assumed constant here) and I is a negative function of the

real interest rate. You can graph the two equations in {r,Y }−space.

Note: see Appendix 9.A in the textbook to have an analytical

representation of the IS−LM model.


Understanding IS−LM: A Brief Roadmap

At the point of crossing of IS and LM the equilibrium interest rate and

desired output that simultaneously satisfy goods and money markets

are determined.

We will now study how the endogenous variables in our model (Y and

r) change when we change exogenous variables like the money supply

(M) and government spending (G). That is, if I change M or G what are

the new Y and r that satisfy the IS = LM condition?

We then relax the assumption that the price level is fixed and we show

that the IS−LM model implies a negative relationship between the

price level and national income.

The IS−LM model provides a theory of the slope and position of the

aggregate demand (AD) curve.


The Aggregate Demand Curve

The AD curve is drawn in {P,Y }−space. It represents how the demand

side of the economy responds to a change in prices.

As P decreases (ceteris paribus – including M),M

Pwill increase. As real

money balances increase, interest rates will fall, Investment will rise

and Y will rise.

Prices affect the demand side of the economy through interest rates

(and consequently investment).


The Aggregate Demand Curve (Continued)

Changes in prices do not affect consumption (consumption is only

affected by PVLR – or real wages – if wages change 1 for 1 with prices

(W

Pis constant), 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.


What Shifts the AD Curve?

Remember: the AD curve represents the demand side of the economy:

Y d = Cd + Id +G+NX

Anything that causes the IS curve to shift to the right, will cause the AD curve

to shift to the right (both the IS curve and the AD curve represent the demand

side of the economy).

Anything that causes the LM curve to shift to the right (except price changes)

will cause the AD curve to shift to the right. A change in prices will cause the

LM curve to shift, but will cause a movement along the AD curve.

Example: Nominal money (M) increases, r will fall, I will increase, AD will shift

rightward.With changes in money:

LM shifts rightMove along the IS curveInterest rates fallI increasesAD shifts rightward


Why Does the AD Slope Downward?

The Wealth (Real-Balances) Effect: a decrease in the price level raises the real value of

money and makes consumers wealthier, which in turn encourages them to spend

more. The increase in consumer spending means a larger quantity of goods and

services demanded. Conversely, an increase in the price level reduces the real value of

money and makes consumers poorer, which in turn reduces consumer spending and

the quantity of goods and services demanded.

The Interest-Rate Effect: a lower price level reduces the interest rate, encourages

greater spending on investment goods, and thereby increases the quantity of goods

and services demanded. Conversely, a higher price level raises the interest rate,

discourages investment spending, and decreases the quantity of goods and services

demanded.

The Exchange-Rate (Foreign Purchases) Effect: When a fall in the U.S. price level

causes U.S. interest rates to fall, the real value of the dollar declines in foreign

exchange markets. This depreciation stimulates U.S. net exports and thereby increases

the quantity of goods and services demanded. Conversely, when the U.S. price level

rises and causes U.S. interest rates to rise, the real value of the dollar increases, and

this appreciation reduces U.S. net exports and the quantity of goods and services

demanded. This would apply to Topic 8.


Labor Market: Some Definitions

In the Short-Run (N adjusts, but it need not be at N , K is fixed)

Nominal Wages are ’Sticky’ (although firms may be able to adjust prices).

W is fixed, but notW

P(because firms may be able to adjust P)

K by definition is fixed.

Because Wages are sticky in the Short-Run, the labor market can be in

’dis-equilibrium’; i.e., labor demand not equal to labor supply (cyclical

unemployment can occur).

In the Long-Run (N adjusts to N , K is still fixed).

W adjusts.

We will be at N (labor market is in equilibrium), but capital still does not

adjust. (K is fixed. This assumption is okay if capital stock moves slowly).

Note: In Really Long-Run (Growth – N adjusts to N and K is not fixed)

Capital can adjust labor market is in equilibrium. See Topic 2 on

economic growth. For the following analysis consider K fixed.


Aggregate Supply Curve in the Long Run (LRAS)

In the Long-Run, the labor market always clears (We are at N).

Define: LRAS (full-employment level of output) gives the level of

output Y associated with N :

Y = AF(K ,N ,Raw Materials)

Note: slight modification (inclusion of raw materials; e.g., oil)

LRAS Curve is vertical at Y – the potential level of GDP. N is the level ofoutput generated when the economy employs N . Also know as the FE(full-employment) line.

N= hours worked in labor market equilibrium(W

P

)equilbrium

What shifts the LRAS: N or A (by definition K is fixed in the long-runsave for some natural disaster like an earthquake)


Notes on the Potential Level of GDP (Y ) and LRAS

The Equilibrium level of Y is not necessarily optimal: tax distortions

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.


Aggregate Supply Curve in the Short Run (SRAS)

The Short-Run Aggregate Supply Curve (the relationship betweenoutput and prices) in the short-run is positive.

If firms get a demand shock, they may chose to produce more (at a givenfixed nominal wage) to satisfy demand. To take advantage of the higher

demand, firms may raise prices (optimally) which drives downW

P. The

lower real wages causes firms to optimally hire more labor – causingoutput to increase.NOTE: Nd has not shifted! Firms decide to meet the increase in demandfor their product by hiring more workers because of the lower real wage(as prices increase). In short-run, firms remain on their labor demandcurve, while workers are off their labor supply curve temporarily(workers have little bargaining power, options in the short-run).In the Short-Run there is disequilibrium in the labor market.NOTE: the textbook assumes a different SRAS firms always produce tomeet demand. See chapter 9 for details.


Notes on AS in Short-Run

If firms get a positive demand shock (demand for goods increase),

firms will raise prices and keep labor costs fixed. This will reduce real

wages causing firms to hire more labor and produce more.

The Short-Run AS curve slopes upwards because and increase in

prices reduces real wages and causes firms to higher more workers and

consequently to produce more.

Consequence, N > N and Y > Y and u < u

u = current unemployment rateu = Natural Rate of Unemployment (only frictional and structural, nocyclical unemployment)

See text for a discussion of the utilization rate of labor (and capital).


Notes on AS in Short-Run (Continued)

What Shifts the SRAS curve?

SRAS = F(A,K ,N , raw materials).

K is fixed save for a natural disaster

A is exogenous (i.e. I tell you when changes)

Raw materials is the new twist. Anything that effects the nominal price of

raw materials will effect the quantity of raw materials purchased and will

shift the short-run AS. For every given labor and capital – if the price of

raw materials get more expensive, firms will produce less (i.e. oil prices).

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.

For our discussion – only input prices (nominal wages and nominal oil

prices) and technology will shift the SRAS. Higher costs of production

means SRAS will shift leftward, ceteris paribus.


The Self-Correcting Mechanism

Let us focus on SRAS. It has a better link to the labor market.

When the economy is in short-run disequilibrium (Yshort-run not equal

to Y ), the economy will naturally move towards Y .

Reason: the 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.


The Self-Correcting Mechanism (Continued)

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, if W increases, the SRAS will shift in (the cost of production has

increased).

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 .


Notes on SRAS (Continued)

Some Macroeconomists (starting from Keynes) had the notion that prices

are fixed in the short-run. This is a second type of SRAS. 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. Think about the price of milk at

Walgreens or Jewel-Osco. Macroeconomic conditions are changing all the

time and the price of milk – over the last half-year has been approximately

$1.79 per quart.

In this case 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. It adds a dimension to our problem: utilization rate of labor

(and an associated concept labor hoarding).

In this case the labor market isn’t really in equilibrium at all in the short-run.

In such a case prices are fixed and the SRAS curve is horizontal.

NOTE: we will work with both the upward sloping (short-run) and the

horizontal (Keynesian) SRAS curves.


Neoclassical Approach to AD−AS

Money neutrality in the Long-Run. However the Short-Run is very

"short". Prices and wages are assumed to adjust quickly and markets

are in equilibrium.

This approach faces two main empirical obstacles.1 Disequilibrium in the Labor Market (i.e. Unemployment is > 0 and

counter-cyclical).2 Money has real effects in the short-run (Money is non-neutral to real

outcomes – even Friedman admits it – and leads the cycle. Increasing Mincreases Y above Y ).

Can we match these two facts and maintain that there is no

sluggishness in prices and wage adjustments?


Neoclassical Approach to AD−AS (Continued)

Solution to 1: Unemployment is justified by search frictions and

reallocation of workers to new business or industries. This requires

time and produces unemployment.

Solution to 2: Misperceptions theory (Milton Friedman and RobertLucas). Because of costs in collecting information concerning thenature of price changes in the economy, agents may be fooled bynominal shocks into considering aggregate price hikes as increases inrelative prices of the goods they produces (shock to the demand of thegoods they produce) and hence they supply more goods. However, ifchanges in money supply (and hence prices) are expected all theinformation will be immediately incorporated and no mistake will bemade (rational expectations [more on this in Topic 7]).

The misperceptions theory: an unexpectedly low price level leads somesuppliers to think their relative prices have fallen, which induces a fall inproduction.


Neoclassical Approach to AD−AS (Continued)

Alternative explanations to arrive at an upward sloping SRAS curve:

The sticky-wage theory: an unexpectedly low price level raises the realwage, which causes firms to hire fewer workers and produce a smallerquantity of goods and services.The sticky-price theory: an unexpectedly low price level leaves somefirms with higher than desired prices, which depresses their sales andleads them to cut back production.


One Caveat on the Shape of the SRAS Curve

The shape of the SRAS curve is believed not to be linear.

The shape of the SRAS curve looks more curved; going from left to

right it is flat then becomes much steeper.

It is bounded at some "technological constraints".

It flattens out at low levels of output.


What is Equilibrium for the Economy?

Short-Run equilibrium:

AD = SRAS & IS = LMThe Labor Market need not be in equilibrium (nominal wages are sticky,remember).We need not be at the potential level of GDP.

Long-Run equilibrium:

AD = SRAS = LRAS = Y & IS = LM = FE = Y & Nd = N s = NIn the long-run, by definition, we will move to Y .In the long-run, by definition, the labor market will clear.


More on Equilibrium

Equilibrium is a point of attraction for the economy.

Most macroeconomists believe that, in the absence of shocks, the

economy would reach equilibrium 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.

Note: there are alternative theories we will briefly discuss in Topic 7.

Why is the long-run equilibrium point attractive?

Because there 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.


How Do We Represent Recessions?

Unofficial definition – two consecutive quarters of negative real GDP growth. Remember

the NBER officially dates recessions using more involved criteria.

Our model: Y < Y

We define the output gap as Y −Y s−req

Remember: Y trends upward overtime (even though in our model – we have it constant –

population growth, K grows (we abstract from these trends in our model), TFP is growing

every period). It makes things easier to keep Y constant initially.

Our model removes the trends in N and K due to population growth and K (by

assumption).

To put things in perspective: all economic models in courses like ECON 221 or the

upper-level electives (e.g. ECON 331 or ECON 333) only use, at most, static-deterministic

general equilibrium models. Eventually to have more complete models you would need

dynamic stochastic general equilibrium (DSGE) models . . . but then you hate life because

that means you are in grad school.Questions for the rest of class:

What causes recessions?Why would the fed be concerned about inflation when Y < Y s−r

eq ?How do we get out of recessions once we are in them?Can the economy correct itself?


Where Do Recessions Originate?

Temporary or Permanent changes in technology (or productivity); i.e.,

productivity shocks, drought?

Shocks to Expectations (individual beliefs about the future); i.e., stocks

are overvalued, a recession will be coming (self-fulfilling prophesies),

etc.

Increases in relative prices of inputs (like oil prices; e.g., the 1970s)

Bad (or good) Economic Policy (monetary or fiscal)

External Crises ( for small open economies). [More on this in Topic 8]


Analysis of the Business Cycle: Examples

We now start analyzing shocks to the economy that move it away from

full-employment output.

In the examples that follows such shocks are permanent. You can also

study their temporary counterparts.

Convention: the initial "shocked variable" (say, G, M , consumer

confidence, etc.) has a "2" subscript (example if I tell you we are

increasing G then we move from G1 to G2 where G2 > G1).


Some Examples

1974 Recession: OPEC – rapid increase in oil prices

1980 Recession: OPEC II – Iranian Revolution

1982 Recession: "Good" Fed Policy (Volker’s Recession)

1990 Recession: Consumer Confidence

1990s Japan: End to speculative bubbles, bad policy, debt overhung

and liquidity traps

2001 Recession: Consumer Confidence (Burst of Stock Market bubble

– The Economist "The Kiss of Life?").

2009 Recession: Credit Crunch and Home Prices Collapse


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