MODERN MODERN ECONOMICSECONOMICS

MODERN MODERN ECONOMICSECONOMICS

A Survey of ContemporaryA Survey of Contemporary

ThoughtThought

Based on Schools Briefs in the Economist, 03 November 1990 to 09 March 1991 and12 February to 02 April 1994.

PARADIGM LOST• Macroeconomic Analysis: the

Paradigm• Classic Keynes• Meltdown• New Classical/New Keynesian

Schools

Macroeconomic Analysis: The Closed Economy Paradigm

r

y

LM

IS

The LM CurveEQUILIBRIUM IN THE MONEY MARKET

If the interest rate rises, the demand for spendable money, as opposed to

higher interest, non-spendable assets, falls. Hence, if we are to experience

equilibrium, the supply must also fall, an event that occurs if income falls.

The higher interest rate makes bonds more attractive because

of the yield. But, bond prices are lower, making them more attractive

also because of the higher probability of capital gain.

The IS CurveEQUILIBRIUM IN THE GOODS

& SERVICES MARKET If income (output) rises, saving &

tax payments rise; demand increases fall short of the output increases. This creates an excess supply of goods & services, which can be

offset by rising demand, an event that occurs if interest rates fall.

Factors Causing LM to Shift

Changes in the supply of money.Changes in the domestic price levelrelative to the stock of money.Changes in the demand for moneyor in liquidity preference.

Shifting the LM Curve

r

y

LMThe shift may be considered to the left or up if M/P (the real value of the money stock) falls. TheFED’s recent tightening ofmonetary policy reduced Mrelative to P and put upwardpressure on interest rates.Monetary tightness mayalso result from risingdemand by the public to hold money balances.This is the Japanesesituation today.

Similarly, the shift may be to the right or down if M/P rises. Expansionary monetary policy by the FED or Central Bank.

Economy wide reductions in thedemand for money will also causethe LM to shift to the right or down.

Factors Causing IS to Shift

Shifts in the demand curves for investment or consumption goods relativeto the interest rate or income.Changes in government spending.Changes in tax rate policy.Changes in price levels.

Shifting the IS Curver

y

Macroeconomic Analysis: the Open Economy Paradigm

E

y

DD

AA

The AA CurveMONETARY EQUILIBRIUM

If Inland currency appreciates (E falls), expectation of future depreciation is stronger. Markets will adjust with

higher Inland interest rates and reduced demand for money. Income growth, if

forthcoming, will restore money demand and monetary equilibrium.

The DD CurveOUTPUT MARKET EQUILIBRIUMIf Inland currency appreciates (E falls), X - M falls, creating excess supplies in

Inland goods & services markets. Output reduction, if forthcoming, will eliminate

the excesses.

Factors Causing DD to Shift

Changes in Government SpendingChanges in Tax Policies

Changes in Investment or ConsumptionChanges in Inland price levels

Changes in Outland price levelsChanges in relative Outland/Inland

goods preferences.

Factors Causing AA to Shift

Changes in the Money SupplyChanges in Inland price levels

Changes in the expected long-runexchange rate

Changes in Outland interest ratesChanges in real money demand.

Classic KeynesDemand Side: Functions concerning

investment, consumption, governmentdemand and net exports.

Supply Side: Functions concerninglabor supply & demand related to the

real wage rate.The Phillips curve and its inflation/

unemployment trade-off.

CONSUMPTION ACCORDING TO

KEYNES45°

45°

C + I + G + CA

C = Consumption

Y = C + I + G + CA

INCOME OR OUTPUT

CIGCA

MODEL WITH INVESTMENT (I or G or CA) GROWTH

45°

45°

C + I' + G + CA

C + I + G + CA

Y' = C + I' + G + CA

INCOME OR OUTPUT

CIGCA

Y Y'

Y = C + I + G + CA

INVESTMENT & SAVING + THE GOVERNMENT

BUDGET

r

I & SI

I + G

S

S + T

The {S + T} & {I + G} Curves:

Assume that Income risesr

I, S, T & G

S+T

S'+T'

I+G

I’+G'

If income rises, saving and taxpayments rise sharply.However, investmentrises mildly & government spendingfalls (why?)

Lowerinterestrate goeswith higherincome atequilibriumpoints.

Labor, Capital & Production: Full

Employment Real OutputW/p

Realwagerate

NLabor Force

Demand for LaborSupply of Labor

NF {Full Employment}

(W/p)F

At full employment, thecorresponding level ofoutput (yF) is called FullEmployment Real Output.Why is the supply curvebackward bending?

The Complete Model

r

yyF

IS

LM

r

The Phillips CurveInflation

Unemployment

P18%

4%

P23%

6%

MeltdownIf prices rise, real wages fall inducing anincrease in the quantity of labor demanded.If labor is oblivious to these changes, theincreased demand will induce an increasein supply, and unemployment will fall.

Is Labor Oblivious?Not perfectly rational, but able to learn from their mistakes. Policies designed to lower real wages to induceemployment lose effectiveness asrapidly as labor is able to learn.That’s fast!