Our analysis leads us to believe that recovery is sound onlyif it does come of itself. For any revival which is merely dueto artificial stimulus leaves part of the work of depressionsundone and adds, to an undigested remnant of maladjustment,new maladjustments of its own.

Joseph A. Schumpeter, 1934

Monetary and fiscal stimulusFreeing up resources from dying to thriving industries

Excess Housing and debtGold, commoditiesforeign property

P/P = (P/P)et+1 + [Y – YP] +

SRAS curve implies that wages and prices are sticky in the short-run (the aggregate price level adjusts slowly over time). The more flexible wages and prices are, the more P/P responds to deviations of output, Y, from potential output, YP. This will increase the absolute value of and create a steeper curve. If wages and prices are completely flexible, then gets very large and the SRAS = LRAS.

Shifts in SRAS 1. (P/P)e

t+1 . (shifts curve up and to the left)2. Supply shock, . (shifts curve up and to the left)

3. Persistent output gap, [Y – YP] => (P/P)et+1 .

If [Y – YP] > 0 is persistent, then the rise in P/P due to the movement along the SRAS curve, ( [Y – YP]) => (P/P)e

t+1 which shifts the SRAS curve up and back.

When [Y – YP] = 0 , then the SRAS stops shifting up because P/P and (P/P)et+1

stop rising. If [Y – YP] < 0 is persistent, then the fall in P/P due to the movement along the

SRAS curve, ( [Y – YP]) =>(P/P)et+1 which shifts the SRAS curve down

and to the right. Shifting stops when Y = YP

Short Run Aggregate Supply Curve

All markets are simultaneously in equilibrium – Quantity of aggregate output demanded is equal to quantity of aggregate output supplied.

Self-Correcting Mechanism – over time the short-run equilibrium moves/migrates to the long-run equilibrium. So if Y* = YP ,the short-run equilibrium, Y* will move over time to reach YP.

If the current level of P/P changes from its initial level, the SRAS curve will shift as wages and prices adjust to a new P/P)e

t+1. This shift over time will restore the economy to long-run equilibrium at full employment and YP.

General Equilibrium in the AD & AS Analysis

Knowns: What we knowExample: 10 transmission channels ofmonetary policy

Economic Wisdom

I only know, that I know nothing.Socrates, 400 BC

Translation:•Wisdom is limited to an awareness

of your own ignorance.•You are only educated when you understand

how ignorant you are.

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

F.A. Hayek, 1988The Fatal Conceit

Known unknownsExample: Sensitivity coefficients of some economic variables

Unknown unknownsExample: Unknown monetary channels

Unknown knowns: Things we think we know but are wrongExample: Inaccurate economic parameters/coefficients

Y

P/P LRAS

YP

AD08

AS1

Bust

AD04 AD06 = C + I + G + X - M

Deposits

Loans

Reserves

Loanable FundsFed’s new

moneyBank

I = S

DH

PH

Lending

Feedback Loop

Low Interest Rates & Capital Structure:•credit => mal-investment => surplus housing => PH

=> foreclosures => broke banking system => credit crunch•Monetary stimulus => “pushing on a string” to C, I

(hair of the dog)

Animal Spirits•Pessimism => savings => C

(Paradox of Thrift) •Sticky wages => no SRAS

(“In L.R. we are all dead”)•Monetary stimulus => shift AD (if “liquidity trap”, then deficits)•Fiscal stimulus => G => Shift AD (bailouts, payoffs by politicians?)

Boom

AS24%

2%

1%

6

GDP Output Gap vs.Inflation (CPI)

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

85 88 91 94 97 00 03 06 09 12

-8%

-7%

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

RecessionOutput GapHeadline Inflation2% Inflation Target

Source: CBO & Federal Reserve.

P/P

MP Curver = r + (P/P)e

t+1

AD2

r %

Y

IS Curve

Y

P/P

r %

2%

-1.0%-1.0%$15T$14 T

2.0%

A

A

A

Shift AD Curve (due to r )Assume 2% P/P The debt crisis => Fed’s “Financial Repression” => r falls from 1 to -2. (autonomous easing of MP) => r falls from 2 to -1 => I, NX, => Y, at every givenP/P => Y at point B.

-1 = -2 + 0.5(2)

B

B

2 = 1 + 0.5(2)

2.0%

B

2.0%

LRAS

YP

AD1

4.0%

SRAS

THE GREAT DEBATE:Stimulus Vs Austerity

J.M. Keynes1883-1946

Father of Modern Macroeconomics“The General Theory of Employment, Interest

and Money”

Advocated the use of fiscal and monetary measures to offset recessions.

AD determines the overall level of economic activity.

The modern capitalist economy does not automatically work at top efficiency, but can be raised to that level by government intervention.

F.A. Hayek1899-1992

1974 Nobel Prize“The Road to Serfdom”

Changing prices communicate signals to enable individuals to coordinate their plans. This leads to an efficient exchange and use

of resources.

Leading critic of collectivism/socialism because it required a central planner that would eventually become totalitarianism.

The free price system is a spontaneous order – the result of human action, but not of

human design.

Central banks do not possess the relevant info to govern the money supply, nor the

ability to use it correctly.

1. We’ve been going back and forth for a century2. [Keynes] I want to steer markets,3. [Hayek] I want them set free4. There’s a boom and bust cycle and good reason to fear it5. [Hayek] Blame low interest rates.6. [Keynes] No… it’s the animal spirits7. [Keynes Sings:]8. John Maynard Keynes, wrote the book on modern macro9. The man you need when the economy’s off track, [whoa]10. Depression, recession now your question’s in session11. Have a seat and I’ll school you in one simple lesson12. BOOM, 1929 the big crash13. We didn’t bounce back—economy’s in the trash14. Persistent unemployment, the result of sticky wages15. Waiting for recovery? Seriously? That’s outrageous!16. I had a real plan any fool can understand17. The advice, real simple—boost aggregate demand!18. C, I, G, all together gets to Y19. Make sure the total’s growing, watch the economy fly20. We’ve been going back and forth for a century21. [Keynes] I want to steer markets,22. [Hayek] I want them set free23. There’s a boom and bust cycle and good reason to fear it24. [Hayek] Blame low interest rates.25. [Keynes] No… it’s the animal spirits26. You see it’s all about spending, hear the register cha-ching27. Circular flow, the dough is everything28. So if that flow is getting low, doesn’t matter the reason29. We need more government spending, now it’s stimulus season

“Fear the Boom and Bust”Lyrics

30. So forget about saving, get it straight out of your head31. Like I said, in the long run—we’re all dead32. Savings is destruction, that’s the paradox of thrift33. Don’t keep money in your pocket, or that growth will never lift…because…34. Business is driven by the animal spirits35. The bull and the bear, and there’s reason to fear its36. Effects on capital investment, income and growth37. That’s why the state should fill the gap with stimulus both…38. The monetary and the fiscal, they’re equally correct39. Public works, digging ditches, war has the same effect40. Even a broken window helps the glass man have some wealth41. The multiplier driving higher the economy’s health42. And if the Central Bank’s interest rate policy tanks43. A liquidity trap, that new money’s stuck in the banks!44. Deficits could be the cure, you been looking for45. Let the spending soar, now that you know the score46. My General Theory’s made quite an impression47. [a revolution] I transformed the econ profession48. You know me, modesty, still I’m taking a bow49. Say it loud, say it proud, we’re all Keynesians now50. We’ve been goin’ back n forth for a century51. [Keynes] I want to steer markets,52. [Hayek] I want them set free53. There’s a boom and bust cycle and good reason to fear it54. [Keynes] I made my case, Freddie H55. Listen up , Can you hear it?Hayek sings:

Keynes’s Viewpoint

56. I’ll begin in broad strokes, just like my friend Keynes57. His theory conceals the mechanics of change,58. That simple equation, too much aggregation59. Ignores human action and motivation60. And yet it continues as a justification61. For bailouts and payoffs by pols with machinations62. You provide them with cover to sell us a free lunch63. Then all that we’re left with is debt, and a bunch64. If you’re living high on that cheap credit hog65. Don’t look for cure from the hair of the dog66. Real savings come first if you want to invest67. The market coordinates time with interest68. Your focus on spending is pushing on thread69. In the long run, my friend, it’s your theory that’s dead70. So sorry there, buddy, if that sounds like invective71. Prepared to get schooled in my Austrian perspective72. We’ve been going back and forth for a century73. [Keynes] I want to steer markets,74. [Hayek] I want them set free75. There’s a boom and bust cycle and good reason to fear it76. [Hayek] Blame low interest rates.77. [Keynes] No… it’s the animal spirits78. The place you should study isn’t the bust79. It’s the boom that should make you feel leery, that’s the thrust80. Of my theory, the capital structure is key.81. Malinvestments wreck the economy

82. The boom gets started with an expansion of credit83. The Fed sets rates low, are you starting to get it?84. That new money is confused for real loanable funds85. But it’s just inflation that’s driving the ones86. Who invest in new projects like housing construction87. The boom plants the seeds for its future destruction88. The savings aren’t real, consumption’s up too89. And the grasping for resources reveals there’s too few90. So the boom turns to bust as the interest rates rise91. With the costs of production, price signals were lies92. The boom was a binge that’s a matter of fact93. Now its devalued capital that makes up the slack.94. Whether it’s the late twenties or two thousand and five95. Booming bad investments, seems like they’d thrive96. You must save to invest, don’t use the printing press97. Or a bust will surely follow, an economy depressed98. Your so-called “stimulus” will make things even worse99. It’s just more of the same, more incentives perversed100. And that credit crunch ain’t a liquidity trap101. Just a broke banking system, I’m done, that’s a wrap.102. We’ve been goin’ back n forth for a century103. [Keynes] I want to steer markets,104. [Hayek] I want them set free105. There’s a boom and bust cycle and good reason to fear it106. [Hayek] Blame low interest rates.107. [Keynes] No it’s the animal spirits

“Fear the Boom and Bust”Lyrics

Hayek’s Viewpoint

“Fight of the Century” Lyrics Written by John Papola and Russ RobertsKEYNESHere we are… peace out! great recessionthanks to me, as you see, we’re not in a depressionRecovery, destiny if you follow my lessonLord Keynes, here I come, line up for the processionHAYEKWe brought out the shovels and we’re still in a ditch…And still digging. don’t you think that it’s time for a switch…From that hair of the dog. Friend, the party is over.The long run is here. It’s time to get sober!KEYNESAre you kidding? my cure works perfectly fine…have a look, the great recession ended back in ’09.I deserve credit. Things would have been worseAll the estimates prove it—I’ll quote chapter and verseHAYEKEconometricians, they’re ever so piousAre they doing real science or confirming their bias?Their “Keynesian” models are tidy and neatBut that top down approach is a fatal conceitREFRAINWhich way should we choose?more bottom up or more top down…the fight continues…Keynes and Hayek’s second roundit’s time to weigh in…more from the top or from the ground…lets listen to the greatsKeynes and Hayek throwing downKEYNESWe could have done better, had we only spent moreToo bad that only happens when there’s a World WarYou can carp all you want about stats and regressionDo you deny World War II cut short the Depression?HAYEKWow. One data point and you’re jumping for joythe Last time I checked, wars only destroyThere was no multiplier, consumption just shrankAs we used scarce resources for every new tankPretty perverse to call that prosperityRationed meat, Rationed butter… a life of austerityWhen that war spending ended your friends cried disasteryet the economy thrived and grew fasterKEYNESYou too only see what you want to seeThe spending on war clearly goosed GDPUnemployment was over, almost down to zeroThat’s why I’m the master, that’s why I’m the heroHAYEKCreating employment’s a straightforward craftWhen the nation’s at war, and there’s a draftIf every worker was staffed in the army and fleetWe’d have full employment and nothing to eatREFRAIN REPEATS

“Fight of the Century”Lyrics

HAYEKjobs are a means, not the ends in themselvespeople work to live better, to put food on the shelvesreal growth means production of what people demandThat’s entrepreneurship not your central planKEYNESMy solution is simple and easy to handle..its spending that matters, why’s that such a scandal?The money sloshes through the pipes and the sluicesrevitalizing the economy’s juicesit’s just like an engine that’s stalled and gone darkTo bring it to life, we need a quick sparkSpending’s the life blood that gets the flow goingWhere it goes doesn’t matter, just get spending flowingHAYEKYou see slack in some sectors as a “general glut”But some sectors are healthy, only some in a rutSo spending’s not free – that’s the heart of the mattertoo much is wasted as cronies get fatter.The economy’s not a car, there’s no engine to stallno expert can fix it, there’s no “it” at all.The economy’s us, we don’t need a mechanicPut away the wrenches, the economy’s organicREFRAIN REPEATSKEYNESso what would you do to help those unemployed?this is the question you seem to avoidwhen we’re in a mess, would you just have us wait?Doing nothing until markets equilibrate?HAYEKI don’t want to do nothing, there’s plenty to doThe question I ponder is who plans for whom?Do I plan for myself or leave it to you?I want plans by the many, not by the few.Let’s not repeat what created our troublesI want real growth not a series of bubblesStop bailing out loser, let prices workIf we don’t try to steer them they won’t go berserkKEYNESCome on, Are you kidding? Don’t Wall Street’s gyrationsChallenge your world view of self-regulation?Even you must admit that the lesson we’ve learnedIs more oversight’s needed or else we’ll get burnedHAYEKOversight? The government’s long been in bedWith those Wall Street execs and the firms that they’ve bledCapitalism’s about profit and lossyou bail out the losers there’s no end to the costthe lesson I’ve learned? It’s how little we know,the world is complex, not some circular flowthe economy’s not a class you can master in collegeto think otherwise is the pretense of knowledgeREFRAIN REPEATS

“Fight of the Century”LyricsContinued

KEYNESYou get on your high horse and you’re off to the racesI look at the world on a case by case basisWhen people are suffering I roll up my sleevesAnd do what I can to cure our diseaseThe future’s uncertain, our outlooks are frailThats why free markets are so prone to failIn a volatile world we need more discretionSo state intervention can counter depressionHAYEKPeople aren’t chessmen you move on a boardat your whim–their dreams and desires ignoredWith political incentives, discretion’s a jokeThose dials you’re twisting… just mirrors and smokeWe need stable rules and real market pricesso prosperity emerges and cuts short the crisisgive us a chance so we can discoverthe most valuable ways to serve one anotherFINAL REFRAINWhich way should we choose?more bottom up or more top downthe fight continues…Keynes and Hayek’s second roundit’s time to weigh in…more from the top or from the ground…lets listen to the greatsKeynes and Hayek throwing down

Econ 330 Chapter 23 Homework

Chapter 23Review the attached lyrics and YouTube video,

“Fear the Boom and Bust”. Then ask yourself, who do you believe is right, Keynes or Hayek? Debate this with other econ students. You do not need to hand in anything to your TA.