intermediate macroeconomics · readings lecture 2 slide 2 § required reading: mankiw, chapter 10...
TRANSCRIPT
Intermediate Macroeconomics
Introduction to Economic Fluctuations
The IS curve
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Today’s Outline – Part I
slide 1
§ facts about the business cycle
§ how the short run differs from the long run
§ an introduction to aggregate demand
§ an introduction to aggregate supply in the short
run and long run
§ how the model of aggregate demand and aggregate supply can be used to analyze the short-run and long-run effects of “shocks.”
Readings
Lecture 2 slide 2
§ Required reading: Mankiw, chapter 10
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Facts about the business cycle
Lecture 2 slide 3
§ GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.
§ Consumption and investment fluctuate with GDP,
but consumption tends to be less volatile and investment more volatile than GDP.
§ Unemployment rises during recessions and falls during expansions.
§ Okun’s law: the negative relationship between GDP and unemployment.
-2
0
2
4
6
8
Growth rates of real GDP and consumption US
Percent 10
change
from 4
quarters
earlier
Average growth
rate
Real GDP growth rate
Consumption growth rate
-4 1970
Lecture 2
1975 1980 1985 1990 1995 2000 2005 2010
slide 4
-20
-10
0
10
Growth rates of real GDP, cons. and investment US
Investment growth rate
Real GDP growth rate
Consumption growth rate
-30 1970
Lecture 2
1975 1980 1985 1990 1995 2000 2005 2010
slide 5
Percent
change 40
from 4
quarters 30
earlier 20
8
6
4
2
0
10
12
1970 1975 1980 1985 1990 1995 2000 2005 2010
Unemployment US
Lecture 2 slide 6
Percent
of
labour
force
-4
-2
0
2
4
6
8
-3 -2 -1 0
Okun’s Law
Percentage 10
change in
real GDP
1 2 3 4
Change in unemployment rate
Y
Y 3 2 u
1975
1982 1991
2001
1984
1951 1966
2003
1987
2008
1971
2009
Lecture 2 slide 7
Time horizons in macroeconomics
Lecture 2 slide 8
§ Long run
Prices are flexible, respond to changes in supply or demand.
§ Short run
Many prices are “sticky” at a predetermined level.
The economy behaves differently
when prices are sticky.
Recap of classical macro theory
Lecture 2 slide 9
§ Output is determined by the supply side: – supplies of capital, labour
– technology
§ Changes in demand for goods & services (C, I, G ) only affect prices, not quantities.
§ Assumes complete price flexibility.
§ Applies to the long run.
When prices are sticky…
Lecture 2 slide 10
…output and employment also depend on demand, which is affected by:
– fiscal policy (G and T )
– monetary policy (M )
– other factors, like exogenous changes in C or I
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The model of aggregate demand and supply
Lecture 2 slide 11
§ The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy
§ Shows how the price level and aggregate output are determined
§ Shows how the economy’s behaviour is different in the short run and long run
Aggregate demand
Lecture 2 slide 12
§ The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.
§ For now, we use a simple theory of aggregate demand based on the quantity theory of money.
§ Next week we will develop the theory of aggregate demand in more detail.
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The Quantity Equation as Aggregate Demand
Lecture 2 slide 13
§ Recall the quantity equation
MV = PY
§ For given values of M and V,
this equation implies an inverse relationship between P and Y …
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The downward-sloping AD curve
An increase in the
price level causes
a fall in real money
balances (M/P),
causing a decrease
in the demand for
goods & services.
Y
P
AD
Lecture 2 slide 14
Shifting the AD curve
An increase in
the money supply
shifts the AD
curve to the
right.
P
AD1
Y
AD2
Lecture 2 slide 15
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Aggregate supply in the long run
§ Recall from last week:
In the long run, output is determined by factor supplies and technology
Y F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
Lecture 2 slide 16
The long-run aggregate supply curve
Y
P LRAS
depend on P, so LRAS is vertical.
Y does not
Y
F (K , L)
Lecture 2 slide 17
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Long-run effects of an increase in M
Y
P
AD1
LRAS
Y
An increase in M shifts
AD to the right.
P1
P2 In the long run,
this raises the
price level…
…but leaves
output the same.
AD2
Lecture 2 slide 18
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Aggregate supply in the short run
Lecture 2 slide 19
§ Many prices are sticky in the short run.
§ We assume that – all prices are stuck at a predetermined level in
the short run.
– firms are willing to sell as much at that price level as their customers are willing to buy.
§ Therefore, the short-run aggregate supply (SRAS) curve is horizontal:
The short-run aggregate supply curve
Y
P
P SRAS
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
Lecture 2 slide 20
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Short-run effects of an increase in M
Y
P
AD1
In the short run
when prices are
sticky,…
P
Y2 …causes output
to rise. Y1
SRAS
AD2
…an increase in aggregate demand…
Lecture 2 slide 21
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From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
then over time, P will…
Y Y rise
Y Y fall
Y Y remain constant
Lecture 2 slide 22
The adjustment of prices is what moves
the economy to its long-run equilibrium.
The SR & LR effects of M > 0
Y
P
AD1
LRAS
Y
P2
P
Y 2
A = initial equilibrium
A
B
C B = new short-run
equilibrium
after Central
Bank
increases M
C = long-run
equilibrium
SRAS
AD2
Lecture 2 slide 23
Stabilization policy
Lecture 2 slide 24
§ shocks: exogenous changes in aggregate supply or demand
§ Shocks temporarily push the economy away from full employment.
§ Stabilization policy: policy actions aimed at
reducing the severity of short-run economic
fluctuations.
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Demand shocks
Lecture 2 slide 25
§ Example: exogenous decrease in velocity
If the money supply is held constant, a
decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.
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P SRAS
LRAS
The effects of a negative aggregate demand shock
Y
P
AD
AD2
1
Y
P2
Y2
AD shifts left, depressing output and employment in the short run.
A B
C
Over time, prices
fall and the
economy moves
down its demand
curve toward full
employment.
Lecture 2 slide 26
Supply shocks
Lecture 2 slide 27
§ A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)
§ Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing up food prices.
– Workers unionize, negotiate wage increases.
– New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.
§ Favourable supply shocks lower costs and prices.
CASE STUDY: The 1970s oil shocks
Lecture 2 slide 28
§ Early 1970s: OPEC coordinated a reduction in the supply of oil.
§ Oil prices rose
11% in 1973 68% in 1974 16% in 1975
§ Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.
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1 P SRAS1
Y
P
AD
LRAS
Y Y2
CASE STUDY: The 1970s oil shocks
The oil price shock shifts SRAS up, causing output and employment to fall.
B
There is stagflation
– combination of
falling output and
inflation.
2 P SRAS2
Lecture 2 slide 29
A
P1 SRAS 1
Y
P
AD
LRAS
Y Y2
CASE STUDY: The 1970s oil shocks
Option 1. No stabilization
B
In the absence of
further price
shocks, prices will
fall over time and
the economy moves
back toward full
employment.
2 P SRAS2
Lecture 2 slide 30
A
CASE STUDY: The 1970s oil shocks
1 P
Y
P
AD 1
B
A
C
Y2
LRAS
Y
Option 2. The
central bank
accommodates the
shock by raising
aggregate demand.
P is permanently
higher, but Y
remains at its full-
employment level.
2 P SRAS2
AD
Lecture 2 slide 31
2
Summary
slide 32 Lecture 2 32
§ Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies.
Short run: prices are sticky, shocks can push output and employment away from their natural rates.
§ Aggregate demand and supply: a framework to analyze economic fluctuations
§ The aggregate demand curve slopes downward.
§ The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.
§ The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.
Summary
slide 33 Lecture 2 33
§ Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run
§ The central bank can attempt to stabilize the economy with monetary policy
Today’s Outline – Part II
Lecture 2 slide 34
§ the IS curve and its relation to: – the Keynesian cross
– the loanable funds model
Readings
Lecture 2 slide 35
§ Required reading: Mankiw, chapter 11
Context
Lecture 2 slide 36
§ The first part of the lecture introduced the model of aggregate demand and aggregate supply.
§ Long run: – prices flexible
– output determined by factors of production & technology
– unemployment equals its natural rate
§ Short run: – prices fixed
– output determined by aggregate demand
– unemployment negatively related to output
Context
Lecture 2 slide 37
§ Now we will start developing the IS-LM model, the basis of the aggregate demand curve.
§ We focus on the short run and assume the price level is fixed (so the SRAS curve is horizontal).
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The Keynesian cross
Lecture 2 slide 38
§ A simple closed-economy model in which income is determined by expenditure. (due to John Maynard Keynes)
§ Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
§ Difference between actual & planned expenditure
= unplanned inventory investment
Elements of the Keynesian cross
C C (Y T )
G G , T T
I I
PE C (Y T ) I G
Lecture 2 slide 39
consumption function:
planned expenditure:
govt policy variables:
for now, planned
investment is exogenous:
equilibrium condition:
actual expenditure = planned expenditure
Y PE
Graphing planned expenditure
income, output, Y
PE planned
expenditure
PE =C +I +G
MPC
Lecture 2 slide 40
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Graphing the equilibrium condition
income, output, Y
PE planned
expenditure PE =Y
45º
Lecture 2 slide 41
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The equilibrium value of income
income, output, Y
PE planned
expenditure PE =Y
PE =C +I +G
Equilibrium
income
Lecture 2 slide 42
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An increase in government purchases
Y
PE
PE1 = Y1
PE =C +I +G2
PE =C +I +G1
PE2 = Y2 Y
At Y1, there is now an
unplanned drop
in inventory…
…so firms
increase output,
and income
rises toward a
new equilibrium.
G
Lecture 2 slide 43
Solving for Y
1 1 MPC
Y
G
Y C I G
Y C I G
C G
MPC Y G
Collect terms with Y on the left side of the
equal sign:
(1 MPC)Y G
equilibrium condition
in changes
because I exogenous
because C = MPC× Y
Solve for Y :
Lecture 2 slide 44
The government purchases multiplier
Example: If MPC = 0.8, then
Definition: the increase in income resulting from a £1 increase in G.
In this model, the government purchases multiplier equals
1
Y
G 1 MPC
5 Y
1
G 1 0.8
An increase in G
causes income to
increase 5 times
as much!
Lecture 2 slide 45
Why the multiplier is greater than 1
Lecture 2 slide 46
§ Initially, the increase in G causes an equal increase in Y:
§ But Y
Y = G.
C
further Y
further C
further Y
§ So the final impact on income is much bigger than
the initial G.
Why the multiplier is greater than 1
Lecture 2 slide 47
§ Example: the government spends and additional
£100 million on defense G=£100 million
§ The revenue of defense firms increases by £100 million, all of which becomes income to workers, managers, shareholders, etc. Hence, Y=G=£100 million.
§ The workers, managers, shareholders, etc, are also consumers and increase consumption by a fraction MPC of the extra income. C=MPC×£100
§ This additional consumption becomes income for the firms who provide the goods and services being consumed.
Why the multiplier is greater than 1
Lecture 2 slide 48
An increase in taxes
Y
PE
PE =C2 +I +G
PE2 = Y2
1 PE =C +I +G
PE1 = Y1 Y
At Y1, there is now an unplanned
inventory buildup… …so firms
reduce output,
and income falls
toward a new
equilibrium
C = MPC T
Initially, the tax
increase reduces
consumption and
therefore PE:
Lecture 2 slide 49
Solving for Y
Y C I G
C
MPC Y T
(1 MPC)Y MPC T
equilibrium condition in
changes
I and G exogenous
Solving for Y :
1 MPC
Y MPC
T Final result:
Lecture 2 slide 50
The tax multiplier
def: the change in income resulting from a £1 increase in T :
MPC
Y
T 1 MPC
0.2
Lecture 2 slide 51
0.8
0.8 4
Y
T 1 0.8
If MPC = 0.8, then the tax multiplier equals
The tax multiplier
…is negative: A tax increase reduces C, which reduces income.
…is greater than one (in absolute value):
A change in taxes has a multiplier effect on income.
…is smaller than the govt spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
Lecture 2 slide 52
The IS curve
def: a graph of all combinations of r and Y that result in goods market equilibrium
i.e. actual expenditure (output) = planned expenditure
The equation for the IS curve is:
Lecture 2 slide 53
Y2 Y1
Y1 Y2
Deriving the IS curve
Y
PE
Y
r
r1
r2
PE =Y PE =C +I (r2 )+G
PE =C +I (r1 )+G
IS
I
r I
PE
Y
Lecture 2 slide 54
Why the IS curve is negatively sloped
Lecture 2 slide 55
§ A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ).
§ To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.
The IS curve and the loanable funds model
Lecture 2 slide 56
§ The IS curve gets its name from equilibrium in
the loanable funds market (which we studied last week)
I (Investment) = S (Saving)
S=Y-C-G
§ The IS curve shows all combinations of r and
Y such that investment (I) equals saving (S)
The IS curve and the loanable funds model
S, I
r
I (r ) r1
r2
r
Y Y1
r1
r2
(a) The L.F. model (b) The IS curve
Y2
S2 S1
IS
Lecture 2 slide 57
A reduction in
income causes a
fall in national
savings
r must increase to
restore equilibrium
in the loanable
funds market
Y1 Y2
Y1 Y2
Shifting the IS curve: G
Y
PE
r
r1
PE =Y PE =C +I (r1 )+G2
PE =C +I (r1 )+G1
IS1
The horizontal
distance of the
IS shift equals
IS2
Y
At any value of r,
G PE Y
…so the IS curve
shifts to the right.
1
1MPC Y G Y
Lecture 2 slide 58
NOW YOU TRY
Shifting the IS curve: T
§ Use the diagram of the Keynesian cross or
loanable funds model to show how an increase
in taxes shifts the IS curve.
§ Determine the size of the shift.
50
ANSWERS
Shifting the IS curve: T
Y2
PE =C2 +I (r1 )+G
IS2
The horizontal
distance of the
IS shift equals
Y
PE
Y Y1
Y2 Y1
PE =Y PE =C1 +I (r1 )+G
r
r1
IS 1
At any value of r,
T C PE
…so the IS curve
shifts to the left.
1MPC Y
MPC T Y
60
Lecture 2 slide 61
Summary
1. Keynesian cross
– basic model of income determination
– takes fiscal policy & investment as exogenous
– fiscal policy has a multiplier effect on income
2. IS curve
– comes from the Keynesian cross when planned investment depends negatively on the interest rate
– shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services
– shows all combinations of r and Y
such that investment (I) equals saving (S)