javier lozano 1 advanced applied macroeconomics introduction javier lozano universitat de les illes...

1Javier LozanoJavier Lozano

Advanced Applied MacroeconomicsAdvanced Applied Macroeconomics

IntroductionIntroduction

Javier Lozano

Universitat de les Illes Balears

Master and PhD programs in Tourism and Environmental Economics

University of the Balearic Islands


What is macroeconomics about?

• National income (economic growth)

• Price level (inflation)

• Unemployment

• Exchange rates


What is this course about?• Introduction (Javier Lozano, 4h)

– Basic macroeconomic tools and concepts

• Topics on unemployment, and macroeconomic policy (Javier Andrés, 12h)

• Topics on international macroeconomics (Javier Lozano, 12h)– Determination of the exchange rate– Exchange rate regimes– Balance of payment crisis

Combination of macro theory, data analysis and readings.


What is the introduction about?

• Basic model of income determination– IS-LM AD-AS

• Useful for analyzing:– Economic fluctuations (business cycles)– Effects of macroeconomic policies on national

income

• It will help us to answer questions 1, 2, 3, 4, 8, 10, 13, 14 of questionnaire


Warning!

War

ning

!

Warning!


Warning!

• A model is always false because:– It is a simplification of reality; therefore, it

always makes “false” assumptions– It is useful for explaining certain kind of

economic phenomena but not useful for explaining other kind of economic phenomena


Warning!

This is “false”:Wrog size, wrong number of dimensions, wrong colors…

This is not useful for:Knowing where this night’s “fogerons” are located, knowing what people do during leisure time, knowing the race composition of population…

It is useful for knowing how to go from one place to another.


Basic concepts

• Aggregate demand and aggregate supply• Short run and long run in macroeconomics• Aggregate supply (AS): total amount of final goods

and services produced in an economy during a given period of time (=Gross Domestic Product, GDP=national income, Y)

• Aggregate demand (AD): total demand of final goods and services produced in an economy during a given period of time (also called aggregated expenditure)

AD=C+I+G+X-IM


Basic concepts

• Short run and long run in macroeconomics


Basic concepts

0.00E+00

1.00E+14

2.00E+14

3.00E+14

4.00E+14

5.00E+14

6.00E+14

7.00E+14

8.00E+14

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

income level

growth rate

Source: WDI


Basic concepts

Short run macro (Keynesian macro)

Long run macro (classical macro)

Main assumption

Sticky prices (nominal wages and/or g&s prices)

Flexible prices

Main implication

AD shocks and AD policies affect real variables (real income, unemployment)

National income is demand and supply driven

AD shocks and AD policies do not have effect on real variables

National income is only supply driven: amount of production factors; technology; long run factors that affect how much of the factors we use

Kind of explained phenomena

Cycles (recessions, expansions); cyclical unemployment

Long run economic growth; long run unemployment


• Output is determined by the interaction between supply and demand. Specifically, when there is a shift in demand, firms will react changing the output or the prices (or a combination of both)

• Let us now assume that firms are willing to produce as much g&s as are demanded for a given price (this is reasonable for the short run in a situation where production is below full capacity)

• In this case, changes in aggregate demand will imply changes in aggregate output and no change in the price level: aggregate demand determines national income

• The IS-LM model helps us to know the determinants of AD and, under the previous assumption about the behavior of suppliers, of national income

• The IS-LM model with fixed price level says that national income is determined by two equilibrium conditions:– Equilibrium in the g&s markets (IS)– Equilibrium in the money market (LM)

Model of national income determination: IS-LM with fixed prices



• Equilibrium in the g&s markets (IS)

AS=AD

Y=AD=C+I+G+NX

C=C0+cYd=C0+c(1-t)Y

I=I0-br

G, NX exogenous



• Equilibrium in the money market• Money (theoretical)= assets that can be

used as medium of exchange and store of valueMoney (empirical)= coins, bank notes in the hands of individuals and non-financial firms; certain bank deposits that can be used as medium of exchange or converted very quickly (and cheaply) in medium of exchange

• Nominal money supply: Ms

• Real money supply: Ms/P



• Equilibrium in the money market (cont.)

• Advantadge of holding money: liquidity

• Disadvantadge of holding money: opportunity cost (interest rate)

• Money demand (=liquidity preference)

Md=PL(amount of transactions, opportunity cost)

Md=PL(Y,r)

Md/P=L(Y,r)

• Equilibrium: Ms/P=Md/P=L(Y,r)

0,0

r

LY

L



Y

r

IS (C0, I0,G, NX)

LM (Ms/P)


What are we going to learn today?

• How to use the IS-LM model• Macroeconomic stabilization policies• How to derive the AD function• How to derive the AS function• An illustration of the importance of

expectations in macroeconomics• How to use the AD-AS model• The analysis of a real case (The

Economist’s article)


• How to use the IS-LM model?– Let us first define a long term equilibrium level

of income ( ). It is determined by:• Production capacity (amount of physical capital, human capital,

labour force, technology)

• Long term determinants of capacity utilization. (More on this with Javier Andrés)

– Since we deal with the short run, we will consider that is constant


Y

Y


• How to use the IS-LM model? (cont.)– The economy experiences shocks that shift the IS

and/or the LM curves. Due to these shocks, national income departures temporally from the long run equilibrium giving place to business cycles. An important variable in business cycles analysis is the output gap:

– Typical shocks:• Changes in consumers confidence (C0 changes)• Changes in firms confidence (I0 changes)• Changes in exports (NX changes)• Changes in public expenditure• Changes in taxes• Changes in money supply


YY gapoutput

Private sector’s shocks

Public sector’s shocks


• How to use the IS-LM model? (cont.)

– There are reasons to believe that these short run economic fluctuations are not “good”:

• Fall in aggregate demand (recession)increase in unemployment

• Too fast growth of aggregate demand inflation

– Therefore, there is a case for countercyclical policies:

• Fiscal policy

• Monetary policy



• How to use the IS-LM model? (cont.)– Countercyclical fiscal policy

• Recession (or slow economic growth): reduce taxes and/or increase public expenditure

• Too fast expansions: increase taxes and/or reduce public expenditure

Public budget balance• PBB=tax revenues-public transfers-public purchases of g&s

• PBB>0public surplus• PBB<0 public deficit• Recession: increase public deficit (reduce public surplus)• Too fast expansion: reduce public deficit (increase public

surplus)



• How to use the IS-LM model? (cont.)– Countercyclical monetary policy

• Monetary policy has some technical complications that we will skip for the moment

• In essence, we can consider that the Central Bank may want to control either the nominal money supply (Ms) or the interest rate (in both cases the control is not perfect in reality)

• In the IS-LM framework to control the interest rate implies to set Ms in a level such that the interest rate has a given target value.

• Countercyclical monetary policy implies:– Increase MS (reduce rt) during recessions or low econ. Growth– Reduce MS (increase rt) during too fast expansion



Model of national income determination: from IS-LM to AD

Y

r

IS

LM (Ms/P1)

Y

P

P1 AD

P2

LM (Ms/P2)


• Up to now we have assumed that firms are willing to produce as much g&s as are demanded for a given price, that is, we have assumed a flat AS curve:

• Let us now be a bit more sophisticated about AS behaviour

Model of national income determination: the aggregate supply

Y

P

AS

AD

Y



• A very common formulation for AS (see for instance Mankiw) is: )( es PPYY

Y

PAS (short

run)

AD

Y

AS (long run)

P>Pe

P<Pe

P=Pe



• What this AS expression tell us about the behaviour of aggregate output?– If the price level increases, aggregate output will

increase– But, in fact, aggregate output will expand only if the

price increase is unexpected. An expected increase in the price level has no effect on aggregate output



• Different models help to justify the previous AS formulation. We will focus just on one: a model of sticky nominal wages (for other possible explanations, see Mankiw and/or Blanchard)

• To understand the AS we need to explain two things:– Why does aggregate supply change when the price

level changes?– Why does aggregate supply change only when the price

change is unexpected?



• Why does aggregate supply changes when the price level changes? The reasoning is the following:

– Nominal wages are sticky (they change slowly)– For a given nominal wage, an increase in the price

level reduces the real wage and therefore stimulates firms to hire more workers

– The increase in employment implies an increase in production



• Why does aggregate supply changes only when the price increase is unexpected? The reasoning is the following:– When wage bargainers, that is firms and workers

(unions), negotiate the nominal wages (W), in fact they are worried about the real wage (w=W/P). For instance, unions will want a nominal wage that guarantees a given desired real wage given their expectations about the future price level.

– To simplify things, let us assume that the effective nominal wage is decided by the unions. Therefore, the nominal wage is:

W=desired real wagexPe



• Why does aggregate supply changes only when the price increase is unexpected? (cont.)

– But the effective real wage (the one that determines the amount of employment and aggregate output) will depend not on Pe but on the effective price level, that is:

effective real wage=W/P=desired real wagexPe/P– This last expression shows that if the price level goes up

unexpectedly, this will reduce real wages and will boost employment and output. But if it were forecasted properly, nominal wages would have increase accordingly to keep the real wage at the desired level. In this case the price increase does not have effect neither on the real wage nor on employment and output.


Model of national income determination: AD and AS

Y

P AS (short run)

AD

Y

AS (long run)

An unexpected shift of AD…

…increases prices (inflation) and output

(income growth) in the short run…

…but eventually the nominal wage increases to

compensate for higher prices…

…so the only long run effect is an

increase in prices


Source: US Federal Reserve

http://www.federalreserve.gov/releases/G17/Current/ipg1.

gif



0123456789

10US unemployment rate (in %)

Source: IMF



Y

r

IS (C0, I0,G, NX)

LM (Ms/P)

IS (C0, I0,G, NX)

LM (Ms/P)


rt

When the CB wants to control the interest rate, if there is a shock…

The CB changes Ms to keep the interest rate at its targeted value


• One complication of monetary policy is that the Central Bank can only control the (short term) nominal interest rate, whereas aggregate demand (and therefore economic activity) depends on the (long term) real interest rate.

• The difference between nominal and real interest rate is expected inflation:

i=nominal interest rate

r=real interest rate

e=expected inflation

• For the CB it is not easy to control expected inflation


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javier lozano 1 advanced applied macroeconomics introduction javier lozano universitat de les illes...

Documents

macroeconomics slide

wdi slide

questionnaire slide

unemployment national

aggregate supply short

ad policies

y aggregate demand ad

real variables national