Chapter 12: Intro to Econ. Fluctuations PDF

CHAPTER 12: Intro to Econ. Fluctuations ▪ 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 t...

CHAPTER 12: Intro to Econ. Fluctuations ▪ 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.” 0  Facts about the business cycle ▪ 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. CHAPTER 10 Introduction to Economic Fluctuations 1 Growth rates of real GDP, consumption Growth rates of consumption and investment  Growth rates of real GDP, consumption, investment A line graph shows the growth rates for Gross Domestic Product, Consumption, and Investment. The graph is titled, FRED. The horizontal axis shows the Years and has markings from 1975 to 2020 in 5-year increments. The vertical axis is labeled Percent Change from a Year Ago from negative 30 to 40 in increments of 10. Three lines show Real Gross Domestic Product, Real Personal Consumption Expenditures, and Real Gross Private Domestic Investment. Vertical shaded bars extend from the approximate markings of the horizontal axis: 1974 to 1975 1980 1982 1991 2001 2009 2020. The approximate data appear as follows: Real Gross Domestic Product ◦ (1975, 0) ◦ (1980, 5) ◦ (1985, 7) ◦ (1990, 0) ◦ (1995, 5) ◦ (2000, 7) ◦ (2005, 5) ◦ (2010, negative 5) ◦ (2015, 4) ◦ (2020, negative 8) ◦ The line begins at 0 in 1970, then rises to a range of 5 where it remains until 1980. It drops back to 0 in 1981, then rises to 7 in 1985 then drops to the range of 5 before falling to 0 in 1990. It rises again to 5 in 1995 and stays fairly steady until it rises to 7 in 2000, then drops back to 5 in 2005. A large drop occurs in 2009 going into 2010 to negative 5. The line rises to the range of 2 to 4 from 2011 to 2019, then drops to a low of negative 8 in 2020, and ends at 1 by 2025. Real Personal Consumption Expenditures ◦ (1975, 0) ◦ (1980, negative 1) ◦ (1985, 5) ◦ (1990, 0) ◦ (1995, 4) ◦ (2000, 5) ◦ (2005, 4) ◦ (2010, 1) ◦ (2015, 5) ◦ (2020, negative 8) ◦ The line for Real Personal Consumption Expenditures mirrors the line for Real Gross Domestic Product with only minimal differences from 1975 to 2020, and ends at 1 by 2025. Real Gross Private Domestic Investment ◦ (1975, negative 22) ◦ (1980, negative 18) Unemployment Okun’s law  Time horizons in macroeconomics ▪ 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 much differently when prices are sticky. CHAPTER 10 Introduction to Economic Fluctuations 7  Recap of classical macro theory (Chaps. 3-11) ▪ Output is determined by the supply side: ▪ supplies of capital, labor ▪ technology ▪ Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. ▪ Assumes complete price flexibility. ▪ Applies to the long run. CHAPTER 10 Introduction to Economic Fluctuations 8  When prices are sticky… …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 CHAPTER 10 Introduction to Economic Fluctuations 9  The model of aggregate demand and supply ▪ 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 behavior is different in the short run and long run CHAPTER 10 Introduction to Economic Fluctuations 10  Aggregate demand ▪ The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. ▪ For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the quantity theory of money. ▪ Chapters 13–14 develop the theory of aggregate demand in more detail. CHAPTER 10 Introduction to Economic Fluctuations 11  The Quantity Equation as Aggregate Demand ▪ From Chapter 5, recall the quantity equation MV = PY ▪ For given values of M and V, this equation implies an inverse relationship between P and Y … CHAPTER 10 Introduction to Economic Fluctuations 12  The downward-sloping AD curve P An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. AD Y CHAPTER 10 Introduction to Economic Fluctuations 13  Shifting the AD curve P An increase in the money supply shifts the AD curve to the right. AD2 AD1 Y CHAPTER 10 Introduction to Economic Fluctuations 14  Aggregate supply in the long run ▪ Recall from Chap. 4: 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). CHAPTER 10 Introduction to Economic Fluctuations 15  The long-run aggregate supply curve P LRAS Y does not depend on P, so LRAS is vertical. Y Y = F (K , L ) CHAPTER 10 Introduction to Economic Fluctuations 16  Long-run effects of an increase in M P LRAS An increase in M shifts AD to the right. In the long run, P2 this raises the price level… P1 AD2 AD1 …but leaves Y output the same. Y CHAPTER 10 Introduction to Economic Fluctuations 17  Aggregate supply in the short run ▪ Many prices are sticky in the short run. ▪ For now, we assume ▪ 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: CHAPTER 10 Introduction to Economic Fluctuations 18  The short-run aggregate supply curve P The SRAS curve is horizontal: The price level is fixed at a SRAS predetermined P level, and firms sell as much as buyers demand. Y CHAPTER 10 Introduction to Economic Fluctuations 19  Short-run effects of an increase in M In the short run P …an increase when prices are in aggregate sticky,… demand… SRAS P AD2 AD1 Y …causes Y1 Y2 output to rise. CHAPTER 10 Introduction to Economic Fluctuations 20  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 then over time, equilibrium, if P will… Y Y rise Y Y fall Y =Y remain constant The adjustment of prices is what moves the economy to its long-run equilibrium. CHAPTER 10 Introduction to Economic Fluctuations 21  The SR & LR effects of ΔM > 0 A = initial P LRAS equilibrium B = new short- run eq’m P2 C after Fed B SRAS increases M P A AD2 AD1 C = long-run equilibrium Y Y Y2 CHAPTER 10 Introduction to Economic Fluctuations 22  Shocks ▪ shocks: exogenous changes in agg. supply or demand ▪ Shocks temporarily push the economy away from full employment. ▪ 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. CHAPTER 10 Introduction to Economic Fluctuations 23  The effects of a negative demand shock AD shifts left, P LRAS depressing output and employment in the short run. B A SRAS Over time, P prices fall and P2 C AD1 the economy moves down its AD2 demand curve Y toward full Y2 Y employment. CHAPTER 10 Introduction to Economic Fluctuations 24  Supply shocks ▪ 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. ▪ Favorable supply shocks lower costs and prices. CHAPTER 10 Introduction to Economic Fluctuations 25  CASE STUDY: The 1970s oil shocks ▪ Early 1970s: OPEC coordinates 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. CHAPTER 10 Introduction to Economic Fluctuations 26  CASE STUDY: The 1970s oil shocks The oil price shock P LRAS shifts SRAS up, causing output and employment to fall. B SRAS2 P2 In absence of A SRAS1 further price P1 shocks, prices will AD fall over time and economy moves Y back toward full Y2 Y employment. CHAPTER 10 Introduction to Economic Fluctuations 27  CASE STUDY: The 1970s oil shocks 70% 12% Predicted effects 60% of the oil shock: 50% 10% inflation  40% output  30% 8% unemployment  20% 6% …and then a 10% gradual recovery. 0% 4% 1973 1974 1975 1976 1977 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)  CASE STUDY: The 1970s oil shocks 60% 14% Late 1970s: 50% 12% As economy 40% was recovering, 10% oil prices shot up 30% 8% again, causing 20% another huge 6% 10% supply shock! 0% 4% 1977 1978 1979 1980 1981 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)  CASE STUDY: The 1980s oil shocks 40% 10% 1980s: 30% 20% 8% A favorable 10% supply shock— 6% 0% a significant fall -10% in oil prices. 4% -20% As the model -30% 2% predicts, -40% inflation and -50% 0% unemployment 1982 1983 1984 1985 1986 1987 fell. Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)  Stabilization policy ▪ definition: policy actions aimed at reducing the severity of short-run economic fluctuations. ▪ Example: Using monetary policy to combat the effects of adverse supply shocks… CHAPTER 10 Introduction to Economic Fluctuations 31  Stabilizing output with monetary policy P LRAS The adverse supply shock B SRAS2 moves the P2 economy to A SRAS1 point B. P1 AD1 Y Y2 Y CHAPTER 10 Introduction to Economic Fluctuations 32  Stabilizing output with monetary policy But the Fed P LRAS accommodates the shock by raising agg. B C SRAS2 demand. P2 A results: P1 AD2 P is permanently AD1 higher, but Y remains at its full- Y employment level. Y2 Y CHAPTER 10 Introduction to Economic Fluctuations 33  CHAPTER 16: The inflation-unemployment trade-off  two models of aggregate supply in which output depends positively on the price level in the short run  the short-run tradeoff between inflation and unemployment known as the Phillips curve 0 Introduction  In previous chapters, we assumed the price level P was “stuck” in the short run.  This implies a horizontal SRAS curve.  Now, we consider two prominent models of aggregate supply in the short run:  Sticky-price model  Imperfect-information model 1 Introduction  Both models imply: Y  Y   (P  EP ) agg. expected output price level a positive natural rate actual parameter of output price level  Other things equal, Y and P are positively related, so the SRAS curve is upward sloping. 2 The sticky-price model  Reasons for sticky prices:  long-term contracts between firms and employees, firms and customers  menu costs  firms not wishing to annoy customers with frequent price changes  Assumption:  Firms set their own prices (e.g., as in monopolistic competition). 3 The sticky-price model  An individual firm’s desired price is: p  P  a(Y  Y ) where a > 0. Suppose two types of firms: firms with flexible prices, set prices as above firms with sticky prices, must set their price before they know how P and Y will turn out: p  EP  a( EY  EY ) 4 The sticky-price model p  EP  a( EY  EY )  Assume sticky-price firms expect that output will equal its natural rate. Then, p  EP  To derive the aggregate supply curve, first find an expression for the overall price level. s= fraction of firms with sticky prices. Then, we can write the overall price level as… 5 The sticky-price model P  s[ EP ]  (1  s)[ P  a(Y  Y )] price set by price set by sticky-price firms flexible-price firms  Subtract (1−s)P from both sides: sP  s[ EP ]  (1  s)[a(Y  Y )]  Divide both sides by s: (1 s )a P  EP  (Y  Y ) s 6 The sticky-price model (1 s )a P  EP  (Y  Y ) s  High EP g High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices.  High Y g High P When income is high, the demand for goods is high. Firms with flexible prices set high prices. The greater the fraction of flexible-price firms, the smaller is s and the bigger the effect of Y on P. 7 The sticky-price model (1 s )a P  EP  (Y  Y ) s  Finally, derive AS equation by solving for Y : Y  Y   (P  EP ), s where    0 (1  s ) a 8 The imperfect-information model Assumptions:  All wages and prices are perfectly flexible, all markets clear.  Each supplier produces one good, consumes many goods.  Each supplier knows the nominal price of the good she produces, but does not know the overall price level. 9 The imperfect-information model  Supply of each good depends on its relative price: the nominal price of the good divided by the overall price level (p / P)  Supplier does not know price level at the time she makes her production decision, so uses EP.  Suppose P rises but EP does not.  Supplier thinks relative price has risen, so she produces more.  With many producers thinking this way, Y will rise whenever P rises above EP. 10 Summary & implications P LRAS Y  Y   (P  EP) P  EP Both models SRAS of agg. supply P  EP imply the P  EP relationship summarized Y by the SRAS Y curve & equation. 11 Summary & implications Suppose a positive SRAS equation: Y  Y   (P  EP) AD shock moves P SRAS2 output above its LRAS natural rate and SRAS1 P above the level people had P3  EP3 expected. P2 Over time, AD2 EP2  P1  EP1 EP rises, SRAS shifts up, AD1 and output returns Y to its natural rate. Y2 Y3  Y1  Y 12 Inflation, unemployment, and the Phillips curve The Phillips curve states that π depends on  expected inflation, Eπ  cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate  supply shocks, (Greek letter “nu”).   E   (u  u )  n where β > 0 is an exogenous constant. 13 Deriving the Phillips curve from SRAS (1) Y  Y   (P  EP ) (2) P  EP  (1  )(Y  Y ) (3) P  EP  (1  )(Y  Y )  (4) (P  P1 )  ( EP  P1 )  (1  )(Y Y )  (5)   E  (1  )(Y  Y )  (6) (1  )(Y Y )    (u  un ) (7)   E   (u  un )  14 Comparing SRAS and the Phillips curve SRAS: Y  Y   (P  EP ) Phillips curve:   E   (u  un )   SRAS curve: Output is related to unexpected movements in the price level.  Phillips curve: Unemployment is related to unexpected movements in the inflation rate. 15 Adaptive expectations  Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation.  A simple version: Expected inflation = last year’s actual inflation E   1  Then, Phillips curve eq’n becomes    1   (u  un )  16 Inflation inertia    1   (u  un )  In this form, the Phillips curve implies that inflation has inertia:  In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.  Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. 17 Two causes of rising & falling inflation    1   (u  un )   cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up.  demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up. 18 Graphing the Phillips curve In the short run,   E   (u  un )  policymakers face a tradeoff between inflation and u.  1 The short-run E  Phillips curve n u u 19 Shifting the Phillips curve People adjust   E   (u  un )  their expectations over time, E 2  so the tradeoff only holds in E 1  the short run. E.g., an increase in expected n u inflation shifts u the short-run P.C. upward. 20 The sacrifice ratio  To reduce inflation, policymakers can contract aggregate demand, causing unemployment to rise above the natural rate.  The sacrifice ratio measures the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percentage point.  A typical estimate of the ratio is 5. 21 The sacrifice ratio  Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP: GDP loss = (inflation reduction) × (sacrifice ratio) 20 = 4 × 5  This loss could be incurred in one year or spread over several, e.g., 5 p.p. loss for each of four years.  The cost of disinflation is lost GDP. One could use Okun’s law to translate this cost into unemployment. 22 Rational expectations Ways of modeling the formation of expectations:  adaptive expectations: People base their expectations of future inflation on recently observed inflation.  rational expectations: People base their expectations on all available information, including information about current and prospective future policies. 23 Painless disinflation?  Proponents of rational expectations believe that the sacrifice ratio may be very small:  Suppose u = un and  = E = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible.  If the announcement is credible, then E will fall, perhaps by the full 4 points.  Then,  can fall without an increase in u. 24 The natural-rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural-rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3–9). 25 An alternative hypothesis: Hysteresis  Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment.  Negative shocks may increase un, so economy may not fully recover. 26 Chapter 18 Two policy debates 1. Should policy be active or passive? 2. Should policy be by rule or discretion? Should policy be active or passive? Growth rate of U.S. real GDP U.S. unemployment rate (percent of labor force)  Increase in unemployment during recessions Peak Through Increase in no. of unemployed persons (millions) July 1953 May 1954 2.11 August 1957 April 1958 2.27 April 1960 February 1961 1.21 December 1969 November 1970 2.01 November 1973 March 1975 3.58 January 1980 July 1980 1.68 July 1981 November 1982 4.08 July 1990 March 1991 1.67 March 2001 November 2001 1.50 December 2007 June 2009 6.14 February 2020 February 2021 4.26 The natural-rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural-rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model (Chaps. 3–8). An alternative hypothesis: Hysteresis ▪ Hysteresis: the long-lasting influence of history on variables such as the natural rate of unemployment. ▪ Negative shocks may increase un, so economy may not fully recover. Arguments for active policy ▪ Recessions cause economic hardship for millions of people. ▪ The Employment Act of 1946: “It is the continuing policy and responsibility of the Federal Government to (…) promote full employment and production.” ▪ The model of aggregate demand and supply (chapters 12-14) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. Arguments against active policy Policies act with long & variable lags, including: inside lag: the time between the shock and the policy response. ▪ takes time to recognize shock ▪ takes time to implement policy, especially fiscal policy outside lag: the time it takes for policy to affect economy. If conditions change before the policy’s impact is felt, the policy may destabilize the economy. Automatic stabilizers ▪ Definition: policies that stimulate or depress the economy when necessary without any deliberate policy change. ▪ They can reduce the lags associated with stabilization policy. ▪ Examples: ▪ income tax ▪ unemployment insurance ▪ welfare Forecasting the macroeconomy Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts: ▪ Leading economic indicators data series that fluctuate in advance of the economy ▪ Macroeconometric models Large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies  Mistakes forecasting the 1982 recession Unemployment rate Mistakes forecasting the 2008–2009 recession Forecasting the macroeconomy ▪ Since policies have lags, policymakers must predict future conditions ▪ The preceding slides show that the forecasts are often wrong ▪ For this is reason, some economists advice against active policies The Lucas critique ▪ Due to Robert Lucas (1995 Nobel Prize for “having developed and applied the hypothesis of rational expectations…”) ▪ Forecasts of the effects of policy changes are usually based on historical data (e.g., model parameters estimated with data from recent past) ▪ Lucas critique: if the policy change alters expectations and thus agents’ behavior, predictions will not be valid An example of the Lucas critique ▪ Prediction (based on past experience): Expansionary monetary policy will reduce unemployment. ▪ The critique points out that expansionary monetary policy may raise expected inflation, in which case unemployment would not necessarily fall. Effects of M r LRAS LM(M /P ) 1 1 IS Y Y P LRAS P1 SRAS1 AD1 Y Y Short-run effects of M in AS-AD model LM and AD shift right. r LRAS LM(M /P ) 1 1 r1 LM(M2/P1) r2 r falls, Y rises above Y IS Y Y2 Y P LRAS P1 SRAS AD2 AD1 Y Y2 Y Transition to long run equilibrium Over time, r LRAS LM(M /P ) 1 2 1 3 ▪ P rises LM(M2/P1) r3 = r1 ▪ SRAS moves upward r2 ▪ M/P falls IS ▪ LM moves leftward Y Y2 Y Long-run equilibrium ▪ P higher P LRAS P3 SRAS ▪ all real variables back at their initial values P1 SRAS AD2 AD1 Y Y2 Y Money neutrality If people change their r LRAS LM(M /P ) 1 2 1 3 expectations r3 = r1 LM(M2/P1) immediately, r2 the economy could move to long run IS equilibrium right away Y Y2 Y P LRAS P3 SRAS P1 SRAS AD2 AD1 Y Y2 Y Lucas critique and the Phillips curve Short run   = E −  (u − u n ) + tradeoff between  and u holds for  1 The short-run a given E E + Phillips curve n u u Lucas critique and the Phillips curve As soon as   = E −  (u − u n ) + people adjust their expectations E 2 + over time, the tradeoff changes E 1 + n u u Should policy be active or passive? ▪ If the economy has experienced many large shocks and policy has successfully insulated the economy -> case for active policy ▪ few large shocks and observed fluctuations can be traced to bad policy -> case for passive policy What does the evidence say? ▪ It’s hard to identify shocks in the data. ▪ It’s hard to tell how outcomes would have been different had actual policies not been used. Should policy be conducted by rule or discretion? Rules and discretion: basic concepts ▪ Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through. ▪ Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. Arguments for rules 1. Distrust of policymakers and the political process ▪ misinformed politicians ▪ politicians’ interests sometimes not the same as the interests of society 2. Time inconsistency of discretionary policy ▪ a situation in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. Examples of time inconsistency: 1 ▪ Example: Policymakers consider an exception to a “no bailouts” policy if the imminent failure of an AIG or GM threatens the broader economy. ▪ Consequence: destroys policymakers’ credibility, thus reducing effectiveness of future policies Examples of time inconsistency: 2 ▪ To encourage investment, the government announces it will not tax income from capital. ▪ But once the factories are built, the government reneges in order to raise more tax revenue. Examples of time inconsistency: 3 ▪ To reduce expected inflation, the central bank announces it will tighten monetary policy. ▪ But faced with high unemployment, the central bank may be tempted to cut interest rates. Examples of time inconsistency: 4 ▪ Aid is given to poor countries contingent on fiscal reforms. ▪ The reforms do not occur, but aid is given anyway, because the donor countries do not want the poor countries’ citizens to starve. Monetary policy rules a. Constant money supply growth rate b. Target growth rate of nominal GDP c. Target the inflation rate Central bank independence ▪ A policy rule announced by central bank will work only if the announcement is credible. ▪ Credibility depends in part on degree of independence of central bank.  Inflation and central bank independence average inflation index of central bank independence  CHAPTERS 9-11: Economic Growth ▪ the closed economy Solow model ▪ how a country’s standard of living depends on its saving and population growth rates ▪ how to use the “Golden Rule” to find the optimal saving rate and capital stock ▪ how to incorporate population growth and technological progress in the Solow model ▪ growth policies and growth empirics ▪ endogenous technological progress 0 Why growth matters ▪ Data on infant mortality rates: ▪ 20% in the poorest 1/5 of all countries ▪ 0.4% in the richest 1/5 ▪ One-fourth of the poorest countries have had famines during the past 3 decades. ▪ Poverty is associated with oppression of women and minorities. Economic growth raises living standards and reduces poverty…. 1  Income and poverty in the world selected countries, 2010 100 90 Zambia % of population living on $2/day or less Nigeria 80 70 Senegal 60 50 Indonesia 40 Kyrgyz Republic Georgia 30 Panama Peru Uruguay 20 Mexico 10 Poland 0 $0 $2,000 $4,000 $6,000 $8,000 $10,000 $12,000 $14,000 Income per capita in U.S. dollars Why growth matters ▪ Anything that effects the long-run rate of economic growth – even by a tiny amount – will have huge effects on living standards in the long run. annual increase in standard growth rate of of living after… income per capita …25 years …50 years …100 years 2.0% 64.0% 169.2% 624.5% 2.5% 85.4% 243.7% 1,081.4% 3 The lessons of growth theory …can make a positive difference in the lives of hundreds of millions of people. These lessons help us ▪ understand why poor countries are poor ▪ design policies that can help them grow ▪ learn how our own growth rate is affected by shocks and government’s policies 4 The Solow model ▪ due to Robert Solow, who won The Nobel Prize for contributions to the study of economic growth ▪ a major paradigm: ▪ widely used in policy making ▪ benchmark against which most recent growth theories are compared ▪ looks at the determinants of economic growth and the standard of living in the long run 5 How Solow model is different from Chapter 4’s model 1. K is no longer fixed: investment causes it to grow, depreciation causes it to shrink 2. L is no longer fixed: population growth causes it to grow 3. The consumption function is simpler 4. no G or T (only to simplify presentation; we can still do fiscal policy experiments) 5. cosmetic differences 6 The production function ▪ In aggregate terms: Y = F (K, L) ▪ Define: y = Y/L = output per worker k = K/L = capital per worker ▪ Assume constant returns to scale: zY = F (zK, zL ) for any z > 0 ▪ Pick z = 1/L. Then Y/L = F (K/L, 1) y = F (k, 1) y = f(k) where f(k) = F(k, 1) 7 The production function Output per worker, y f(k) MPK = f(k +1) – f(k) 1 Note: this production function exhibits diminishing MPK. Capital per worker, k 8 The national income identity ▪ Y=C+I (remember, no G ) ▪ In “per worker” terms: y=c+i where c = C/L and i = I /L 9 The consumption function ▪ s = the saving rate, the fraction of income that is saved (s is an exogenous parameter) Note: s is the only lowercase variable that is not equal to its uppercase version divided by L ▪ Consumption function: c = (1–s)y (per worker) 10 Saving and investment ▪ saving (per worker) = y – c = y – (1–s)y = sy ▪ National income identity is y = c + i Rearrange to get: i = y – c = sy (investment = saving, like in chap. 3!) ▪ Using the results above, i = sy = sf(k) 11 Output, consumption, and investment Output per f(k) worker, y c1 y1 sf(k) i1 k1 Capital per worker, k 12 Depreciation Depreciation δ = the rate of depreciation per worker, δk = the fraction of the capital stock that wears out each period δk δ 1 Capital per worker, k 13 Capital accumulation The basic idea: Investment increases the capital stock, depreciation reduces it. Change in capital stock = investment – depreciation Δk = i – δk Since i = sf(k) , this becomes: Δk = s f(k) – δk 14 The equation of motion for k Δk = s f(k) – δk ▪ The Solow model’s central equation ▪ Determines behavior of capital over time… ▪ …which, in turn, determines behavior of all of the other endogenous variables because they all depend on k. E.g., income per person: y = f(k) consumption per person: c = (1 – s) f(k) 15 The steady state Δk = s f(k) – δk If investment is just enough to cover depreciation [sf(k) = δk ], then capital per worker will remain constant: Δk = 0. This occurs at one value of k, denoted k*, called the steady state capital stock. 16 The steady state Investment and δk depreciation sf(k) k* Capital per worker, k 17 Moving toward the steady state Δk = sf(k) − δk Investment and δk depreciation sf(k) Δk investment depreciation k1 k* Capital per worker, k 18 Moving toward the steady state Δk = sf(k) − δk Investment and δk depreciation sf(k) Δk k 1 k2 k* Capital per worker, k 19 Moving toward the steady state Δk = sf(k) − δk Investment and δk depreciation sf(k) Δk investment depreciation k2 k* Capital per worker, k 20 Moving toward the steady state Δk = sf(k) − δk Investment and δk depreciation sf(k) Δk k2 k3 k* Capital per worker, k 22 Moving toward the steady state Δk = sf(k) − δk Investment and δk depreciation Summary: sf(k) As long as k < k*, investment will exceed depreciation, and k will continue to grow toward k*. k3 k* Capital per worker, k 23 A numerical example Production function (aggregate): Y = F (K , L ) = K  L = K 1 / 2L1 / 2 To derive the per-worker production function, divide through by L: 1/2 Y K L 1/2 1/2 K  = =  L L L  Then substitute y = Y/L and k = K/L to get y = f (k ) = k 1 / 2 24 A numerical example, cont. Assume: ▪ s = 0.3 ▪ δ = 0.1 ▪ initial value of k = 4.0 25 Approaching the steady state: A numerical example Year k y c i δk Δk 1 4.000 2.000 1.400 0.600 0.400 0.200 2 4.200 2.049 1.435 0.615 0.420 0.195 3 4.395 2.096 1.467 0.629 0.440 0.189 4 4.584 2.141 1.499 0.642 0.458 0.184 … 10 5.602 2.367 1.657 0.710 0.560 0.150 … 25 7.351 2.706 1.894 0.812 0.732 0.080 … 100 8.962 2.994 2.096 0.898 0.896 0.002 … ∞ 9.000 3.000 2.100 0.900 0.900 0.000 26 Solving for the steady state Continue to assume s = 0.3, δ = 0.1, and y = k 1/2 Use the equation of motion Δk = s f(k) − δk to solve for the steady-state values of k, y, and c. 27 Solving for the steady state s f (k *) =  k * eq'n of motion with k = 0 0.3 k * = 0.1k * using assumed values k* 3= = k * k* Solve to get: k * = 9 and y * = k * = 3 Finally, c * = (1 − s )y * = 0.7  3 = 2.1 28 An increase in the saving rate An increase in the saving rate raises investment… …causing k to grow toward a new steady state: Investment δk and depreciation s2 f(k) s1 f(k) k k 1* k 2* 29 Prediction: ▪ The Solow model predicts that countries with higher rates of saving and investment will have higher levels of capital and income per worker in the long run. ▪ Are the data consistent with this prediction? 30  International evidence on investment rates and income per person Income per 100,000 person in 2010 (log scale) 10,000 1,000 100 0 10 20 30 40 50 Investment as percentage of output (average 1960-2010) The Golden Rule: Introduction ▪ Different values of s lead to different steady states. How do we know which is the “best” steady state? ▪ The “best” steady state has the highest possible consumption per person: c* = (1–s) f(k*). ▪ An increase in s ▪ leads to higher k* and y*, which raises c* ▪ reduces consumption’s share of income (1–s), which lowers c*. ▪ So, how do we find the s and k* that maximize c*? 32 The Golden Rule capital stock k gold * = the Golden Rule level of capital, the steady state value of k that maximizes consumption. To find it, first express c* in terms of k*: c* = y* − i* = f (k*) − i* In the steady state: = f (k*) − δk* i* = δk* because Δk = 0. 33 The Golden Rule capital stock steady state output and depreciation δ k* Then, graph f(k*) and δk*, f(k*) look for the point where the gap between c gold * them is biggest. i gold * =  k gold * y gold * = f (k gold * ) k gold * steady-state capital per worker, k* 34 The Golden Rule capital stock c* = f(k*) − δk* δ k* is biggest where the slope of the f(k*) production function equals the slope of the depreciation line: c gold * MPK = δ k gold * steady-state capital per worker, k* 35 The transition to the Golden Rule steady state ▪ The economy does NOT have a tendency to move toward the Golden Rule steady state. ▪ Achieving the Golden Rule requires that policymakers adjust s. ▪ This adjustment leads to a new steady state with higher consumption. ▪ But what happens to consumption during the transition to the Golden Rule? 36 Starting with too much capital If k *  k gold * then increasing c* y requires a fall in s. In the transition to c the Golden Rule, consumption is i higher at all points in time. t0 time 37 Starting with too little capital If k *  k gold * then increasing c* requires an y increase in s. c Future generations enjoy higher consumption, but the current i one experiences an initial drop t0 time in consumption. 38 Population growth ▪ Assume the population and labor force grow at rate n (exogenous): L = n L ▪ EX: Suppose L = 1,000 in year 1 and the population is growing at 2% per year (n = 0.02). ▪ Then ΔL = n L = 0.02 ×1,000 = 20, so L = 1,020 in year 2. 39 Break-even investment ▪ (δ + n)k = break-even investment, the amount of investment necessary to keep k constant. ▪ Break-even investment includes: ▪ δ k to replace capital as it wears out ▪ nk to equip new workers with capital (Otherwise, k would fall as the existing capital stock is spread more thinly over a larger population of workers.) 40 The equation of motion for k ▪ With population growth, the equation of motion for k is: Δk = s f(k) − (δ + n) k actual break-even investment investment 41 The Solow model diagram Investment, Δk = s f(k) − (δ+n)k break-even investment (δ + n ) k sf(k) k* Capital per worker, k 42 The impact of population growth Investment, break-even (δ +n2) k investment ( δ + n1 ) k An increase in n causes an sf(k) increase in break- even investment, leading to a lower steady-state level of k. k2 * k1* Capital per worker, k 43 Prediction: ▪ The Solow model predicts that countries with higher population growth rates will have lower levels of capital and income per worker in the long run. ▪ Are the data consistent with this prediction? 44  International evidence on population growth and income per person Income per 100,000 person in 2010 (log scale) 10,000 1,000 100 0 1 2 3 4 5 Population growth (percent per year, average 1961-2010) The Golden Rule with population growth To find the Golden Rule capital stock, express c* in terms of k*: c* = y* − i* = f (k* ) − (δ + n) k* In the Golden c* is maximized when Rule steady state, MPK = δ + n the marginal product of capital net of or equivalently, depreciation equals MPK − δ = n the population growth rate. 46 Alternative perspectives on population growth The Malthusian Model (1798) ▪ Predicts population growth will outstrip the Earth’s ability to produce food, leading to the impoverishment of humanity. ▪ Since Malthus, world population has increased sixfold, yet living standards are higher than ever. ▪ Malthus neglected the effects of technological progress. 47 Alternative perspectives on population growth The Kremerian Model (1993) ▪ Posits that population growth contributes to economic growth. ▪ More people = more geniuses, scientists & engineers, so faster technological progress. ▪ Evidence, from very long historical periods: ▪ As world pop. growth rate increased, so did rate of growth in living standards ▪ Historically, regions with larger populations have enjoyed faster growth. 48 Technological progress in the Solow model ▪ A new variable: E = labor efficiency ▪ Assume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g: E g= E 49 Technological progress in the Solow model ▪ We now write the production function as: Y = F (K , L  E ) ▪ where L × E = the number of effective workers. ▪ Increases in labor efficiency have the same effect on output as increases in the labor force. 50 Technological progress in the Solow model ▪ Notation: y = Y / LE = output per effective worker k = K / LE = capital per effective worker ▪ Production function per effective worker: y = f(k) ▪ Saving and investment per effective worker: s y = s f(k) 51 Technological progress in the Solow model (δ + n + g) k = break-even investment: the amount of investment necessary to keep k constant. Consists of: ▪ δ k to replace depreciating capital ▪ n k to provide capital for new workers ▪ g k to provide capital for the new “effective” workers created by technological progress 52 Technological progress in the Solow model Investment, Δk = s f(k) − (δ +n +g)k break-even investment (δ+n +g ) k sf(k) k* Capital per effective worker, k 53 Steady-state growth rates in the Solow model with tech. progress Steady-state Variable Symbol growth rate Capital per k = K / (L × E ) 0 effective worker Output per y = Y / (L × E ) 0 effective worker Output per worker (Y/ L) = y × E g Total output Y = y×E×L n+g 54 The Golden Rule with technological progress To find the Golden Rule capital stock, express c* in terms of k*: In the Golden * c = y * − i * Rule steady state, = f (k* ) − (δ + n + g) k* the marginal product of capital c* is maximized when net of depreciation MPK = δ + n + g equals the pop. growth rate or equivalently, plus the rate of MPK − δ = n + g tech progress. 55 Growth empirics: Income and Growth 56 Growth empirics: Long-run Growth 57 Growth empirics: Long-run Growth 58 Growth empirics: VERY Long-run Growth 59 Growth empirics: Convergence ▪ Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones. ▪ If true, then the income gap between rich & poor countries would shrink over time, causing living standards to converge. ▪ In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails? 60 Growth empirics: Convergence ▪ Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones. ▪ No, because “other things” aren’t equal: ▪ In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year. ▪ In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year. 61 Growth empirics: Convergence ▪ What the Solow model really predicts is conditional convergence—countries converge to their own steady states, which are determined by saving, population growth, and education. ▪ This prediction comes true in the real world. 62 Growth empirics: Convergence 63 Growth empirics: Convergence 64 Growth empirics: Factor accumulation vs. production efficiency ▪ Differences in income per capita among countries can be due to differences in: 1. capital—physical or human—per worker 2. the efficiency of production (the height of the production function) ▪ Studies: ▪ Both factors are important. ▪ The two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency. 65 Sources of differences in output per capita 66 Growth accounting Production function Y = AF(K,L), where A is total factor productivity (TFP). Can break down growth in output by: Growth in Contribution Contribution Growth in = + + Output of Capital of Labor TFP Using our production function, the above equation becomes: Y K L A = + (1 −  ) + , Y K L A A where is the Solow residual. A Productivity slowdown ▪ Accounting for Growth in the United States ▪ SOURCES OF GROWTH Years Output = Capital + Labor (1−α)∆L/L + Total Factor Growth α∆K/K Productivity ∆Y/Y ∆A/A (Average percentage increase per year) 1948–2022 3.4 1.3 1.0 1.1 1948–1973 4.2 1.3 1.0 1.9 1973–2022 2.9 1.3 1.0 0.6 ▪ Data from: U.S. Department of Labor. Data are for the nonfarm business sector. Parts may not add to total due to rounding. Policy issues ▪ Are we saving enough? Too much? ▪ What policies might change the saving rate? ▪ How should we allocate our investment between privately owned physical capital, public infrastructure, and human capital? ▪ How do a country’s institutions affect production efficiency and capital accumulation? ▪ What policies might encourage faster technological progress? 69 Policy issues: How to increase the saving rate ▪ Reduce the government budget deficit (or increase the budget surplus). ▪ Increase incentives for private saving: ▪ Reduce capital gains tax, corporate income tax, estate tax, as they discourage saving. ▪ Replace federal income tax with a consumption tax. ▪ Expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts. 70 Policy issues: Allocating the economy’s investment ▪ In the Solow model, there’s one type of capital. ▪ In the real world, there are many types, which we can divide into three categories: ▪ private capital stock ▪ public infrastructure ▪ human capital: the knowledge and skills that workers acquire through education ▪ How should we allocate investment among these types? 71 Policy issues: Allocating the economy’s investment Two viewpoints: 1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product. 2. Industrial policy: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors don’t consider. 72 Policy issues: Establishing the right institutions ▪ Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples: ▪ Institutions: protection of property rights, enforcing contracts, a corruption-free government, promoting competition, etc. ▪ Capital markets, to help financial capital flow to the best investment projects. ▪ Trade integration, to increase competition and expand business 73 Establishing the right institutions: North versus South Korea ▪ After WW2, Korea split into: North Korea with institutions based on authoritarian communism South Korea with Western-style democratic capitalism ▪ Today, GDP per capita is over 10 times higher in South Korea than in North Korea. Institutions and Development 75 Technology and Growth 76 Policy issues: Encouraging tech. progress ▪ Patent laws: encourage innovation by granting temporary monopolies to inventors of new products. ▪ Tax incentives for R&D ▪ Grants to fund basic research at universities ▪ Industrial policy: encourages specific industries that are key for rapid tech. progress (subject to the preceding concerns). 77 Endogenous growth theory ▪ Solow model: ▪ sustained growth in living standards is due to tech progress. ▪ the rate of tech progress is exogenous. ▪ Endogenous growth theory: ▪ a set of models in which the growth rate of productivity and living standards is endogenous. 78 The basic model ▪ Production function: Y = A K where A is the amount of output for each unit of capital (A is exogenous & constant) ▪ Key difference between this model & Solow: MPK is constant here, diminishes in Solow ▪ Investment: sY ▪ Depreciation: δK ▪ Equation of motion for total capital: ΔK = sY − δK 79 The basic model ΔK = sY − δK ▪ Divide through by K and use Y = A K to get: Y K = = sA −  Y K ▪ If s A > δ, then income will grow forever, and investment is the “engine of growth.” ▪ Here, the permanent growth rate depends on s. In Solow model, it does not. 80 Does capital have diminishing returns or not? ▪ Depends on definition of capital. ▪ If capital is narrowly defined (only plant & equipment), then yes. ▪ Advocates of endogenous growth theory argue that knowledge is a type of capital. ▪ If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth. 81 A two-sector model ▪ Two sectors: ▪ manufacturing firms produce goods. ▪ research universities produce knowledge that increases labor efficiency in manufacturing. ▪ u = fraction of labor in research (u is exogenous) ▪ Mfg prod func: Y = F [K, (1 − u )E L] ▪ Res prod func: ΔE / E = g (u) ▪ Cap accumulation: ΔK = s Y − δK 82 A two-sector model ▪ In the steady state, mfg output per worker and the standard of living grow at rate ΔE / E = g (u ). ▪ Key variables: s: affects the level of income, but not its growth rate (same as in Solow model) u: affects level and growth rate of income 83 U.S. real GDP per capita (2012 dollars) Growth rates of real GDP, consumption U.S. real GDP per capita (2012 dollars) U.S. unemployment rate (percent of labor force) U.S. inflation rate (2012 dollars) Review of Chapter 12 Chapter 12 introduced the model of aggregate demand and aggregate supply. Long run: prices flexible output determined by factors of production and technology unemployment equals its natural rate Short run: prices fixed output determined by aggregate demand unemployment negatively related to output Macro Analysis of Fluctuations: The Big Picture CHAPTER 13: Building the IS-LM Model This chapter develops 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). IS curve and its relationship to: the Keynesian cross LM curve and its relationship to: the theory of liquidity preference How the IS–LM model determines income and the interest rate in the short run when P is fixed. The Keynesian cross A simple closed-economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual and planned expenditure = unplanned inventory investment Elements of the Keynesian cross Consumption function C = C(Y – T) Government policy variables: G = G,T = T For now, planned investment is exogenous: I = I Planned expenditure: PE = C (Y − T ) + I + G Equilibrium Condition: Y = PE Actual expenditure = planned expenditure Graphing planned expenditure Graphing the equilibrium condition The equilibrium value of income Adjustment to equilibrium An increase in government purchases Solving for ΔY Y = C + I + G equilibrium condition ΔY = ΔC + ΔI + ΔG in changes = ΔC + ΔG as I is fixed = (MPC × ΔY) + ΔG as ΔC = (MPC × ΔY) Collect terms with ΔY on the Solve for ΔY : left side of the equals sign:  1  ΔY =   × ΔG (1-MPC) x ΔY = ΔG  1− MPC  The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the government purchases multiplier equals ΔY 1 = ΔG 1− MPC Example: If MPC = 0.8, then ΔY 1 An increase in G = =5 ΔG 1 − 0.8 causes income to increase 5 times as much! Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: ΔY = ΔG. But Y causes C which causes further Y which then causes further C which then causes further Y So the final impact on income is much bigger than the initial ΔG.  A decrease in taxes A decrease in taxes increases planned expenditure (PE) by MPC × ΔT. Equilibrium moves from A to B; assuming MPC > 0.5, income rises by more than the decrease in T. Solving for ΔY Y = C + I + G equilibrium condition ΔY = ΔC + ΔI + ΔG in changes = ΔC as G and I are fixed = MPC x (ΔY - ΔT) as ΔC = MPC x (Δ Y – ΔT) Solving for ΔY: (1 - MPC) x ΔY = -MPC x ΔT Final result:  − MPC  ΔY =   × ΔT  1 − MPC  The tax multiplier, part 1 Definition: the change in income resulting from a $1 increase in T : ΔY − MPC = ΔT 1 − MPC If MPC = 0.8, then the tax multiplier equals ΔY − 0.8 − 0.8 = = = −4 ΔT 1 − 0.8 0.2 The tax multiplier, part 2 The tax multiplier is: negative: A tax increase reduces C, which reduces income. is greater than one (in absolute value) if MPC > 0.5: A change in taxes has a multiplier effect on income. smaller than the government 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. Effects of increasing I PE At Y1, PE =C +I2 +G there is now an unplanned drop PE =C +I1 +G in inventory… ΔI …so firms increase output, and income Y rises toward a new equilibrium. PE1 = Y1 ΔY PE2 = Y2 23 The IS curve Definition: a graph of all combinations of r and Y that result in goods market equilibrium Actual expenditure (output) = planned expenditure The equation for the IS curve is: Y = C (Y − T ) + I (r) + G Deriving the IS curve PE PE =Y PE =C +I (r )+G 2 r  I PE =C +I (r1 )+G  PE ΔI  Y Y1 Y2 Y r r1 r2 IS Y1 Y2 Y Intuition behind the negative slope of the IS curve 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 (Y) must increase. Fiscal policy and the IS curve We can use the IS–LM model to see how fiscal policy (G and T) affects aggregate demand and output. Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve... Shifting the IS curve: ΔG  Shifting the IS curve: ΔG At any value of r, G  PE  Y... so the IS curve shifts to the right. The horizontal distance of the IS shift equals 1 ΔY = ΔG 1− MPC Shifting the IS curve: ΔT The theory of liquidity preference Due to John Maynard Keynes A simple theory in which the interest rate is determined by money supply and money demand Money supply The supply of real money balances is fixed: (M P ) s =M P Money demand Demand for real money balances: (M P ) d = L(r ) Equilibrium Resulting in an equilibrium interest rate at r* How the Fed raises the interest rate A fall in the money supply shifts MS left … which raises the interest rate The LM curve Now let’s put Y back into the money demand function: (M P ) d = L(r,Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P = L(r,Y )  Deriving the LM curve As income increases from Y1 to Y2, money demand shifts out, increasing the interest rate. The LM curve summarizes these changes in the money market equilibrium. Why the LM curve is upward sloping An increase in income raises money demand. Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. The interest rate must rise to restore equilibrium in the money market.  How ΔM shifts the LM curve The Fed reduces the money from M1 to M2, causing interest rates to rise. This then results in the LM curve shifting up to LM2.  The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods and money markets: Y = C(Y − T ) + I (r ) + G M P = L(r ,Y ) The big picture  CHAPTER 14: IS-LM model how to use the IS-LM model to analyze the effects of shocks, fiscal policy, and monetary policy how to derive the aggregate demand curve from the IS-LM model several theories about what caused the Great Depression 42  Equilibrium in the IS -LM model The IS curve represents r equilibrium in the goods LM market. Y = C (Y − T ) + I (r ) + G r1 The LM curve represents money market equilibrium. M P = L (r ,Y ) IS Y The intersection determines Y1 the unique combination of Y and r that satisfies equilibrium in both markets.  Policy analysis with the IS -LM model Y = C (Y − T ) + I (r ) + G r LM M P = L (r ,Y ) We can use the IS-LM model to analyze the r1 effects of fiscal policy: G and/or T IS monetary policy: M Y Y1  An increase in government purchases 1. IS curve shifts right r 1 LM by G 1 − MPC causing output & r2 income to rise. 2. r1 2. This raises money demand, causing the 1. IS2 interest rate to rise… IS1 3. …which reduces investment, so Y Y1 Y2 the final increase in Y 3. 1 is smaller than G 1 − MPC  A tax cut Consumers save (1−MPC) of r the tax cut, so the initial LM boost in spending is smaller for ΔT than for an equal ΔG… r2 2. r1 and the IS curve shifts by −MPC 1. IS2 1. T IS1 1 − MPC Y Y1 Y2 2. …so the effects on r 2. and Y are smaller for ΔT than for an equal ΔG.  Monetary policy: An increase in M r 1. ΔM > 0 shifts LM1 the LM curve down (or to the right) LM2 2. …causing the interest r1 rate to fall r2 3. …which increases IS investment, causing Y Y 1 Y2 output & income to rise.  Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples: ▪ stock market boom or crash  change in households’ wealth  ΔC ▪ change in business or consumer confidence or expectations  ΔI and/or ΔC  Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money. Examples: ▪ A wave of credit card fraud increases demand for money. ▪ More ATMs or the Internet reduce money demand.  Effects of Housing market crash IS shifts left, causing r and Y to fall. r LM1 C falls due to lower wealth and lower r1 income, r2 I rises because r is lower IS1 IS2 u rises because Y Y2 Y1 Y is lower (Okun’s law) 50  Effects of Increase in money demand LM shifts left, causing LM2 r to rise and Y to fall. r LM1 I falls because r2 r is higher r1 C falls due to lower income, IS1 u rises because Y Y is lower Y2 Y 1 (Okun’s law) 51  Equilibrium in the IS -LM model The IS curve represents r equilibrium in the goods LM market. Y = C (Y − T ) + I (r ) + G r1 The LM curve represents money market equilibrium. M P = L (r ,Y ) IS Y The intersection determines Y1 the unique combination of Y and r that satisfies equilibrium in both markets.  IS-LM and aggregate demand So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed. However, a change in P would shift LM and therefore affect Y. The aggregate demand curve (introduced in Chapter 12) captures this relationship between P and Y.  Deriving the AD curve r LM(P2) Intuition for slope LM(P1) r2 of AD curve: r1 P  (M/P ) IS  LM shifts left Y2 Y1 Y P  r P2  I P1  Y AD Y2 Y1 Y  Monetary policy and the AD curve r LM(M1/P1) The Fed can increase r1 LM(M2/P1) aggregate demand: r2 M  LM shifts right IS  r Y1 Y2 Y P  I  Y at each P1 value of P AD2 AD1 Y1 Y2 Y  Fiscal policy and the AD curve r LM Expansionary fiscal policy (G and/or T ) increases r2 agg. demand: r1 IS2 T  C IS1 Y1 Y2 Y  IS shifts right P  Y at each P1 value of P AD2 AD1 Y1 Y2 Y  IS-LM and AD-AS in the short run & long run Recall from Chapter 12: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. In the short-run then over time, the equilibrium, if price level will Y Y rise Y Y fall Y =Y remain constant  The SR and LR effects of an IS shock r LRAS LM(P ) 1 A negative IS shock shifts IS and AD left, causing Y to fall. IS1 IS2 Y Y P LRAS P1 SRAS1 AD1 AD2 Y Y  The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y  Y IS1 IS2 Y Y P LRAS P1 SRAS1 AD1 AD2 Y Y  The SR and LR effects of an IS shock r LRAS LM(P ) 1 In the new short-run equilibrium, Y  Y IS1 IS2 Y Y Over time, P gradually falls, causing: P LRAS SRAS to move down P1 SRAS1 M/P to increase, which causes LM AD1 to move down AD2 Y Y  The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) IS1 IS2 Y Y Over time, P gradually falls, causing: P LRAS SRAS to move down P1 SRAS1 M/P to increase, which P2 SRAS2 causes LM AD1 to move down AD2 Y Y  The SR and LR effects of an IS shock r LRAS LM(P ) 1 LM(P2) This process continues until IS1 economy reaches a long- IS2 run equilibrium with Y Y Y =Y P LRAS P1 SRAS1 P2 SRAS2 AD1 AD2 Y Y Short Run & Long Run effects of Increase in M r LRAS LM(M /P ) 1 1 r1 IS Y Y P LRAS P1 SRAS AD1 Y Y 63  Short Run & Long Run effects of Increase in M LM and AD shift right. r LRAS LM(M /P ) 1 1 r1 LM(M2/P1) r2 r falls, Y rises above Y IS Y Y2 Y P LRAS P1 SRAS AD2 AD1 Y Y2 Y 64  Short Run & Long Run effects of Increase in M Over time, r LRAS LM(M /P ) 1 2 1 3 ▪ P rises r3 = r1 LM(M2/P1) ▪ SRAS moves upward r2 IS ▪ M/P falls ▪ LM moves leftward Y Y Y2 P LRAS New long-run eq’m P3 SRAS ▪ P higher P1 SRAS ▪ all real variables back at AD2 their initial values AD1 Money is neutral in the long run. Y Y2 Y 65 CHAPTER 19 About the size of the U.S. government’s debt and how it compares to that of other countries [About problems measuring the budget deficit] About the traditional and Ricardian views of the government debt  Gross Debt of General Government (2021) Country Government Debt as a Percentage of GDP Japan 256 Greece 224 Italy 173 United States 148 Portugal 144 Spain 143 United Kingdom 143 France 138 Canada 134 Belgium 129 Australia 84 Germany 77 Netherlands 67 Switzerland −42 Ratio of U.S. government debt to GDP Indebtedness of the world’s governments (2019) Country Government Debt as a Percentage of GDP Greece 139.2 Japan 125.2 Italy 121.7 Portugal 100.3 United States 84.5 Belgium 83.9 United Kingdom 79.9 Spain 78.3 France 77.5 Netherlands 31.6 Germany 29.9 Canada 23.0 Australia −11.5 Switzerland −12.4 The U.S. experience in recent years The 2008–2009 recession and its aftermath: huge spending increases; bailouts of banks (TARP) and auto industry, and a stimulus package (ARRA). TARP: 431 billion, ARRA: 787 billion. Weak recovery kept tax revenues low Covid-19 Recession: Multiple relief bills passed to help unemployed people and the economy CARES: 2.2 trillion, December 2020 bill: 900 billion. ARP: 1.9 trillion. Is government debt really a problem? Consider a tax cut with corresponding increase in the government debt. Two viewpoints: 1. Traditional view 2. Ricardian view The traditional view Short run: Y, u Long run: Y and u back at their natural rates r, I Very long run: slower growth until the economy reaches a new steady state with lower income per capita The Ricardian view Due to David Ricardo (1820), advanced more recently by Robert Barro. David Ricardo famously did not believe the idea that now has his name According to Ricardian equivalence, a debt- financed tax cut has no effect on consumption, national saving, the real interest rate, investment, net exports, or real GDP, even in the short run. The logic of Ricardian equivalence Consumers are forward-looking, know that a debt-financed tax cut today implies an increase in future taxes that is equal—in present value—to the tax cut. The tax cut does not make consumers better off, so they do not increase consumption spending. Instead, they save the full tax cut in order to repay the future tax liability. Result: Private saving rises by the amount public saving falls, leaving national saving unchanged. Problems with Ricardian equivalence Myopia: Not all consumers think so far ahead; some see the tax cut as a windfall. Borrowing constraints: Some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut. Future generations: If consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending. CHAPTER 21 Functions of a healthy financial system Common features of financial crises Government policies to alleviate or prevent crises WHAT THE FINANCIAL SYSTEM DOES 1. Financing investment 2. Sharing risk 3. Dealing with asymmetric info 4. Fostering economic growth WHAT THE FINANCIAL SYSTEM DOES 1. Financing investment, part 1 The financial system helps channel funds from savers—households with income they do not need to spend immediately...... to investors—firms that need funds to finance investment projects WHAT THE FINANCIAL SYSTEM DOES 1. Financing investment, part 2 financial system: the institutions in the economy that facilitate the flow of funds between savers and investors The financial system includes financial markets, like the stock market, through which households directly provide funds for investment financial intermediaries, like banks or mutual funds, through which households indirectly provide funds for investment WHAT THE FINANCIAL SYSTEM DOES 1. Financing investment, part 3 debt finance: selling bonds to raise funds for investment A bond represents a loan from the bondholder to the firm. equity finance: selling stock to raise funds for investment A share of stock represents an ownership claim by the shareholder in the firm. WHAT THE FINANCIAL SYSTEM DOES 1. Financing investment, part 4 Financial intermediaries accept funds from savers and direct them to investors. For example, banks accept deposits from households and make loans to firms. Other examples: mutual funds, pension funds, and insurance companies WHAT THE FINANCIAL SYSTEM DOES 2. Sharing risk, part 1 Many people are risk averse: other things equal, they dislike uncertainty. The financial system allows people to share risks: Investors can share the risk that their projects will fail with the savers who provide the funds. Savers may be willing to accept these risks for the prospect of a higher return than they could earn otherwise. WHAT THE FINANCIAL SYSTEM DOES 2. Sharing risk, part 2 Many people are risk averse: other things equal, they dislike uncertainty. The financial system allows people to share risks: Savers can reduce risk through diversification: providing funds to many different investors with uncorrelated assets. Diversification can reduce idiosyncratic risks, risks that differ across individual businesses. Diversification cannot reduce systematic risks, which affect most/all businesses. WHAT THE FINANCIAL SYSTEM DOES 3. Dealing with asymmetric information, part 1 asymmetric information: a situation in which one party to a transaction has more information about it than the other party adverse selection: a situation in which people with hidden knowledge about attributes sort themselves in a w