AB 106 Lecture 11 2010

8/6/2019 AB 106 Lecture 11 2010

1/77

Ke nesian Model Assumes constant Prices

What happens if prices change?

Wealth Effect: They feel poorer. They buy less.Businessmen invest less as a result.

Substitution Effect: Things are more expensivenow and in future, things may be cheaper. Theybu less now.

We export less too and we import more asimported goods are cheaper.

(1) The AE curve shifts down when the price levelrises due to wealth effect

2 e curve s ts up w en wea t ncreases

via upward shift of the consumption function.

8/6/2019 AB 106 Lecture 11 2010

2/77

Keynesian Model is Demand-Driven Model

Keynesian Model

AE Higher expenditure implieshigher income, (Y)

AE

Assumes constant pricesbut what are prices? Pricesare measured in terms of

0money. What is money? What is the

rice of mone ? It is interestrate.

Along the AE line, interestrate is constant but will it

Y = GDP

Y0 Y* Y

change? Would the changeaffect the AE line?

= Income=Aggregate Expenditure

affects investment and also

consumption

8/6/2019 AB 106 Lecture 11 2010

3/77

The Central Bank can change quantity of money (M)

.

M = Money Multiplier (k) . Monetary Base (MB)

= . ; = . qua on

1. Required reserve ratios; raising b will reduce

2. Discount rate; Lowering discount willencourage banks to borrow more and hence

MB and therefore M will increase3. Open market operations: Sales of bonds to

and M will fall.

8/6/2019 AB 106 Lecture 11 2010

4/77

Relation between Aggregate Demand and ther ce eve

Keynesian Model

AE0(P0) = f(G0, T0)0

AE0(P1) = f(G0, T0),

AE

0 1> 0

Y=Real GDPY0(P0)Y0(P1)P

P0 H

P1 H0 Curve, AD0(G0,T0)

Y0Y1

AD0(G0,T0)

Y

8/6/2019 AB 106 Lecture 11 2010

5/77

Monetary Policy and Keynesian Model

Keynesian ModelAE

H11 1 1

AE0 = a bT + I0(i 0 ) + G + bY

H0 Increase money supply (MS),

interest rate falls from i0 to i1.0

I1, shifting AE upward (Increase in MS has increased Y)

=

Y0 YY1

= Income=Aggregate Expenditure

8/6/2019 AB 106 Lecture 11 2010

6/77

Relation between Aggregate Demand and thepr ce eve a ng n o accoun one ary o cy

Keynesian Model

AE0(P0) = f(G0, T0, MS0)H0

AE0(P1) = f(G0, T0, MS0)

0 P1 > P 0

Y=Real GDPY0(P0)Y0(P1)

P0 H0

P1 H0 Curve, AD0(G0, T0, MS0)

Y0Y1

AD0(G0, T0, MS0)

8/6/2019 AB 106 Lecture 11 2010

7/77

Aggregate Supply and

Aggregate Demand

8/6/2019 AB 106 Lecture 11 2010

8/77

GDP* is full employment output. Also known aspotential output

GDP2

Production Function

GDP

GDP* En is full employment level whenthe unemployment rate is un

Recessionary output gap = u1 >

un

Inflationary output gap = un > u2

En

Unemployment rateunu1 u2

4% 3%5%

8/6/2019 AB 106 Lecture 11 2010

9/77

The ClassicalModel determinesfull employment

n

E

unEmployment

8/6/2019 AB 106 Lecture 11 2010

10/77

The macroeconomic long run is a time frame that issufficiently long for the real wage rate to haveadjusted to achieve full employment:

Real GDP equals potential GDP.Unemployment is at the natural unemploymentrate.

money.

8/6/2019 AB 106 Lecture 11 2010

11/77

The macroeconomic short run a period during whichsome moneyprices are sticky so that

Real GDP might be below, above, or at potential

GDP.The unemployment rate might be above, below, orat the natural unemployment rate.

.

8/6/2019 AB 106 Lecture 11 2010

12/77

We have a re ate demand curve linkin a re ate

demand to prices.Where is the aggregate supply curve, linking output to

pr ces

, ,is no output!

8/6/2019 AB 106 Lecture 11 2010

13/77

Production function is the factory. But we wantoutput to link with prices?

GDP2

Production Function

GDP

GDP* En is full employment level whenthe unemployment rate is un

Recessionary output gap = u1 >u

nInflationar out ut a = u > u

n

Unemployment rateunu1 u24% 3%5%

8/6/2019 AB 106 Lecture 11 2010

14/77

The quantity of real GDP suppliedis the total

period. It depends on The quantity of the labor employed The quantity of physical and human capital State of technology

A re ate su l is the relationshi between thequantity of real GDP supplied and the price level.

We distinguish two time frames associated with

Long-run aggregate supply Short-run aggregate supply

8/6/2019 AB 106 Lecture 11 2010

15/77

8/6/2019 AB 106 Lecture 11 2010

16/77

Long-run Aggregate Supply

Along the LAScurve,all prices and wagera es c ange y e

same percentage sorelative prices and thereal wage rate remainconstant. Hence, the

supplied remains atpotential GDP.

Money: Fixed output, higher

MS

higher price level

8/6/2019 AB 106 Lecture 11 2010

17/77

Short-Run A re ate Su l

Short-run aggregate supply is the relationshipbetween the quantity of real GDP supplied and thepr ce eve w en e money wage ra e, e pr ces oother resources, and potential GDP remain

constant.

A rise in the price level with no change in themoney wage rate and other factor prices increases

the quantity of real GDP supplied.

8/6/2019 AB 106 Lecture 11 2010

18/77

-

CSB version Price

From a to b, pricesdo not rise as output

d

(Keynesian range)

From b to c, prices

SAS

start to rise. Oncereal output exceedsGDP* rices rise

a bc

significantlyY=Real GDP

GDP*

8/6/2019 AB 106 Lecture 11 2010

19/77

Short-run Aggregate Supply The SAScurve is

upward-sloping because:

A rise in the price level

with no change in costsinduces firms to bear ahigher marginal cost

and increase

A fall in the price levelwith no change in costs

induces firms todecrease production to

.

Real GDP suppliedincreases if P increases

8/6/2019 AB 106 Lecture 11 2010

20/77

Aggregate Supply

Movements Along theLASand SASCurves

A change in the pricelevel with an equalpercentage c ange nthe money wage

causes a movementalong the LAScurve.

No change in the

money wage means amovement along theSAScurve.

8/6/2019 AB 106 Lecture 11 2010

21/77

Aggregate Supply

ven money wage rate,at P = 115, SAScutsLAScurve at otential

GDP. Given the money wage,,

real GDP supplied

decreases along thecurve.

With the given moneywage rate, as P rises

above 115, real GDPsupplied increases

. Real GDP exceeds

potential GDP.

8/6/2019 AB 106 Lecture 11 2010

22/77

A re ate Su l

Aggregate supply changes if an influence onproduction plans other than the price levelchanges.

These influences include a change in: Potential GDP

Money wage rate and other factor prices

8/6/2019 AB 106 Lecture 11 2010

23/77

Changes in Aggregate Supply

en potent a ncreases, ot t e an

SAScurves shift rightward.

, :

The full-employment quantity of labor

The quantity of capital (physical or human)changes

Technology advances

8/6/2019 AB 106 Lecture 11 2010

24/77

An increase in

potent a s ts

the LAScurve and theSAScurve shifts alonwith the LAScurve.

CSB version: the shiftof SAS is notpermanent.

ence, c ange nwill not cause SAS toshift

8/6/2019 AB 106 Lecture 11 2010

25/77

Aggregate Supply

Suppose unions askfor higher wages

A rise in the moneywage rate decreasess or -run aggrega esupply and shifts

the SAScurveleftward.

It has no effect on

long-run aggregatesupply.

8/6/2019 AB 106 Lecture 11 2010

26/77

From Lecture 10: Relation between Aggregate

eman an e r ce eve

Keynesian Model

AE0(P0) = f(G0, T0)0

AE0(P1) = f(G0, T0),

AE

0 1> 0

Y=Real GDPY0(P0)Y0(P1)P

P0 H

P1 H0

Curve, AD0(G0,T0)

Y0Y1

AD0(G0,T0)

Y

8/6/2019 AB 106 Lecture 11 2010

27/77

The ADcurve slopesdownward for tworeasons:

wea e ec

Substitution effect

Y

8/6/2019 AB 106 Lecture 11 2010

28/77

Wealth Effect

A rise in the price level, other things remaining thesame, decreases the quantity of real wealth (money,stoc s, etc. .

To restore their real wealth, people increase saving.

The quantity of real GDP demanded decreases.

Similarly, a fall in the price level, other thingsremaining the same, increases the quantity of real

demanded increases.

8/6/2019 AB 106 Lecture 11 2010

29/77

Substitution Effects

Intertemporal substitution effect: A rise in the rice level other thin s remainin the

same, decreases the real value of money andraises the interest rate.

en e n eres ra e r ses, peop e orrow anspend less so the quantity of real GDP demandeddecreases.

Similarly, a fall in the price level increases the realvalue of money and lowers the interest rate.

When the interest rate falls, people borrow and

spend more so the quantity of real GDP demandedincreases.

8/6/2019 AB 106 Lecture 11 2010

30/77

A rise in the price level, other things remaining thesame, increases the rice of domestic oodsrelative to foreign goods.

So imports increase and exports decrease, which.

Similarly, a fall in the price level, other thingsremainin the same increases the uantit of real

GDP demanded.

8/6/2019 AB 106 Lecture 11 2010

31/77

Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs

the quantity of real GDP supplied at the point of

intersection of the ADcurve and the SAScurve.

8/6/2019 AB 106 Lecture 11 2010

32/77

Macroeconomic Equilibrium

SR macroeconomicequilibrium occurs when realGDP demanded = real GDP

of ADand SAS When price is 105, AD > AS:

inventory down, firmsincrease production and

raise prices

When price is 125, AD< AS,inventory up, firms decrease

These changes bring amovement alon the SAScurve towards equilibrium.

Y* not shown here

8/6/2019 AB 106 Lecture 11 2010

33/77

Long-Run Macroeconomic Equilibrium Long-run macroeconomic equilibrium occurs when

real GDP equals potential GDPwhen the economyis on its LAScurve.

-the ADand LAScurves.

8/6/2019 AB 106 Lecture 11 2010

34/77

A is the long-run

e uilibrium wherethree lines meet.

Long-run equilibriumoccurs when themoney wage has

ad usted to ut the A

SAScurve throughthe long-run

.

GDP*

8/6/2019 AB 106 Lecture 11 2010

35/77

Fluctuations in

Aggregate Demand

We start at A.

Now, an increase inaggregate demandshifts the ADcurve

B

.

Firms increaseroduction and the

price level rises inthe short run at B

8/6/2019 AB 106 Lecture 11 2010

36/77


At the short-runequilibrium at B,there is an

inflationary gap.

C

e money wage ra ebegins to rise and

the SAScurve starts

B

to shift leftward.

B moves up until the

economy hasreturned to full-em lo ment at C.

8/6/2019 AB 106 Lecture 11 2010

37/77

Recessionary Output Gap-

A is SR point. Y0 is belowY*.

LAS

Pricelevel

gap at A.

wage (price) level will SAS.

This will cause SAS to shiftto SAS to reach B, LR

ASAS

.

A to B will take a while asthe economy is self-correcting.

BAD

The government can usefiscal or monetary policy toshift AD to AD.

AD

The LR point is C, back tofull employment but at ahigher price level.

Y0 Y*

8/6/2019 AB 106 Lecture 11 2010

38/77

AD-AS Model A is SR point. Y0 is

*

LASPricelevel

SAS.

a inflationary outputgap at A.

SAS

C will rise.

This will cause SAS to

shift to SAS to reach C,A

po nt. The government can

use fiscal or monetaryolic to shift AD to

D

AD. The new LR point is D,back to full employment

ADAD

level. Y0Y* Y

8/6/2019 AB 106 Lecture 11 2010

39/77

Case 1: Increase in Y* A is LR point.

The LAScurve shifts

rightward because ofhigher productive

SAS0

capacity

A is now SR point. It has

a recessionar out ut

A

gap. Wages (prices) willfall.

SAS1

meet AD at LAS1

Higher output and lower

B

pr ce eve rom oY*Y*

8/6/2019 AB 106 Lecture 11 2010

40/77

Case 1: Increase in Y*

From A to B is a longprocess. The

0

C

AD to AD and the LR

point is C.A SAS1

Back to fullemployment outputfaster but the rice

AD

level is higher. A to C is unlikely

B

ecause t s s a

case of higher Y*

Y*Y*

8/6/2019 AB 106 Lecture 11 2010

41/77

Macroeconomic E uilibrium

Case 2: Shift in AD

An increase in aggregateSAS1

demand shifts the ADcurve

rightward.

C

,output gap. Wages (prices)will rise shifting SAS0 to

SAS A

C is the LR point.

A to B, output and prices

rise. From B to C, higherprice level.

8/6/2019 AB 106 Lecture 11 2010

42/77

Case 2: Shift in AD

demand shifts the ADcurve rightward.

The best way to counterthe unexpected rise in

aggregate demand is to Apolicy to shift AD1 back toAD0.

Hence, there is no Cand the economy willmove from B to A.

8/6/2019 AB 106 Lecture 11 2010

43/77


Workers demand

higher wages, shiftingSAS0 to SAS1.

Real GDP and P . B From A to B, the

economy experiences

sta flation. A

B is a SR point, arecessionary outputgap.

Wages will fall

SAS1 back to SAS0,

from B to A, back to

8/6/2019 AB 106 Lecture 11 2010

44/77

Case 3: Rise in oil

prices

From B to A is a

long process.Unemployment B

C

level is notacceptable.

Most overnments Awill use fiscal ormonetary policy toshift AD to AD1. AD1

C is the LR point.Same output but

8/6/2019 AB 106 Lecture 11 2010

45/77

schools of thought: Classical

Keynesian

8/6/2019 AB 106 Lecture 11 2010

46/77

The Classical View

c ass ca macroeconom st e eves t at t e

economy is self-regulating and always at fullem lo ment.

The term classical derives from the name of the

founding school of economics that includes AdamSmith, David Ricardo, and John Stuart Mill.

A new classical view is that business cycleuc ua ons are e e c en responses o a we -

functioning market economy that is bombarded byshocks that arise from the uneven ace oftechnological change.

8/6/2019 AB 106 Lecture 11 2010

47/77

The Keynesian View

eynes an macroeconom s e eves a e

alone, the economy would rarely operate at fullemployment and that to achieve and maintain fullemployment, active help using fiscal policy andmonetary policy is required.

The term Keynesian derives from the name of oneof the twentieth centurys most famous economists,John Ma nard Ke nes.

A new Keynesian view holds that not only is themoney wage rate sticky but the prices of goods arealso sticky.

8/6/2019 AB 106 Lecture 11 2010

48/77

The Monetarist View

A monetarist is a macroeconomist who believesthat the economy is self-regulating and that it willnorma y operate at u emp oyment, prov ethat monetary policy is not erratic and that the

ace of mone rowth is ke t stead .

The term monetarist was coined by anoutstanding twentieth-century economist, Karl

Brunner, to describe his own views and those ofMilton Friedman.

8/6/2019 AB 106 Lecture 11 2010

49/77

U.S. Inflation, Unemployment,

and Business Cycle

8/6/2019 AB 106 Lecture 11 2010

50/77

In the 1970s, when inflation was raging at a double-

digit rate, Arthur M. Okun proposed a Misery Indexthe inflation rate plus the unemployment rate.

At its peak, in 1980, the misery index hit 22.

At its lowest, in 1953, the misery index was 3.

Inflation raises our cost of living.

Unemployment hits us directly or it scares us intothinking that we might lose our jobs.

We want low inflation and low unemployment.

Can we have both together? Or do we face a tradeoffbetween them?

8/6/2019 AB 106 Lecture 11 2010

51/77

8/6/2019 AB 106 Lecture 11 2010

52/77

8/6/2019 AB 106 Lecture 11 2010

53/77

Starting from full

C

,increase in aggregatedemand moves us to

B

The price level rises, A

higher wages, thismoves us from B to

C. AD will shift up

pers s en y

Inflation Cycles

8/6/2019 AB 106 Lecture 11 2010

54/77

Inflation Cycles

Process

A demand-pull inflationspiral goes from A to B to C

to D to E. D

increasing and the process

just described repeatsB

C

indefinitely.

Although any of several

A

aggregate demand to starta demand-pull inflation,on y an ongo ng ncrease nthe quantity of money can

sustain it.

8/6/2019 AB 106 Lecture 11 2010

55/77

Cost-Push Inflation

An inflation that starts with an increase in costs iscalled cost- ush inflation.

There are two main sources of increased costs:

. 2. An increase in the money price of raw materials,

such as oil.

8/6/2019 AB 106 Lecture 11 2010

56/77

The initial increase in costs creates a one-timerisein the price level, not inflation.

To create inflation, aggregate demand must

increase. That is, the Fed must increase the quantity of

money persistently.

Inflation Cycles

8/6/2019 AB 106 Lecture 11 2010

57/77

Inflation Cycles

We are at A.

A rise in the price of oilcauses increase the cost

of living and workersdemand hi her wa es, B

C

the SAScurve shifts up,we move from A to B

t , recess onary gap

Suppose that the Fed

demand. This moves theeconomy from B to C.

Real GDP and P again

A Cost-Push Inflation Process

8/6/2019 AB 106 Lecture 11 2010

58/77

A Cost Push Inflation Process

At D, workers againask for higher wages

E

responds byincreasing the MS (D

D

to E),

The combination of B

a r s ng pr ce eveand a decreasingreal GDP is called

A

stagflation (A to Band C to D).

8/6/2019 AB 106 Lecture 11 2010

59/77

Fiscal Policy

PP.731-735

The Supply Side Effects of

8/6/2019 AB 106 Lecture 11 2010

60/77

The Supply-Side Effects of

Fiscal Policy

Fiscal policy has important effects employment,

potential GDP, and aggregate supplycalled- .

An income tax changes full employment and

otential GDP.

8/6/2019 AB 106 Lecture 11 2010

61/77

Fiscal policy actions that seek to stabilize theus ness cyc e wor y c ang ng aggrega e

demand.

Automatic

Discretionar fiscal olic is a olic action that isinitiated by an act of Congress.

Automatic fiscal policy is a change in fiscal policy

triggered by the state of the economy.

Stabilizin the Business C cle

8/6/2019 AB 106 Lecture 11 2010

62/77

Stabilizin the Business C cle

Limitations of Discretionary Fiscal Policy

The use of discretionary fiscal policy is seriously

hampered by three time lags:

Recognition lagthe time it takes to figure outthat fiscal policy action is needed.

- pass the laws needed to change taxes orspending.

Impact lagthe time it takes from passing a tax orspending change to its effect on real GDP being.

8/6/2019 AB 106 Lecture 11 2010

63/77

Automatic Stabilizers

real GDP without explicit action by the government.

Induced taxes and needs-tested spending areautomatic stabilizers.

Taxes that vary with real GDP are called inducedaxes.

When real GDP increases in an expansion, wages and,

taxesrise.

profits fall, so the induced taxes on these incomes fall.

Stabilizing the Business Cycle

8/6/2019 AB 106 Lecture 11 2010

64/77


The spending on programs that pay benefits tosuitably qualified people and businesses is callednee s-teste spen ng.

When the economy is in a recession, unemployment-

unemployment benefits and food stamps increases.

When the econom ex ands unem lo ment fallsand needs-tested spending decreases.

Induced taxes and needs-tested spending decrease

the multiplier effects of changes in autonomousexpenditure.

and make real GDP more stable.

8/6/2019 AB 106 Lecture 11 2010

65/77

Discretionary FiscalExpansionary Fiscal Policy

Fiscal policy mightclose a recessionary

.

An increase in

expenditure or a taxcut increases

The multiplier processincreases aggregate

eman urt er.

8/6/2019 AB 106 Lecture 11 2010

66/77

A Reality Check

8/6/2019 AB 106 Lecture 11 2010

67/77

y

Budget Deficit Over theBusiness Cycle

Figure (b) shows the

business cycle from1980 to 2005.

highlighted.

During a recession,the budget deficit

increases.

8/6/2019 AB 106 Lecture 11 2010

68/77


8/6/2019 AB 106 Lecture 11 2010

69/77

g y

This figureillustrates thedistinction between

a structural andc clical sur lus anddeficit.

In part (a), potentialGDP is $12 trillion.

As real GDPfluctuates aroundpotential GDP, ac clical deficit orcyclical surplus

arises.


8/6/2019 AB 106 Lecture 11 2010

70/77

g y

Singapores position A B C

where there has been

budget surplus at full.

Some countries such

represented by Awhere at fullemp oymen , ere s

still budget deficit.

8/6/2019 AB 106 Lecture 11 2010

71/77

Monetary Policy

Fight Recession with Monetary Policy

8/6/2019 AB 106 Lecture 11 2010

72/77

A represents recession. Increase MS increasessupply of loanable funds in the short-term. Results

MS0Interestrate

SASLASMS1

A

B

AD MSMD

1

MY

8/6/2019 AB 106 Lecture 11 2010

73/77

8/6/2019 AB 106 Lecture 11 2010

74/77

Loose Links and Long and Variable Lags

Long-term nterest rates t at n uence spen ng

plans are linked loosely to the federal funds rate.-

change in the nominal rate depends on how

inflation expectations change. The response of expenditure plans to changes in

the real interest rate depends on many factors thatma e t e response ar to pre ct.

The monetary policy transmission process is long

same way.

Monetary Policy Transmission

8/6/2019 AB 106 Lecture 11 2010

75/77

A Reality Check When the Fed

ushes thefederal funds rate

abovethe long-term bond rate,e rea

growth rate slowsin the following

. When the Fed

lowers the federal

the long-termbond rate, the

rate speedsup inthe next year.

8/6/2019 AB 106 Lecture 11 2010

76/77

Production function is the factor

But we want the aggregate supply curve

AD-AS model

Demand-pull inflation

Cost-push inflation

Budget deficits: Cyclical and structural

Which is better: fiscal or monetary?

8/6/2019 AB 106 Lecture 11 2010

77/77

Documents

AB 106 Lecture 11 2010