Transcript Slide 1

Great divide of macroeconomics
Aggregate demand
and business cycles
Aggregate supply
and “economic growth”
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The Great Divide
Classical macro:
- Full employment
- Flexible wages and prices
- Perfect competition and rational expectations
- Only “real” business cycles, and all unemployment is voluntary
and efficient
Keynesian macro:
- Underutilized resources
- Inflexible (or fixed) wages and prices
- Imperfect competition and behavioral expectations
- Yes, business cycles, with persistent slumps, involuntary
unemployment, and macro waste.
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Understanding business cycles
Major elements of cycles
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short-period (1-3 yr) erratic fluctuations in output
pro-cyclical movements of employment, profits, prices
counter-cyclical movements in unemployment
appearance of “involuntary” unemployment in recessions
Historical trends
– lower volatility of output, inflation over time (until 2008)
– movement from stable prices to rising prices since WW II
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The incomplete recovery
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Full employment
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1950
1960
1970
1980
1990
2000
2010
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Shaded areas are NBER recessions.
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Output gaps and the business cycle
17,000
Potential GDP
Actual GDP
16,500
16,000
15,500
15,000
Large
GDP “gap”
14,500
14,000
13,500
2005
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2006
2007
2008
2009
2010
2011
2012
2013
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“The Great Moderation on Output”
Volatility of Real GDP Growth
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STANDARD
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Definition of volatility (often used in finance):
the standard deviation of returns or rates of growth, usually at an
annual rate.
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“The Great Moderation on Inflation”
Volatility of inflation
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STANDARD
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IS-MP model
The major tool for showing the impact of monetary and
fiscal polices, along with the effect of various shocks, in a
short-run Keynesian situation.
The “MP” function replaces the “LM” function, which is
obsolete. Check the reading list very carefully!
Key assumptions in short-run macro model:
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Fixed prices (P=1 and π = 0); or can have fixed inflation.
Unemployed resources (Y < potential Y = Mankiw’s natural Y)
Closed economy (inessential and considered later)
Goods markets (IS) and financial markets (MP)
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IS curve (expenditures)
Basic idea: describes equilibrium in goods market.
Finds Y where planned I = planned S or planned
expenditure = planned output.
Basic set of equations:
1.
2.
3.
4.
5.
Y=C+I+G
C = a + b(Y-T)
T = T0 + τ Y
I = I0 – dr
G = G0
[note assume income tax, τ = marginal tax rate]
[note i = r because zero inflation]
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r = real
interest rate
IS diagram
which gives the IS curve:
(IS) Y =
(IS)
Y
E
re
a - bT0 + G0 + I0 - dr
1 - b(1- τ)
= μ [A0 - dr]
IS(G, T0, …)
Ye
Y = real output (GDP)
where
A0 = autonomous spending = a - bT0 + G0 + I0
μ = simple Keynesian multiplier = 1/[(1 - b(1- τ)]
which we graph as the IS curve.
Note that changes in fiscal policy, investment “animal spirits,”
consumption wealth effect SHIFT IS CURVE
HORIZONTALLY.
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IS curve
r = real
interest rate
IS(G, T0, …)
Y = real output (GDP)11
IS curve
r = real
interest rate
IS(G’, T0, …)
IS(G, T0, …)
Y = real output (GDP)12
MP curve (monetary policy/financial markets)
The simplest MP curve says that the Fed sets the short
term interest rate (i). With given inflation, this gives
real interest rate:
So with Fed setting the interest rate, this is simple MP
curve:
(MP)
r=i-π
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IS-MP diagram
r = real
interest rate
E
re
MP(π*)
IS(G, T0, …)
Ye
Y = real output (GDP)14
… to the real stuff
• In reality, the Fed has a “dual mandate”(see below).
• This is usually represented by the Taylor rule, so let’s go
there.
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The Dual Mandate
Fed’s dual mandate (Federal Reserve Act as amended):
“promote effectively the goals of maximum employment, stable
prices and moderate long-term interest rates.”
In practice (FOMC statement January 2012):
“The Committee judges that inflation at the rate of 2 percent, as
measured by the annual change in the price index for personal
consumption expenditures, is most consistent over the longer
run with the Federal Reserve's statutory mandate.”
“The maximum level of employment is largely determined by
nonmonetary factors that affect the structure and dynamics of
the labor market…In the most recent projections, FOMC
participants' estimates of the longer-run normal rate of
unemployment had a central tendency of 5.2 percent to 6.0
percent”
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MP curve with the dual mandate
The Taylor Rule
Begin with a monetary policy equation in the form of a “Taylor rule”:
(TR)
i = π + r* + b(π-π*) + cy
r* is the equilibrium real interest rate, π inflation rate, π* is inflation
target, y is log output gap [log(Y/Yp)], b and c are parameters.
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Actual and Taylor rule federal funds rate
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Actual
Taylor rule
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MP curve with the dual mandate
The Taylor Rule
Begin with a monetary policy equation in the form of a “Taylor rule”:
(TR)
i = π + r* + b(π-π*) + cy
r* is the equilibrium real interest rate, π inflation rate, π* is inflation
target, y is log output gap [log(Y/Yp)], b and c are parameters.
2. Assume for now that inflation is at target.
So π = π* and we have financial market:
(MP)
r = r* + cy
Later on, we will introduce inflation.
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MP curve with inflation
Now add inflation to the MP curve.
Assume that inflation is a function of output (this will be done later):
(PC)
π = π*+φ y + η (η =inflation shock)
(TR)
i = π + r* + b(π-π*) + cy
So new MP curve is:
i = π + r* + b(φ y + η ) + cy
or
(MP)
i = π + r* + (bφ+c) y + bη
So adding inflation makes the MP curve steeper, but does not change
the basic structure..
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Algebra of IS-MP Analysis
• The analysis looks at simultaneous equilibrium in goods
market and financial markets (Main St and Wall St).
• The algebraic solution for equilibrium Ye is:
Ye = μ*A0 – μ* d r*
where μ* = μ/(1 + μdc) = multiplier with monetary policy.
μ = simple multiplier > μ* ; A0 = autonomous spending
= a - bT0 + G0 + I0 ,
Note impacts on output:
Positive: G, I0, NX
Negative: risk premium (and later inflation shock)
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IS-MP diagram
r = real
interest rate
MP(r*)
E
re
IS(G, T0, …)
Ye
Y = real output (GDP)
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1. What are the effects of fiscal policy?
• A fiscal policy is change in purchases (G) or in taxes (T0, τ),
holding monetary policy constant.
• In normal times, because MP curve slopes upward,
expenditure multiplier is reduced due to crowding out.
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IS shock (as in fiscal expansion)
MP
i
IS(G’)
IS(G)
Y = real output (GDP)
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Multiplier Estimates by the CBO
3.0
Multiplier from G,T on GDP
2.5
2.0
1.5
1.0
0.5
0.0
G: Fed
G: S&L
Trans: indiv
Tax:
Mid/Low
Income
Tax: High
Income
Congressional Budget Office, Estimated Impact of the ARRA, April 2010
Bus Tax
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Inflationary shock
MP(ηt > 0)
MP(ηt = 0)
i
it**
IS
Yt**
Y = real output (GDP)
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