Transcript Slide 1

Midterm info
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Wed Oct 12, 11:35-12:50
Place: TBA
Covers: everything to next Monday
Review sessions: M and T, 5 – 9, LC 211
Last year’s exam as an example (no answers)
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Business cycles and
short run macro
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Let’s review our voyage to date:
We have analyzed:
• Measuring economic activity
• Aggregate production functions and distribution
• Classical AS and AD (flexible w and p)
• Financial macro (including money)
• Open-economy macro
We now move on to
• Business cycles, Keynesian economics, and the ISMP model
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The Great Divide
Classical macro:
- full employment
- flexible wages and prices
- Perfect competition and rational expectations
- No business cycles (or “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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Output gaps and business cycles
15,000
Potential (full employment) real GDP
Actual real GDP
14,500
14,000
Large
GDP “gap”
13,500
13,000
12,500
12,000
2004
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2005
2006
2007
2008
2009
2010
2011
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Unemployment and recessions
Unemployment rates and recessions
Unemployment rate (% of labor force)
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10
9
8
7
6
5
4
3
70
75
80
85
90
95
00
05
10
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Unemployment and vacancies (2000-2011)
4.0
2000
Vacancy rate (%)
3.6
3.2
2.8
2011
2.4
2.0
1.6
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3
4
5
6
7
8
9
10
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Unemployment rate (%)
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Major approaches to business cycles
• “Keynesian cross” (Econ 116): useful for intuition
• AS-AD with p and Y (Econ 116): needs updating and will
not use
• IS-LM: from earlier era
• IS-MP (Econ 122)
• Mankiw’s dynamic model: mainstream modern
Keynesian macro
• Open-economy in short run: Mundell-Fleming: Very
important approach to open economy
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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.
Key assumptions
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Fixed prices (P=1 and π = 0)
Unemployed resources (Y < potential Y = Mankiw’s natural Y)
Closed economy (not essential and will be 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:
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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 fixed P]
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r = real
interest rate
IS diagram
which gives the IS curve:
a - bT0 + G0 + I0 - dr
1 - b(1- τ)
Y =
Y
E
re
= 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)]
or in terms of solving for the interest rate:
r = (A0 - Y/μ ) / d
which we graph as the IS curve.
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MP curve (monetary policy/financial markets)
The MP curve represents equilibrium in financial markets.
1. Monetary Policy: 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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Taylor rule and actual
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8
6
4
2
0
Actual fed funds rate
Taylor rule prediction
-2
-4
90
92
94
96
98
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02
04
06
08
10
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MP curve (monetary policy/financial markets)
The MP curve represents equilibrium in financial markets.
1. Monetary Policy: 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. We will ignore inflation for now to simplify. Add that after have
studied. So π = π* = 0 and we have financial market:
(MP)
r = r* + cy
Later on, we will introduce inflation in the TR and MP.
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• The analysis looks at simultaneous equilibrium in goods
Algebra
of
IS-MP
Analysis
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)
*** There is a small technical issue in the algebra here. The Taylor rule has r as a function of
y = ln(Y/Yp), whereas the IS is Y = f(r). We want to keep the Y in the equation because
mulitpliers are dY/dG (see CBO figure below). And Taylor rule is in y (or sometimes
u). So we need a change of variable. The best way is to use Taylor approximation
(different Taylor), that ln(1+x)= x +o(x2) for x close to zero. So ln (1+Y/Yp-1) ≈ Y/Yp-1,
so we substitute that into the MP. This will give new c’ = cYp. Analysis is identical. 16
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, t),
holding monetary policy constant.
• In normal times, because MP curve slopes upward,
expenditure multiplier is reduced due to crowding out.
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Fiscal policy in normal times
r = real
interest rate
MP
re
IS’
IS
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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What about the abnormal times?
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US short-term interest rates, 1929-45 (% per year)
Liquidity
trap in US in
Great
Depression
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4
3
2
1
0
1930
1932
1934
1936
1938
1940
1942
1944
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US in current recession
Federal funds rate (% per year)
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Policy has
hit the
“zero lower
bound”
three years
ago.
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12
8
4
0
1975
1980
1985
1990
1995
2000
2005
2010
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Japan short-term interest rates, 1994-2010
Liquidity trap from 1996 to today:
15 years and counting.
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Fiscal policy in liquidity trap
r = real
interest rate
IS
IS’
MP
re
Y = real output (GDP)
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Can you see why macroeconomists emphasize the
importance of fiscal policy in the current environment?
“Our policy approach started with a major commitment to fiscal
stimulus. Economists in recent years have become skeptical about
discretionary fiscal policy and have regarded monetary policy as a
better tool for short-term stabilization. Our judgment, however, was
that in a liquidity trap-type scenario of zero interest rates, a
dysfunctional financial system, and expectations of protracted
contraction, the results of monetary policy were highly uncertain
whereas fiscal policy was likely to be potent.”
Lawrence Summers, July 19, 2009
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Case 2. Monetary policy
The MP curve represents monetary policy.
That is, the central bank responds by lowering (raising)
interest rates when output declines (rises).
- somewhat confusing because Fed actually has discretion, so in a
sense the Taylor rule is a forecast of how Fed will act given the
economy and its objectives
Note that cannot follow Taylor rule in liquidity trap (when
nominal short risk-free rates are near zero).
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Case 3. Monetarism
Older approach that emphasized the supply of money.
Very important tradition, particularly Friedman and
Schwartz, A Monetary History of the United States.
Deemphasized in Econ 122, but still important in many
other views of macro (warning about dissensus)
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Summary on IS-MP Model
This is the workhorse model for analyzing short-run
impacts of monetary and fiscal policy
Key assumptions:
- Fixed or rigid prices
- Unemployed resources
Now on to analysis of Great Depression in IS-MP
framework.
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