Transcript Macrohonours - Lecture 1 (Part 2). - Lecture Notes

Factors that effect IS and AD
• Change in the MPC (cy) or MPS (sy):
• e.g. an increase in MPC (lower MPS) increases the multiplier and make the IS
shift right and flatten-out (move counter clockwise) i.e. associated with greater
output for various levels of r
• Higher MPC or lower MPS leads to smaller leakages and a larger multiplier
•
Policy: Lower income tax will increase the size of the multiplier
• Change in the interest elasticity of investment (a):
• e.g. a decrease in interest elastic (lower a) leads to a steeper IS curve (i.e.
investment by firms less responsive to a cut in r as I =A-a(-r), with smaller a)
e.g. SA firms sitting on R500-bn cash pile)
•
•
•
•
Change in non-interest determinants of investment (A):
i.e. if A increases IS shifts up
i.e. if A increases IS shifts up
Policy for increasing A: NDP in SA could enhance investor confidence
The LM Curve
• The LM curve is not explicitly included in the IS-PC-MR model, but it
exists implicitly, please cover this material on the LM curve in selfstudy.
• The LM curve shows combinations of interest rate and output at
which the money market is in equilibrium
• The demand for money is a decision about the form in which to
hold wealth (eg money vs bonds)
• As you move from narrow to broad money (coins, notes and
checkable deposits to fixed deposits) – there is a gain in the interest
earned and a loss in liquidity
• Money is a generally acceptable medium of exchange and it
constitutes a store of value i.e. “capital safe in nominal terms”
(although money is not as effective as a store of value as higher
interest bearing assets and is less effective in the context of high
inflation)
Demand for money
M
= L(y, i)
l- l i
P
L refers to the demand for liquidity (money)
-
or
•
•
•
•
•
i
+
1
.y
vT
Transactions motive:
A rise in the level of income (y) (with i unchanged) leads to an increase in the demand for money
(i.e.¶L / ¶y > 0)
Asset or speculative motive:
A rise in the nominal interest rate (i) (with y unchanged) leads to a decrease in the demand for
money
(i.e.¶l / ¶i < 0)
•
Previously the Quantity Theory of Money regarded y as the only determinant of the demand for
real balances (M/P) (where v is the velocity of circulation) Mv = Py, or M/P = y/v
•
The more general demand for money function (which is now standard) regards money demand
being determined both by y and the interest rate M/P = L (y , i)
Money market equilibrium
-
s
M
L(y,i) =
P
Defines an upward sloping LM curve where Money demand = money supply
Md/P = Ms/P and Md = L(y,i) and Ms = Ms/P fixed by authorities
LM is upward sloping because:
At low y the transactions demand for money is low therefore there must be a high
speculative demand for money i.e. a low i (as return from holding bonds relative to risk is
low) given a fixed Ms
Conversely: high y (high transactions Md) is associated with high i (low speculative
demand for money) where return on bonds is high and speculative demand for money is
low)
Deriving LM curve
• Step 1:
– draw in vertical Ms,
– show for high i (iH) that speculative demand for money is low (c), show
for low I (iL) that speculative demand for money is high (d)
-
l- l i
1
.y
vT
i
– As Ms =
+
(speculative demand plus transactions
demand), calculate transactions demand at iH = a and at iL = b
• Step 2:
– Calculate the level of output y consistent with generating the
transactions demand for money
– at X: y1 = vt x a) (i.e. output level is given by velocity x high transactions
demand (a) with iH (high interest rate)
– at Z: y0 = vt x b (i.e. output level is given by velocity x low transactions
demand with iL (low interest rate)
– Upward sloping LM curve is produced by joining X and Z
Factors that effect LM and AD
• An increase in the money supply shifts the LM curve to the right
• An increase in prices shifts the LM curve to the left
• Increase in the transactions velocity of circulation (vt) will make
the LM flatter e.g. financial innovation such as credit cards
meaning that there is a rise in the number of units of income that
one unit of transaction balances can finance. (slope change)
• An increase in the interest elasticity of the demand for money (li)
will make LM flatter e.g. at a high interest rate there is relatively
reduced speculative demand for money and at a low interest rate
there is a relatively increased speculative demand for money
(hence the flatter slope of the LM curve)
• Note: The instability in money demand due to changes in vt and
lt exposed a problem in Friedman’s monetarist thinking that
stable money supply would bring macro stability. This is a key
reason why models like IS-PC-MR were developed with the
interest rate as the key instrument
Combining IS and LM curve (AD)
• Combining IS and LM gives the interest rate and
the short-run equilibrium level of output (y) for
given price level (P) (AD is in the y,P space)
• Problem: IS uses real interest rate (r) and LM uses
nominal interest rate (i)
• Initial solution: assume that expected inflation is
0 (πe = 0) as i = r + πe then nominal interest rates
and real interest rates are equal
• In future lecture this assumption will be relaxed
AD curve is derived from IS/LM
• How is the AD curve is derived from the IS/LM?
• As the money supply is held constant and the price is
increased from P0 to P1, the LM curve shifts left as
real money balances M/P decrease,
• As result the increased price (P) is associated with
higher interest rates and a fall in output (y),
• This is reflected as a move from B to A along a
negatively sloping AD curve (in y,P space)
– Any factor that shifts the IS/LM curves (eg govt spending,
money supply) will lead to shifts in AD curve
– The AD curve represents two sets of equilibrium
conditions in goods and money markets
1.4 Aggregate Supply
• In the short to medium run, the Supply Side is based on
developments in the labour market as capital is assumed to be
fixed i.e. based on the production function Y = f(K,L) with K fixed, so
changes in L determine the level of Y
• The IS-PC-MR model is based on New Keynesian assumptions of
imperfect competition on the supply side of the economy, which
leads to a level of ye (Nairu) which is below what ye would be if
perfect competition were to be assumed (see VPC)
• Let’s begin by compare the perfect competition and imperfect
competition models
• As we will see Rodrik’s advise that we pay attention to which model
we select depends on the most important facts about the economy
is most important – the imperfect competition model which allows
an explanation of large-scale involuntary unemployment is more
appropriate to a country like SA than the perfect competition model
which assumes that involuntary unemployment is not possible
Perfect competition model
• Labour Demand = Labour Supply at the market clearing
real wage and level of employment
• Unemployment is voluntary – those who do not work
do not wish to work at the going rate (this is a welfare
optimum as it reflects an optimum choice by workers
as to whether to work)
• if there were more who wished to work at the going
rate this would create excess supply pushing out the
labour supply curve in Fig 2.7 lowering real wages and
increasing employment levels
• This is a special case where there are no imperfections
in wage or price setting (firms are price takers)
Imperfect competition model
• Due to imperfections:
– the Price Setting (PS) curve is equivalent to and below the Labour
Demand curve (MPL) and
– the Wage Setting (WS) curve is equivalent to and above the Labour
Supply curve (Es)
– PS and WS intersect at a lower level of employment and usually at a
lower level wage (W/P) (than at intersection of MPL and Es) (See Fig
2.12)
• Some Unemployment is involuntary –
– we can see that the labour supply (Es) curve lies to the right of the WS
curve and that if it were not for the imperfections reflected in the
position of the WS curve more people would be prepared to work at
the going real wage (not an ideal position from a welfare perspective)
• This arguably a more generally applicable model given the
imperfections that evidently exist in wage and price setting (to an
extent firms and workers are price makers, have pricing power)
A
B
Involuntary Unemployment
• At A (where Es = MPL) – all unemployment is
voluntary as even though L > Ece there are no workers
willing to work at the real wage Wce
• At B (where WS = PS) – there is a combination of
voluntary and involuntary unemployment
– Total unemployment = involuntary U + voluntary U
– Involuntary: At the wage Wice there are employees who
would be prepared to work (represented by the distance
between WS and Es curves at that wage)
– Voluntary: the distance between point where Es intersects
with PS and the size of the Labour force (L) shows the
number of workers who are not employed but who would
not wish to work at the going wage Wice
Imperfect competition model
• A major task of macroeconomics is to understand the causes
and consequences of involuntary unemployment
• If there are imperfections in the labour market then
involuntary unemployment is possible
• How does the imperfect competition labour market function?
• Labour supply is reflected in the wage setting curve (WS)
– due to imperfections (insider-outsiders, efficiency wages) wages are
higher than they would be in perfectly competitive market
– This pushes the WS curve above the labour supply curve (i.e. the
real wages W/P is higher than it would be if competition was
perfect)
• Labour demand is reflected in the price setting curve (PS)
– Due to imperfections (pricing power and markups) prices are higher
than they would be in perfectly competitive market
– This pushes the PS curve down below the labour demand (or MPL)
curve (i.e. at every level of labour demand, prices are higher and
real wage W/P lower than they would be if competition was
perfect)
Imperfect competition model
• On labour supply side (WS curve): A number of factors may prevent
nominal wages from falling / cause wages to be set up above
market clearing levels e.g:
– wages are set by collective bargaining,
– wages are not set in the spot market but are based on wage contracts
– Efficiency wages are set by employers to motivate staff performance
• On labour demand side (PS curve): Also in imperfectly competitive
markets firms set prices with a mark-up over their costs (price
markers mean real wages W/P fall)
• The real wage (W/P) is therefore the result of imperfect wage and
price setting decisions
• Equilibrium rate of unemployment (ERU) which in turn determines
the equilibrium rate of output (ye) are in a sub-optimal position as
compared with perfect competition model
• Turn now to analysing imperfect (1) wage setting and (2) price
setting more closely
1.5 Wage setting – in imperfect
competition model
• As per Fig 2.8 the imperfect competition model there is an upward sloping
wage setting curve above the labour supply curve
• At real wage w1 labour market imperfections mean a lower level of
employment (E0) as compared to perfect competition’s (E1)
• Similarly at E0, the imperfect competition model’s real wages is higher at
w1 then the perfect competition’s model of w0
• The excess of the real wage on the wage setting curve (WS curve) over the
perfect competition labour supply curve at any level of employment is the
mark-up per worker (in real terms) associated with labour market
imperfections, due to:
– Wage setting institutions (collective bargaining where union has power to set
wage above competitive wage)
– Efficiency wage setting by firms (above competitive wage)
• The upward sloping wage setting equation is written as:
wws = b(E) where the wage-setting real wage wws = W/P, E is the level of
employment and b is a rising function of employment
wws = b(E) i.e. The Supply of labour E rises with a rise in the real wage
1.6 Price setting – in imperfect competition
model
• In perfect competition – firms take the market price and
set it equal to their marginal cost, this implies a real wage
equal to the marginal product of labour
P = MC
P = W/MPL
=> W/P = MPL
• With imperfect competition – firms set a price to maximise
profits, firms mark-up prices over marginal cost, the size of
the mark-up falls as the elasticity of demand rises
P > MC or P = MC * mark-up (mark-up>1)
or, P = W/MPL * markup
=> W/P = MPL * (1/markup)
=> PS is below MPL (labour demand curve)
Price setting – in imperfect competition model
• Pricing formula: P = e . W
e -1 MPL
• Where ε is the elasticity
of demand is constant and there
e
is a constant mark-up greater than 1 of
e
• There is an inverse relationship between elasticity of
demand ε and the size of the mark-up (if elasticity is low
then mark-up will be high as consumers will not react
strongly to increased prices) e.g.:
-1
– if ε = 2 mark-up is 2,
– if ε = 100 markup is 100/99
– if ε = infinity then there is no mark-up ( i.e. 1.W/MPL)
• As per fig 2.9 the price setting curve (PS curve) lies under
e -1 the price setting real wage is
the MPL because
i.e.
<1
e
a fraction of the MPL (inverse of the markup <1)
• Price-setting real wage is: W = e -1.MPL
P
e
Use of horizontal PS curve in the model
• A horizontal PS curve implies that firms have sticky prices in s-r and
do not change their prices in response to changes in output but
only change prices when costs change (usually annual wage
changes are the trigger for the end of the s-r in the model)
• A horizontal PS curve assisted by the following assumptions of price
stickiness:
– The PS curve is horizontal if the MPL is constant and mark-up is
constant
– If the MPL is constant but the mark-up is counter-cyclical (declines in a
boom to attract new customers or because of entry of new
competitors) this would flatten PS curve
– If firms set prices based on rule of thumb basing price on average cost
over the business cycle this would flatten the PS curve (this may be
motivated by a desire to limit price changes in response to changes in
demand due to menu costs)
Another way of expressing PS curve
• Assume flat PS curve with constant marginal
product and constant mark-up (μ)
• Firms set prices to deliver a specific profit
• Output per worker (Y/E) or (λ) = profits per
worker μ * λ + real wage per worker (W/P) i.e.
W
W
w
=
= l.(1- m )
l = m.l +
P
P
• Conclusion: As the mark-up (μ) rises the real
PS
wage W/P falls (and PS curve falls lower beneath
MPL), this is equivalent to the expression W/P =
MPL * (1/markup)
1.7 Labour market with imperfect competition
• The WS curve lies above the labour supply curve
(as wages are set above market clearing rates)
• The PS curve lies beneath the MPL curve (as
workers are paid less than their marginal product
and firms make supernormal profits)
• At EICE there is total unemployment of UICE made
up of voluntary and involuntary unemployment
• At EICE (unemployment rate UICE) wage and price
setters have no reason to change their behaviour
given institutions and practices in the economy
(supply-side characteristics)
Supply-side interventions to increase employment
• At EICE can be increased (and UICE can be reduced)
through supply-side interventions
– Reduced wage bargaining power or increase pool of skilled
labour would shift the WS down
– Increased product market competition would shift the PS
curve up (by reducing the pricing power of firms and
leading to a higher real wage at each level of employment
• Such supply-side interventions would be indicated by
movements of ye (VPC) in the IS-PC-MR model, but
they are distinct from the kind of short-run demand
management interventions (using r) that the IS-PC-MR
model is mainly focused upon
1.8 Conclusion
• Let us bring together the AD-AS, Labour Market and
IS-LM and look at the impact of an expansion in
demand (eg increased consumption or investment
or a fiscal or monetary expansion) (fig 2.14)
• Note: if we assume perfect competition then y0
reflects ECE and yCE, if we assume imperfect
competition then y0 reflects EICE and yICE
• 2 cases:
– (1) flexible prices and wages
– (2) sticky prices and wages (the IS-PC-MR model is based
on this assumption, hence the upward sloping short-run
Phillips curve which provides for short-run output effects
when prices and wages are sticky)
(1) Flexible prices and wages
• As per Fig 2.14, the AS curve is vertical at yCE and
yICE in the special case where here prices and
wages adjust immediately (i.e. are not sticky)
• Where prices and wages adjust immediately, an
increase in AD (e.g. increase in C or I or fiscal or
monetary expansion) will result in a move from A
to Z – increasing prices but not output and
employment (New Classical result)
• In the labour market ΔW = ΔP => w remains fixed
(2) Sticky prices and wages
• Sluggish adjustment of wages and prices implies that
the economy does not move directly from A to Z in
response to an AD shock (i.e. there is higher
employment (to E1) and output (to at y1) in the shortrun – until prices and wages adjust and output returns
to y0) (Keynesian or New Keynesian result)
• IS curve moves from A to B (prices unchanged at P0 )
• AD curve shifts from A to B (prices unchanged at P0 )
• Labour market not in equilibrium at E1
– The real wage (at w0) at B is too low to elicit a supply of
labour at E1 and too high for employment of E1 workers to
be demanded/profitable
Where prices and wages are sticky? (cont.)
•
•
Process of adjustment:
In the labour market:
– At E1, Money wages W adjust by α (so workers could be described as suffer a form of money
illusion and confusing a nominal wage increase with a real wage increase)
– But, prices increase by ΔP = α + β (ie ΔW < ΔP=> W/P real wages fall)
– This restores equilibrium at point B’ and then C on the price-setting PS side of the labour
market as lower real wages mean a higher demand for labour (eg at at E1 and therefore
elevated output eg at y1)
•
In AD-AS space:
– at B output rises to y1 as prices are fixed at P0
– Then at C output (y) falls and prices rise
•
In the ISLM space:
– the economy moves from B to C as rise in P leads to a fall in the real money supply (M/P) and
a rise in r
•
Move from C to Z:
– The move from C to Z takes place through the upward shifting of the SAS curves as higher
prices are incorporated into the next period’s labour market decisions
– Equilibrium is restored when the price level rises to Pz at the initial output and employment
levels (and the initial real wage) (with a higher real interest rate with reduced investment and
higher consumption)
Comparing fiscal and monetary
expansion (with sticky prices)
• Monetary expansion (Ms)
– shifts the LM curve and AD curve to the right
– In medium run, real wages, output and employment are
unchanged, prices and nominal wages are higher
– in the IS/LM diagram the rise in M is counteracted by the
equi-proportional increase in P (i.e. m1/p1 = m2/p2), the
interest rate initially falls and then returns to its original
level
• Fiscal expansion (G)
– Output returns in the medium run to is initial level, but its
composition is different as higher government spending
crowds out some interest –sensitive private investment,
due to the fact that the interest rates rises as a result of
the fiscal expansion
Summary of key facts
• In the short-run the level of employment and output is
determined by the level of AD (where prices and wages
are sticky)
• In the imperfectly competitive labour market there is a
mixture of voluntary and involuntary unemployment
• The imperfect competition model with sticky wage and
price setting processes which has been the focus of this
introductory lecture will provide the background
context for a number of lectures in the weeks ahead,
which will seek to show the operation of the IS-PC-MR
model in some detail, including the effects of demand
and supply shocks, as well as the impact of the
assumption of different preferences by an inflation
targeting Central Bank