Transcript IS –LM model

INFLATION AND UNEMPLOYMENT
IS-LM MODEL
RATIONAL EXPECTATIONS - MONETARY
POLICY IN THE SHORT-RUN
Lecture 8
Monetary policy
Inflation
Inflation is a significant and persistent
increase in the price level
• significant – more than 1 percent per year
• persistent – there is difference between
sustained and episodic increases in prices
Types of inflation by their magnitudes:
• Creeping inflation –moderate inflation on
the level of 1 to 3 percent per year
• Hyperinflation – price increases more than
50 percent per month
• for example: German hyperinflation with
price index at 1.3 trillion in December 1923
The Causes of Inflation
1. Cost-push inflation
• When unemployment is low, wages will have
risen more then they otherwise would have.
• Hence, wages and prices will be higher when
unemployment is low and output is high.
• lower the unemployment rate, the faster
wages increase
RATE OF WAGE
INCREASES
The Short-Run
UNEMPLOYMENT
Phillips curve
• inverse relationship between rates
of unemployment and corresponding
rates of inflation
RATE OF
INFLATION
The Short-Run
Phillips Curve
UNEMPLOYMENT
• If unemployment falls bellow a certain rate,
there is ever-accelerating inflation.
• The unemployment rate that is just high
enough to avoid this is called the NAIRU
(non-accelerating inflation rate of
unemployment) or the natural
unemployment rate.
Cost-push inflation
AS’
PRICES
AS
E’
p’
E
p
AD
REAL DEMAND AND OUTPUT
Reasons for cost-push inflations and
supply shocks:
• rising labor costs due to increased labor
union power,
• rising cost of raw materials (oil prices …)
• increased mark-ups of prices resulting
from a decline in competition,
• depreciation of domestic currency which
increased prices of imported goods
2. Demand-pull inflation
• Demand curve shifts upward, from D to D’ and prices
rise.
• Such shifts could be due to increase in: the average
propensity to consume, the marginal efficiency of
investment,government expenditures, export, and the
money supply.
• The aggregate demand curve also shifts upward if taxes,
imports or the demand for money decrease
AD = C + I +G + (E – X)
Demand-pull inflation
PRICES
AS
E’
p’
E
p
AD’
AD
REAL DEMAND AND OUTPUT
IS –LM model
IS –LM model
Only at point E, when the interest rate is i* and output is Y *, is there
equilibrium simultaneously in both the goods market (as measured
by the IS curve) and the market for money (as measured by the
LM curve).
At other points, such as A, B, C, or D, one of the two markets
is not in equilibrium, and there will be a tendency to head
toward the equilibrium, point E.
I - investment
C – consumption
expenditure
G – government
purchases
T - taxes
NX – net exports
Ms – money supply
Md – demand for
money
Expansionary monetary policy
The increase in the money
supply shifts the LM curve to
the right from LM1 to LM2; the
economy moves to point 2,
where output has increased to
Y2 and the interest rate has
declined to i2.
Expansionary fiscal policy
The rise in government
spending (or the
decrease in taxes) shifts
the IS curve to the right
from IS1 to IS2; the
economy moves to point
2, aggregate output
increases to Y2, and the
interest rate rises to i2.
ISLM Model in the Long Run
• To see what happens in the ISLM model in the
long run, we make use of the concept of the
natural rate level of output (denoted by Yn ) ,
which is the rate of output at which the price
level has no tendency to rise or fall.
• When output is above the natural rate level, the
booming economy will cause prices to rise;
when output is below the natural rate level, the
slack in the economy will cause prices to fall.
• in the long run the price level
does change
A rise in the money supply causes the LM curve to shift rightward to
LM2, and the equilibrium moves to point 2, where the interest rate
falls to i2 and output rises to Y2.
Because output at Y2 is above the natural rate level Yn, the price
level rises, the real money supply falls, and the LM curve shifts
back to LM1; the economy has returned to the original equilibrium at
point 1.
• in the long run the price level
does change
An increase in government spending shifts the IS curve to the right to
IS2, and the economy moves to point 2, at which the interest rate has
risen to i2 and output has risen to Y2.
Because output at Y2 is above the natural rate level Yn, the price
level begins to rise, real money balances M/P begin to fall, and the
LM curve shifts to the left to LM2. The long-run equilibrium at point
2’ has an even higher interest rate at i2’, and output has returned to
Yn.
Rational Expectations
- Effects of Unanticipated and
Anticipated Policy in Short Run
1. Unanticipated Policy
• Expansionary monetary policy is unexpected by the public.
2. Anticipated Policy
• Expansionary monetary policy is expected by the public.
• Because expectations are rational, workers and firms recognize that
an expansionary policy can increase the price level.
• Workers will demand higher wages so that their real earnings will
remain the same when the price level rises.
• The aggregate supply curve will shift leftward.
New Classical Macroeconomic Model
1. Effects of unanticipated policy
• Initially, the economy is at point 1 at the intersection of AD1
and AS1, where the realized price level is at the expected price
level P1 and aggregate output is at the natural rate level Yn.
• Because point 1 is also on the long-run aggregate supply curve
at Yn, there is no tendency for the aggregate supply to shift.
• An expansionary monetary policy shifts the aggregate demand
curve to AD2, but because this is unexpected, the aggregate
supply curve remains fixed at AS1.
• Equilibrium now occurs at point 2’
• Aggregate output has increased above the natural rate level to
Y2’, and the price level has increased to P2’.
New Classical Macroeconomic Model
2. Effects of Anticipated Policy
• The expansionary monetary policy shifts the aggregate demand
curve rightward to AD2, but because this policy is expected,
the aggregate supply curve shifts leftward to AS2.
• The economy moves to point 2, where aggregate output is still
at the natural rate level but the price level has increased to P2.
• The new classical macroeconomic model demonstrates that
aggregate output does not increase as a result of anticipated
expansionary policy and that the economy immediately moves
to a point of long-run equilibrium (point 2) where aggregate
output is at the natural rate level.
CAN AN EXPANSIONARY POLICY LEAD TO A DECLINE IN
AGGREGATE OUTPUT?
In this case, the
expansionary monetary
policy is less expansionary
than people was expected.
New Keynesian Model
• In the new classical model, all wages and prices are
completely flexible with respect to expected changes in
the price level; that is, a rise in the expected price level
results in an immediate and equal rise in wages and
prices.
• Many economists who accept rational expectations as a
working hypothesis do not accept the characterization of
wage and price flexibility in the new classical model.
• These critics of the new classical model, called new
Keynesians, object to complete wage and price
flexibility and identify factors in the economy that prevent
some wages and prices from rising fully with a rise in the
expected price level - sticky wages, sticky prices
• The expansionary policy that shifts aggregate demand to
AD2 has a bigger effect on output when it is
unanticipated than when it is anticipated.
• When the expansionary policy is unanticipated, the
short-run aggregate supply curve does not shift, and the
economy moves to point U, so that aggregate output
increases to YU and the price level rises to PU.
• When the policy is anticipated, the short-run aggregate
supply curve shifts to ASA (but not all the way to AS2
because rigidities prevent complete wage and price
adjustment), and the economy moves to point A so that
aggregate output rises to YA (which is less than YU) and
the price level rises to PA (which is higher than PU).
1. Effects of unanticipated policy
New Keynesian Model
2. Effects of Anticipated Policy
New Keynesian Model
sticky wages, sticky prices