Download Lecture 8

SGPE Summer School:
Macroeconomics
Lecture 8
Part 2: The Short Run
Questions:
• What causes short-term fluctuations in production and
employment?
• Is there a choice between low inflation and low
unemployment?
2
Introduction: Growth 1961-2011 (GDP fixed
prices)
GDP growth UK
10
5
2010
2005
2000
1995
1990
1985
1980
1975
1970
1965
-5
1960
0
GDP growth uk
GDP growth US
10
5
2010
2005
2000
1995
1990
1985
1980
1975
1970
1965
-5
1960
0
GDP growth us
3
Introduction: Inflation 1950-2011
Inflation UK
25
20
15
10
5
1990
1995
2000
2005
2010
1990
1995
2000
2005
2010
1985
1980
1975
1970
1965
1960
1955
-5
1950
0
inflation uk
Inflation US
25
20
15
10
5
1985
1980
1975
1970
1965
1960
1955
-5
1950
0
inflation us
4
Introduction to Part 2
• Long run:
–
–
–
–
Prices and wages flexible (that is, adjust to shocks)
Production/employment is in equilibrium
Supply factors determine production
Real interest rate is equal to the natural interest rate
• Short run:
–
–
–
–
Prices and wages are sluggish
Production/employment can deviate from equilibrium
Aggregated demand determines production
Expected real interest rate can deviate from the natural rate
5
Introduction to Part 2
Plan:
• Interest and production in the short run
(the IS-LM model)
• Economic activity and inflation in the short run
(the Phillips curve)
6
The interest rate and aggregate demand:
The IS-LM model (Chapter 8)
The IS-LM model:
• A formalisation of Keynes's ideas
• Shows how the nominal interest and production
(income) are determined with a given price level
• Analyses the interaction between the goods and money
markets
7
Aggregate demand: The IS-LM model
We already have the two equations that make up the
IS-LM model:
• IS equation – goods market equilibrium
Y = C (Y,Y e, r, A) + I ( r,Y e, K )
r =i-pe
• LM equation – money market equilibrium
M
Y
=
P V (i)
8
Aggregate demand: The IS equation
9
Aggregate demand: The IS equation
Effect of increased willingness to invest
Multiplier effect: The increase in production will be
greater than the original demand increase
10
Aggregate demand: The IS equation
The multiplier:
•
•
•
•
Investments increase
Production/incomes increase
Consumption increases
Production/incomes increase…
1
DI
1- c
Total effect:
where c is the marginal propensity to consume (MPC)
DY = DI + cDI + c 2 DI + c3DI +... =
11
Aggregate demand: The IS equation
What is the effect of an increase in the interest rate?
Here we also have a multiplier effect
12
Aggregate demand: The IS equation
13
Aggregate demand: The IS equation
The IS curve:
• Shows demand & production for each interest rate level
• Has a negative slope because a higher rate of interest
leads to lower consumption and investments
• The slope is determined by how much the interest rate
affects C and I and the size of the multiplier
• Changes in interest and production lead to movements
along the IS curve
• Changes in exogenous variables (Y e , p e etc. ) lead to shifts
of the IS curve
14
Aggregate demand: The IS equation
The IS curve and long-term equilibrium production
(note that i = r + p )
e
If i = r n + p e
production will be
on the natural
level
i > rn + p e
If
production will be
below the natural
level
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Aggregate demand: The IS equation
mathematically
Consumption function: C = a0 + a1Y + a2Y e - a3r + a4 A
Investment function: I = b0 - b1r + b2Y e - b3 K
Goods’ market equilibrium:
Y = a0 + a1Y + a2Y e - a3r + a4 A+ b0 - b1r + b2Y e - b3 K
(
)
(
) (
)
Y 1- a1 = a0 + b0 - a3 + b1 r + a2 + b2 Y e + a4 A- b3 K
a0 + b0 a3 + b1
b3
a2 + b2 e
a4
Y=
r+
Y +
AK
1- a1 1- a1
1- a1
1- a1
1- a1
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Aggregate demand: The IS equation - example
Y=
a0 + b0 a3 + b1
b
a +b
a
r + 2 2 Y e + 4 A- 3 K
1- a1 1- a1
1- a1
1- a1
1- a1
Effect of an increase in interest rate:
a3 + b1
1
DY = Dr = a3 + b1 Dr
1- a1
1- a1
(
)
The size of the effect depends on:
• The interest rate sensitivity of consumption and
investments (a3+b1)
• The multiplier that depends on the marginal propensity
to consume (a1)
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Aggregate demand: The LM equation
Household assets:
• Money
• Loans to companies
• Shares in the companies, which we assume they retain
The interest rate adjusts so that
supply = demand on loans, which is the same as
supply = demand on money:
M
Y
=
P V (i)
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Aggregate demand: The LM equation
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Aggregate demand: The LM equation
An increase in the money supply leads to a drop in the
interest rate
The central
bank can
influence the
interest rate by
changing the
money supply
20
Aggregate demand: The LM equation
With a given money supply, an increase in production
causes the interest rate to rise
21
Aggregate demand: The LM equation
22
Aggregate demand: The LM equation
The LM curve:
• Shows what the interest rate will be for each level of
production
• Slopes upwards since higher production leads to more
transactions and an increased demand on money
• The slope is determined by how production and
interest rate affect the demand on money
• Changes in production and interest rate lead to
movements along the LM curve
• Changes in exogenous variables (like M) lead to shifts of
the LM curve
23
Aggregate demand: Equilibrium in the IS-LM
model
Y =C+I
Goods’ market equilibrium
C = C (Y,Y e,i - p e, A)
Consumption function
I = I (i - p e,Y e, K )
Investment function
M
Y
=
P V (i)
Money market equilibrium
Four endogenous variables:
Y, C, I, and i
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Aggregate demand: Equilibrium in the IS-LM
model
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Aggregate demand: Equilibrium in the IS-LM
model
Y = C (Y,Y e,i - p e, A) + I (i - p e,Y e, K )
M
Y
=
P V (i)
(IS)
(LM)
A: Both markets in equilibrium
B: Goods’ market not in
equilibrium (Y must go down)
C: Money market not in
equilibrium (i must go up)
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Aggregate demand: Equilibrium in the IS-LM
model
How to use the IS-LM model to analyse the effects of a
change in some exogenous variable:
• Determine whether disturbance shifts IS and/or LM
curve(s) and draw new curves in the diagram
• From the diagram, read what is the effect on interest
rate and production (if they are going up or down)
• Present an economic explanation for what is happening
in the goods’ and money markets (direct and indirect
effects)
• Investigate and explain the effects on other variables
(employment, consumption, investments, etc.)
27
Aggregate demand: Equilibrium in the IS-LM
model
What happens if the money supply increases (M  0 )?
28
Aggregate demand: Equilibrium in the IS-LM
model
What happens if consumers and investors become more
optimistic about the future (DY e > 0 )?
29
Aggregate demand: How do we know if the
model is right?
There are many studies of microdata that show that prices
are sluggish.
It is harder to use macroeconomic data to test the model.
30
Aggregate demand: How do we know if the
model is right?
How can we test if monetary policy has any effects on the
real economy?
• Study the correlation between changes in interest rate
and changes in production?
• Carry out experiments with monetary policy?
• Use statistical methods (VAR) to identify effects of
‘exogenous’ shocks to the interest rate. Studies using
this method suggest that monetary policy has
substantial effects on GDP
31
Aggregate demand: Effects of an unexpected
change in the interest rate in the USA
32