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Macroeconomics V. Polito with C. Brendon EC2065 2016 Undergraduate study in Economics, Management, Finance and the Social Sciences This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see: www.londoninternational.ac.uk This guide was prepared for the University of London International Programmes by: Dr Vito Polito, Lecturer, Cardiff Business School Charles Brendon, Max Weber Fellow, European University Institute This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide. University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2014 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know. Contents Contents Chapter 1: Introduction........................................................................................... 1 Aims and objectives........................................................................................................ 2 Learning outcomes......................................................................................................... 2 Syllabus.......................................................................................................................... 2 The structure of the subject guide................................................................................... 3 How to use the subject guide.......................................................................................... 4 Essential reading............................................................................................................ 5 Further reading............................................................................................................... 7 Online study resources.................................................................................................. 10 Examination advice...................................................................................................... 11 Chapter 2: The IS–LM model.................................................................................. 13 Aims of the chapter...................................................................................................... 13 Learning outcomes....................................................................................................... 13 Essential reading.......................................................................................................... 13 Further reading............................................................................................................. 13 Works cited.................................................................................................................. 13 Introduction................................................................................................................. 14 The IS–LM model: key assumptions............................................................................... 15 The IS–LM model: behavioural equations and identities................................................. 16 Income accounting in a closed economy........................................................................ 19 The IS curve.................................................................................................................. 19 The LM curve................................................................................................................ 21 Equilibrium in the IS–LM model.................................................................................... 22 Fiscal and monetary policy in the IS–LM model............................................................. 23 Policy mixes.................................................................................................................. 25 Solutions to activities.................................................................................................... 26 A reminder of your learning outcomes........................................................................... 29 Sample examination questions...................................................................................... 29 Guidance on answering the sample examination questions........................................... 31 Chapter 3: Unemployment and the AD–AS model................................................ 33 Aims of the chapter...................................................................................................... 33 Learning outcomes....................................................................................................... 33 Essential reading.......................................................................................................... 33 Further reading............................................................................................................. 33 Introduction................................................................................................................. 34 The labour market: main definitions.............................................................................. 35 Labour market and classical unemployment.................................................................. 36 Hysteresis..................................................................................................................... 38 Frictional and structural unemployment......................................................................... 38 The natural rate of unemployment................................................................................ 39 Aggregate supply......................................................................................................... 41 The sticky-wage model................................................................................................. 43 The worker-misperception model................................................................................... 44 The sticky-price model.................................................................................................. 45 The Lucas islands model............................................................................................... 46 i EC2065 Macroeconomics Aggregate demand....................................................................................................... 47 The AD–AS model........................................................................................................ 49 Monetary and fiscal policy in the AD–AS model............................................................ 50 Supply shocks............................................................................................................... 51 Solutions to activities.................................................................................................... 53 A reminder of your learning outcomes........................................................................... 57 Sample examination questions...................................................................................... 57 Guidance on answering the sample examination questions........................................... 58 Chapter 4: Inflation and the Phillips curve............................................................ 59 Aims of the chapter...................................................................................................... 59 Learning outcomes....................................................................................................... 59 Essential reading.......................................................................................................... 59 Further reading............................................................................................................. 59 Introduction................................................................................................................. 60 The inflation rate and the Phillips curve......................................................................... 61 Okun’s law................................................................................................................... 63 The AD–AS model (revisited): long run.......................................................................... 65 The AD–AS model (revisited): short run......................................................................... 67 Costs and benefits of inflation...................................................................................... 68 Costly disinflation policy............................................................................................... 70 Disinflation policy......................................................................................................... 71 Depression, liquidity trap, and deflation......................................................................... 73 Solutions to activities ................................................................................................... 75 A reminder of your learning outcomes........................................................................... 77 Sample examination questions...................................................................................... 78 Guidance on answering the sample examination questions........................................... 79 Chapter 5: Economic growth: stylised facts and the basic Solow model.............. 81 Aims of the chapter...................................................................................................... 81 Learning outcomes....................................................................................................... 81 Essential reading.......................................................................................................... 81 Further reading............................................................................................................. 81 Works cited ................................................................................................................. 82 Introduction................................................................................................................. 82 The algebra of economic growth................................................................................... 83 Measures of the wealth of a country............................................................................. 84 Stylised facts: OECD countries....................................................................................... 84 Stylised facts: rest of the world..................................................................................... 86 The neoclassical production function ............................................................................ 89 The Solow model: basic assumptions............................................................................. 91 The Solow model: the steady state................................................................................ 92 Comparative statics...................................................................................................... 95 Solutions to activities.................................................................................................... 99 A reminder of your learning outcomes......................................................................... 102 Sample examination questions.................................................................................... 102 Guidance on answering the sample examination questions......................................... 102 Chapter 6: Exogenous and endogenous theories of economic growth.............. 105 Aims of the chapter.................................................................................................... 105 Learning outcomes..................................................................................................... 105 Essential reading........................................................................................................ 105 Further reading........................................................................................................... 105 ii Contents Work cited................................................................................................................. 105 Introduction............................................................................................................... 106 Production with exogenous technology ...................................................................... 106 The Solow residual..................................................................................................... 107 The Solow model with exogenous technology............................................................. 108 The steady state......................................................................................................... 110 Comparative statics.................................................................................................... 112 The golden rule.......................................................................................................... 114 New growth theory.................................................................................................... 115 The AK model............................................................................................................. 116 Growth and human capital......................................................................................... 117 Solutions to activities.................................................................................................. 118 A reminder of your learning outcomes......................................................................... 123 Sample examination questions.................................................................................... 123 Guidance on answering the sample examination questions......................................... 124 Chapter 7: The open economy............................................................................. 127 Aims of the chapter.................................................................................................... 127 Learning outcomes..................................................................................................... 127 Essential reading........................................................................................................ 127 Further reading........................................................................................................... 127 Introduction............................................................................................................... 127 The balance of payments............................................................................................ 128 National income accounting in an open economy........................................................ 129 Nominal exchange rates............................................................................................. 129 The trade balance....................................................................................................... 133 The goods market in an open economy....................................................................... 134 Solutions to activities.................................................................................................. 137 A reminder of your learning outcomes......................................................................... 139 Sample examination questions.................................................................................... 140 Guidance on answering the sample examination questions......................................... 141 Chapter 8: The Mundell–Fleming model.............................................................. 143 Aims of the chapter.................................................................................................... 143 Learning outcomes..................................................................................................... 143 Essential reading........................................................................................................ 143 Further reading........................................................................................................... 143 Introduction............................................................................................................... 143 The balance of payments (BP ) curve and capital mobility............................................. 145 The Mundell–Fleming model with perfect and no capital mobility................................ 146 The Mundell–Fleming model under imperfect capital mobility and a fixed exchange rate.................................................................................................... 148 The Mundell–Fleming model under imperfect capital mobility and a flexible exchange rate................................................................................................. 149 Solutions to activities.................................................................................................. 152 A reminder of your learning outcomes......................................................................... 154 Sample examination questions.................................................................................... 154 Guidance on answering the sample examination questions ........................................ 155 Chapter 9: Theories of consumption................................................................... 157 Aims of the chapter.................................................................................................... 157 Learning outcomes..................................................................................................... 157 Essential reading........................................................................................................ 157 iii EC2065 Macroeconomics Further reading........................................................................................................... 157 Introduction............................................................................................................... 157 The Keynesian consumption function, and beyond....................................................... 159 The Fisher model of intertemporal consumption.......................................................... 160 Consumption, interest rates and income...................................................................... 162 The life cycle hypothesis (LCH).................................................................................... 164 The permanent income hypothesis.............................................................................. 166 The Ricardian equivalence proposition......................................................................... 167 The random-walk hypothesis....................................................................................... 168 Solutions to activities.................................................................................................. 169 A reminder of your learning outcomes......................................................................... 172 Sample examination questions.................................................................................... 172 Guidance on answering the sample examination questions......................................... 173 Chapter 10: Theories of investment.................................................................... 175 Aims of the chapter.................................................................................................... 175 Learning outcomes..................................................................................................... 175 Essential reading........................................................................................................ 175 Further reading........................................................................................................... 175 Introduction............................................................................................................... 175 No-arbitrage condition, real and nominal interest rates............................................... 176 IS–LM model, real and nominal interest rates.............................................................. 177 The bond market........................................................................................................ 179 Yield to maturity ........................................................................................................ 180 The stock market........................................................................................................ 181 The Keynesian theory of aggregate investment............................................................ 183 The accelerator model ................................................................................................ 184 The neoclassical model of investment.......................................................................... 185 Tobin’s q model of investment.................................................................................... 186 Keynesian versus neoclassical theory: the empirical evidence....................................... 187 Solutions to activities.................................................................................................. 188 A reminder of your learning outcomes......................................................................... 190 Sample examination questions.................................................................................... 191 Guidance on answering the sample examination questions......................................... 192 Chapter 11: Money demand and money supply.................................................. 193 Aims of the chapter.................................................................................................... 193 Learning outcomes..................................................................................................... 193 Essential reading ....................................................................................................... 193 Further reading........................................................................................................... 193 Introduction............................................................................................................... 194 Definition and functions of money.............................................................................. 194 The demand for money............................................................................................... 195 The Baumol–Tobin transactions demand model........................................................... 196 The Tobin speculative demand model.......................................................................... 197 Empirical evidence on money demand......................................................................... 198 Velocity and money demand....................................................................................... 198 Money supply............................................................................................................. 200 Instruments of monetary control................................................................................. 201 Solutions to activities.................................................................................................. 202 A reminder of your learning outcomes......................................................................... 204 iv Contents Sample examination questions.................................................................................... 205 Guidance on answering the sample examination questions......................................... 206 Chapter 12: Monetary policy............................................................................... 209 Aims of the chapter.................................................................................................... 209 Learning outcomes..................................................................................................... 209 Essential reading........................................................................................................ 209 Further reading........................................................................................................... 209 Introduction............................................................................................................... 210 Macroeconomic stability............................................................................................. 211 Active versus passive demand management policies.................................................... 212 Monetary policy: targets and instruments.................................................................... 214 Inflation targeting....................................................................................................... 216 Rules versus discretion................................................................................................ 217 Monetary policy rules................................................................................................. 220 Solutions to activities.................................................................................................. 222 A reminder of your learning outcomes......................................................................... 224 Sample examination questions.................................................................................... 224 Guidance on answering the sample examination questions......................................... 225 Chapter 13: Fiscal policy..................................................................................... 227 Aims of the chapter.................................................................................................... 227 Learning outcomes..................................................................................................... 227 Essential reading........................................................................................................ 227 Further reading .......................................................................................................... 227 Introduction............................................................................................................... 228 The arithmetic of the government budget constraint.................................................... 229 The Barro–Ricardo equivalence proposition................................................................. 230 The theoretical underpinning of fiscal policy................................................................ 233 Active versus passive fiscal policy................................................................................ 235 Rules versus discretion................................................................................................ 236 Seignorage and tax revenue........................................................................................ 239 Solutions to activities.................................................................................................. 241 A reminder of your learning outcomes......................................................................... 243 Sample examination questions.................................................................................... 244 Guidance on answering the sample examination questions......................................... 245 Appendix 1: Sample examination paper............................................................. 247 Appendix 2: Sample Examiners’ commentary..................................................... 251 v EC2065 Macroeconomics Notes vi Chapter 1: Introduction Chapter 1: Introduction Welcome to course EC2065 Macroeconomics which is a 200 course available on the Economics, Management, Finance and Social Sciences (EMFSS) suite of programmes available through the University of London International Programmes. This course is designed to introduce you to the most influential and compelling theories devised by macroeconomists in order to explain issues related to the determination of output, unemployment and inflation. Through this course you will acquire a logical and consistent framework for understanding the main macroeconomic facts and events, and develop the ability to employ the correct macroeconomic tool(s) to explain specific macroeconomic issues and justify policy proposals. This course is particularly relevant for those of you who want to go on to careers in consulting in both the private and public sectors, public policy, education, journalism, diplomacy, social science and international affairs. It is also relevant for anyone interested in pursuing advanced study in economics, as well as in related fields such as politics, philosophy and economic history. Macroeconomics is the art of imagining a simplified world, a macroeconomic model, in which the interaction between households, firms and policy makers determines the value of aggregate production, the total number of people working in the economy, and the general price level. The ultimate objective of this exercise of imagination is to examine how and to what extent this simplified world might help to answer the following five fundamental macroeconomic questions about the real world: 1. Why does output grow over very long periods of time? 2. Why is output growth not steady, but varies from year to year? 3. What determines the rate of unemployment? 4. Why do prices increase over time? 5. What should policy makers do to boost output growth, reduce unemployment and control inflation? What makes macroeconomics such a fascinating subject is that these questions are – like it or not – a key part of our daily life. Not a day passes without reports in the media about the impressive economic growth performance in China, another music concert organised to raise awareness about public debt in third world countries, some politician or other worrying about the likely consequences of soaring oil prices, or a commentator speculating about what is happening in the stock market. If you are curious about any of these (and more) questions, this is the right course for you! As well as explaining the macroeconomic system, macroeconomists also quantify what we understand (and sometimes do not understand) about the behaviour of the economy in order to recommend specific policy actions. This is another skill that you will acquire by studying this course. For example, you will be able to assess whether or not, and by how much, the interest rate should be changed in order to contain inflation; how much an economy should save to maximise consumption; or whether or 1 EC2065 Macroeconomics not, and how much taxes and public spending should change in order to help the economy recover after a recession. Studying for this course will stimulate and develop your written communication skills, as well as your ability to assess and think analytically about everyday life events. These skills will prove to be great assets in both your professional and personal development. I hope you will enjoy spending your time reading and practising macroeconomics as much as I did preparing this guide. Aims and objectives The aims of this course are to: • show how our understanding of how economic systems operate has evolved substantially • explain why the growth rate of aggregate output varies from year to year • explain what determines unemployment and inflation in the short run and in the long run • discuss how macroeconomic policy might influence business cycles or long-run growth. Learning outcomes At the end of this course and having completed the Essential reading and activities, you should be able to: • define and analyse the determinants of business cycles, long-run economic growth, unemployment and inflation • use and apply a wide range of economic models to analyse contemporary and historical macroeconomic events, and formulate and propose appropriate macroeconomic policies. Syllabus This course covers the main principles involved in the determination of real income, employment and unemployment, the price level and inflation in an open mixed economy, and the conduct of macroeconomic policy. The main topics are: • Aggregate demand in a closed economy: the determinants of consumption, investment, demand for and supply of money; wealth effects; the IS–LM model and policy prescriptions. • Aggregate demand in an open economy: exchange rate regimes, international trade and capital flows, and external balance; the IS–LM– BP model and policy prescriptions. • Aggregate demand, aggregate supply and the price level: the aggregate demand curve; short- and long-run aggregate supply curves; the aggregate demand-aggregate supply model and its applications to the determination of the price level and real income, and demand management policy; the neoclassical (Solow) growth model. • Inflation and unemployment; models of inflation; costs of inflation; counter-inflationary policy; full employment and the natural rate of unemployment; types and causes of unemployment, and policies to reduce them. 2 Chapter 1: Introduction The structure of the subject guide The subject guide organises the material covered in the syllabus as follows: Part 1: The short run Chapter 2: The IS–LM model Chapter 3: Unemployment and the AD–AS model Chapter 4: Inflation and the Phillips curve Part 2: The long run Chapter 5: Economic growth: stylised facts and the basic Solow model Chapter 6: Exogenous and endogenous theories of economic growth Part 3: The open economy Chapter 7: The open economy Chapter 8: The Mundell–Fleming model Part 4: Microfounded macroeconomic theories Chapter 9: Theories of consumption Chapter 10: Theories of investment Chapter 11: Money demand and money supply Part 5: Monetary and fiscal policy Chapter 12: Monetary policy Chapter 13: Fiscal policy As you can see, the content of the syllabus has been divided thematically into five different parts. Each part is then divided into several chapters. • Part 1 is dedicated to the analysis of the economy in the short run and it includes three chapters. Chapter 2 covers all the material related to the analysis of aggregate demand in a closed economy and in the short run, by employing the IS–LM model. Chapters 3 and 4 study short-run fluctuations in output and inflation within the conceptual framework of the AD–AS model. • Part 2 includes Chapters 5 and 6, and is focused on the analysis of the economy in the long run. In these two chapters we cover the topic of economic growth from the perspective of the neoclassical (Solow) growth model, as well as discussing the empirical and theoretical underpinnings of endogenous growth models. • Part 3 extends in Chapters 7 and 8 the analysis of aggregate demand to the open economy, from the perspective of the Mundell–Fleming (IS–LM–BP) model. • Part 4 surveys microfounded theories of consumption (Chapter 9), investment (Chapter 10), money demand and money supply (Chapter 11), in order to provide a more realistic and consistent description of the demand side of the economy, but also to derive policy prescriptions alternative to those suggested by the Keynesian theory. • Part 5 concludes by focusing on the design and the conduct of monetary (Chapter 12) and fiscal policy (Chapter 13), in particular discussing the main issues surrounding the effectiveness of macroeconomic policy which is used to maintain economic stability. 3 EC2065 Macroeconomics How to use the subject guide As you can see from the syllabus, macroeconomics is a very broad subject and there is a lot of material to cover. This subject guide aims to give you a structured and systematic approach with which to engage in – and enjoy – the course. The best way to use the subject guide is to go through each chapter in the sequential order proposed. I strongly advise you to study each chapter of the guide using the following strategy: Read the introduction first: Each chapter begins with a short introduction that clarifies the contents of the chapter: how these relate to the rest of the material in the syllabus, some background thoughts and warnings that you may want to bear in mind before doing your reading, and an outline of where to find the relevant reading material. You are advised to read carefully the introduction to each chapter and then carry out the reading suggested in the Essential reading list before undertaking any other activity. Do the required reading from the textbook(s): The reading is divided into Essential reading and Further reading. Essential reading normally refers to one or more chapters of the main textbook that you must read in order to cover the topics included in the relevant chapter of the guide. You are strongly advised to carry out the Essential reading before passing on to any other activity, such as Further reading or studying other sections of the chapter. The Further reading list includes a number of optional books and articles that will enhance your knowledge and understanding of the topic, and help you to prepare for the examination more thoroughly. Go through the summary of the material in the guide: Once you have done the Essential reading from the textbook, you are ready to go through the summary of the material covered in the relevant chapter of the guide. The aim of the chapter is to give you a quick summary of the material, focusing on the description of the macroeconomic model(s) relevant to the chapter. The strategy by which a model is presented consists (almost) always of: • clarifying the macroeconomic issue that the model wants to answer • specifying and discussing all underlying assumptions • writing the model analytically • determining the solution of the model either analytically, graphically, or both • assessing the policy implications • thinking critically about the plausibility and limits of the model’s implications. Take an active role: The main purpose of this subject guide is to engage you in active learning as much as possible. To this end, throughout the discussion, I include in each chapter a number of ‘activities’. The objective of each activity is to encourage you to take an active role in developing your understanding of the material. The activities will involve carrying out a numerical exercise, solving specific macroeconomic problems, thinking about the likely consequences of changing specific parameters and assumptions, and reflecting upon the policy implications of a model. 4 Chapter 1: Introduction I include detailed discussions of all the activities at the end of each chapter, so you can get immediate feedback on your understanding of the material directly from the guide. I strongly advise you to try the questions in each activity on your own, before looking at the solutions. The activities and their solutions cover important aspects of the topic of the chapter, and you should not omit them. Learning outcomes and sample questions: Each chapter ends with a restatement of the main learning outcomes and a number of questions selected from past examination papers. Make sure you carefully read the list of learning outcomes and that you feel you have achieved them before moving on to the next chapter. The sample examination questions give you a chance to assess your command of the tools discussed in the chapter. You should always carry out these activities to check and enhance your understanding of the material. ►Optional material: In several places in this guide, sections are presented as ‘Optional material’. This is more advanced material for those of you who wish to explore ideas further. This will help you to think like an economist and to do well in the examinations. However, for those who are finding the material in this guide challenging enough there is no requirement for you to read these sections. Essential reading You should use at least one of the following textbooks: Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ: Prentice Hall, 2012) sixth edition [ISBN 9780273766339] (www.prenhall.com/blanchard). Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) eleventh edition [ISBN 9780071289252]. Mankiw, N.G. Macroeconomics. (Worth, 2012) eighth edition [ISBN 9781464121678]. These are all excellent and widely adopted textbooks. Most of the material in Parts I, II, III, IV (Chapter 11) and V of the subject guide is covered in Blanchard and Johnson and Dornbusch et al., and I would strongly advise you to use both these textbooks to prepare for this course. Unfortunately, neither of these textbooks covers adequately the material in Chapters 9 and 10 of Part IV. Mankiw gives a good verbal description of each model discussed in these two chapters, but it lacks analytical details. Pentecost (see the Further reading list in the next section) provides an extended coverage and you may want to use this textbook to study this part of the syllabus. The choice of textbook ultimately depends on your own preference. If you are already familiar (and happy) with one of these books you may want to carry on working with it. The main advantage of using a different book is that you will acquire a different perspective on the subject. If you do not know any of the above textbooks, ideally you should have a careful look at each of them before choosing one. My advice is to start by checking out the home page of each textbook on the website of its publishers. Blanchard and Johnson can be accessed at www.pearsonhighered.com/ blanchard. If you click on ‘Instructor resources’, you will be able to access the table of contents of the book and a description of its main features. You can also click on the link to the companion website to get an idea of the available online facilities. 5 EC2065 Macroeconomics Dornbusch et al. can be accessed at www.mhhe.com/dornbusch11e Once you access the web page of the book, you can read two sample chapters and the table of contents. You can also access the learning centre by clicking on the link Student Edition. This includes online quizzes for each chapter of the book. You can submit your answers and receive a quick evaluation. I particularly like ‘Economagic’, an economic time series data site that you can access in order to engage in the empirical questions at the end of each chapter. Mankiw can be accessed following the links for Economics and then Intermediate Macroeconomics at www.worthpublishers.com. You will get a preview of the book, a description of its main features and the table of contents, and be able to look at specific parts of the book. You can easily surf through the site to become aware of the resources available. In particular, you will find tests for self-assessments, tutorials and a number of macroeconomic data. I doubt you will be able to resist the temptation of playing the ‘Presidential game’, which will seriously test your macroeconomic skills. I find all these textbooks clear and very easy to read, and your choice of textbook should ultimately depend on your macroeconomics background. I particularly like the fact that each of them constantly relates macroeconomic theory and models to real facts and events. If you already have a good background in economics, you might find both Blanchard and Johnson and Dornbusch et al. more stimulating. In addition, they are slightly more advanced and include more analytical details than Mankiw, and provide a treatment of the material consistent with the level required by this course. Mankiw keeps the analytical details of the models to a minimum, but gives you a clearer idea of the distinction between Classical and Keynesian theories. If you have used Mankiw’s Principles of Economics at the introductory level, you might find it natural to choose his textbook at the intermediate level. However, be aware that Mankiw on its own is not sufficient preparation for some parts of the syllabus, and, in the guide, you are advised to look for fuller and more comprehensive treatments of these parts by referring to the other textbooks. A key skill, which you must acquire by studying for this course, is the ability to write down and describe macroeconomic models analytically. Unfortunately, each textbook adopts a different notation when referring to variables and parameters, so you need to be careful when reading from different sources. However, this should not discourage you from reading from more than one textbook, which is a very good way to gain a deeper understanding of the material. In this respect, you need to be aware that this guide tries to follow – as much as possible – the notation employed by Blanchard and Johnson. Each of the textbooks listed above also has a study guide with detailed explanations and many questions (see below). I strongly suggest that you systematically consult the students guide(s) accompanying the textbook(s) you choose, as this will facilitate the reading and give you a structured view of the material covered in the textbook. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the virtual learning environment (VLE) regularly for updated guidance on readings. 6 Chapter 1: Introduction Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below). Other useful texts for this course include: Blanchard, O. and D. Findlay Study guide [to accompany] Macroeconomics. (Upper Saddle River, NJ: Prentice Hall, 2008) fifth edition [ISBN 9780132078337]. Student guide and tutorial for use with Blanchard’s Macroeconomics. Dornbusch, R., S. Fisher and R.Startz Macroeconomics – study guide. (New York: McGraw-Hill, 2011) eleventh edition available online at www.mhhe. com/dornbusch11e Student guide for use with Dornbusch–Fischer–Startz Macroeconomics. Estrin, S. and A. Marin. Essential readings in economics. (Basingstoke: Macmillan Press, 1995) first edition [ISBN 9780312125110]. Mankiw, N.G. Macroeconomics – study guide. (Worth, 2012) eighth edition [ISBN 9781464104930]. Student guide and workbook for use with Mankiw’s Macroeconomics. Pentecost, E. Macroeconomics: an open economy approach. (Basingstoke: Palgrave Macmillan, 2000) first edition [ISBN 9780312233686]. Journals and websites Unless otherwise stated, all websites in this subject guide were accessed in March 2014. We cannot guarantee, however, that they will stay current and you may need to perform an internet search to find the relevant pages. Your preparation would benefit, substantially, if you get into the habit of browsing through daily newspapers and weekly magazines such as: • Wall Street Journal (http://online.wsj.com) • Financial Times (www.ft.com) • The Economist (www.economist.com) Stimulating online reading and material for macroeconomists can often be found on the following web pages: • World Bank (www.worldbank.org), where you can access a wide range of free downloadable documents, including project documents, advisory works, and evaluations, formal and informal research papers, and most Bank publications. • Organisation for Economic Co-operation and Development (www.oecd.org), which gives you free access to country surveys, statistics and a large number of publications which cover a wide variety of macroeconomic topics, including analyses of the major macroeconomic trends and policies around the world. • International Monetary Fund (www.imf.org), for another chance to read about macroeconomic facts and events around the world, including country surveys and statistics. • National Bureau of Economic Research (www.nber.org), for a very useful source of economic articles and data. • European Commission (http://ec.europa.eu), for in-depth information about European countries. 7 EC2065 Macroeconomics Another skill you should acquire, through taking this course, is the habit of reading articles in economic journals. To this end, the reading list for each chapter will include references to articles that you may want to read in order to enhance your understanding of the topic. Reading economics articles is not always an easy task, even for experienced economists. You are not expected to understand fully all the minute technical details of the articles, but gaining a general sense of the main points is likely to be beneficial. To help you read extensively, all International Programmes students have free access to the University of London Online Library where you will find the full text or an abstract of some of the journal articles listed in this guide. For further details, see Online study resources below. As a student of macroeconomics, you may find interesting and accessible economic articles in: • Journal of Economic Literature (JEL) • Journal of Economic Perspectives (JEP). I advise you to access the Online Library and have a look at the latest issues of the JEL and JEP, and browse through articles with titles that, first and foremost, capture your curiosity. If, before you start preparing to work on this course, you want to do a review of the key macroeconomic concepts and models, I would advise you to thoroughly revise the macroeconomics part of the EC1002 Introduction to economics subject guide. For ease of reference, the following is a full list of all further reading in the guide: Alesina, Alberto ‘The political economy of the budget surplus in the United States’, Journal of Economic Perspectives 14(3) 2000, pp.3–19. Ball, Laurence and N.G. Mankiw ‘The NAIRU in theory and practice’, Journal of Economic Perspectives 16(4) 2002, pp.115–36. Barro, Robert ‘Are government bonds net wealth?’, Journal of Political Economy 82(6) 1974, pp.1095–17. Barsky, Robert, B., and L. Kilian ‘Oil and the macroeconomy since the 1970s’, Journal of Economic Perspectives 18(4) 2004, pp.115–34. Baumol, William J. ‘Productivity growth, convergence, and welfare: What the long-run data show’, American Economic Review 76(5) 1986, pp.1072–85. Baumol, William J. ‘The transactions demand for cash: an inventory theoretic approach’, Quarterly Journal of Economics 66 1952, pp.545–56. Bernanke, Ben S. and Frederic S. Mishkin ‘Inflation targeting: a new framework for monetary policy?’, Journal of Economic Perspectives 11(2) 1997, pp.97–116. Besley, Timothy, and R. Burgess ‘Halving global poverty’, Journal of Economic Perspectives 17(3) 2003, pp.3–22. Blanchard, O. ‘European unemployment: the evolution of facts and ideas’, NBER working paper, No. 11750, 2005. Bosworth, Barry, and S. M. Collins ‘Accounting for growth: comparing China and India’, Journal of Economic Perspectives 22(1) 2008, pp.45–66. Calvo, Guillermo A., and F.S. Mishkin. ‘The mirage of exchange rate regimes for emerging market countries’, Journal of Economic Perspectives 17(4) 2003, pp.99–118. Chari, V.V. and Patrick J. Kehoe ‘Modern macroeconomics in practice: how theory is shaping policy’, Journal of Economic Perspectives 20(4) 2006, pp.3–28. Crowe, Christopher and Ellen E. Meade ‘The evolution of central bank governance around the world’, Journal of Economic Perspectives 21(4) 2007, pp.69–90. 8 Chapter 1: Introduction Davis, Steven J., R.J. Faberman and J. Haltiwanger ‘The flow approach to labor markets: new data sources and micro-macro links’, Journal of Economic Perspectives 20(3) 2006, pp.3–26. Easterlin, Richard A. ‘The worldwide standard of living since 1800’, Journal of Economic Perspectives 14(1) 2000, pp.7–26. Fischer, Stanley, R. Sahay and C.A. Végh ‘Modern hyper- and high inflations’, Journal of Economic Literature 40(3) 2002, pp.837–80. Friedman, Milton A theory of the consumption function. (Princeton, NJ: Princeton University Press, 1957). Friedman, Milton ‘The role of monetary policy’, American Economic Review 58(1) 1968 pp.1–17. Also in Estrin, S. and A. Marin, Chapter 10. Hall, Robert, E. and Dale W. Jorgenson ‘Tax policy and investment behaviour’, American Economic Review 57(3)1967, pp.391–414. Hall, Robert, E. ‘Stochastic implications of the life cycle-permanent income hypothesis: theory and evidence’, Journal of Political Economy 86(6) 1978, pp.971–87. Hoshi, Takeo and A. K. Kashyap ‘Japan’s financial crisis and economic Stagnation’, Journal of Economic Perspectives 18(1) 2004, pp.3–26. Hutchison, Michael ‘Japan’s recession: Is the liquidity trap back?’ Federal Reserve Bank of San Francisco. FRBSF Economic Letter/Pacific Basin Notes. 2000–19, 16 June 2000 (available at www.frbsf.org/econrsrch/wklyltr/2000/el200019.html). Jones, Charles I. Introduction to economic growth. (Norton, 2002) second edition [ISBN 9780393977455] Chapters 1, 2.1, 3 and 4. Jones, Charles I. ‘On the evolution of the world income distribution’, Journal of Economic Perspectives 11(3) 1997, pp.19–36. Keynes, John, M. 1936 ‘The state of long term expectations’, Chapter 12 of The general theory of employment, interest and money. Also in Estrin, S. and A. Marin, Chapter 15. Lucas, Robert ‘Understanding business cycles’, in K. Brunner and A. Meltzer (eds) Stabilization of the domestic international economy, 5, pp.7–29. Also in Estrin, S. and A. Marin Essential reading in economics. (Basingstoke: Macmillan Press, 1995) first edition [ISBN 9780312125110] Chapter 16. Ludvigson, Sydney C. ‘Consumer confidence and consumer spending’, Journal of Economic Perspectives 18(2) 2004, pp.29–50. Mann, Catherine L. ‘Perspectives on the US current account deficit and sustainability’, Journal of Economic Perspectives 16(3) 2002, pp.131–52. Modigliani, Franco ‘Life cycle, individual thrift, and the wealth of nations’, American Economic Review 76(3)1986, pp.297–313. Modigliani, Franco ‘The monetarist controversy, or, should we forsake stabilisation policies?’, American Economic Review 67(2) 1977, pp.1–17. Also in Estrin, S. and A. Marin, Chapter 20. Pentecost, E. Macroeconomics: an open economy approach. (Basingstoke: Palgrave Macmillan, 2000) Chapters 6, 7 and 11. Romer, David ‘Keynesian macroeconomics without the LM curve’, Journal of Economic Perspectives 14(2) 2000, pp.149–69. Romer, Paul M. ‘The origins of endogenous growth’, Journal of Economic Perspectives 8(1) 1994, pp.3–22. Sargent, Thomas J. and N. Wallace ‘Rational expectations and the theory of economic policy’, Journal of Monetary Economics 2(2) 1976, pp.169–83. Also in Estrin, S. and A. Marin, Chapter 19. Svensson, Lars E. O. ‘Escaping from a liquidity trap and deflation: The foolproof way and others’, Journal of Economic Perspectives 17(4) 2003, pp.145–66. Södersten, Bo. and G. Reed International economics. (Basingstoke: Macmillan, 1994) Chapters 28.3 and 29.6. Taylor, John B. ‘Reassessing discretionary fiscal policy’, Journal of Economic Perspectives 14(3) 2000, pp.21–36. 9 EC2065 Macroeconomics Tobin, James. ‘Inflation and unemployment’, American Economic Review 62(1) 1972, pp.1–18. Also in Estrin, S. and A. Marin, Chapter 11. Tobin, James ‘Liquidity preference as behavior towards risk’, Review of Economic Studies 25 1958, pp.65–86. Zarnowitz, Victor ‘Theory and history behind business cycles: Are the 1990s the onset of a golden age?’ Journal of Economic Perspectives 13(2) 1999, pp.69–90. Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page. The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: • Electronic study materials: All of the printed materials which you receive from the University of London are available to download, to give you flexibility in how and where you study. • Discussion forums: An open space for you to discuss interests and seek support from your peers, working collaboratively to solve problems and discuss subject material. Some forums are moderated by an LSE academic. • Videos: Recorded academic introductions to many subjects; interviews and debates with academics who have designed the courses and teach similar ones at LSE. • Recorded lectures: For a few subjects, where appropriate, various teaching sessions of the course have been recorded and made available online via the VLE. • Audiovisual tutorials and solutions: For some of the first year and larger later courses such as Introduction to Economics, Statistics, Mathematics and Principles of Banking and Accounting, audio-visual tutorials are available to help you work through key concepts and to show the standard expected in exams. • Self-testing activities: Allowing you to test your own understanding of subject material. • Study skills: Expert advice on getting started with your studies, preparing for examinations and developing your digital literacy skills. 10 Chapter 1: Introduction Note: Students registered for Laws courses also receive access to the dedicated Laws VLE. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates. Making use of the Online Library The Online Library (http://onlinelibrary.london.ac.uk) contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login. The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please use the online help pages (http://onlinelibrary. london.ac.uk/resources/summon) or contact the Online Library team: [email protected] Examination advice Important: the information and advice given in the following section is based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. The examination paper is designed to test both your understanding of the topics in the syllabus and your ability to apply the relevant theories, or models, to address actual macroeconomic issues. To get a feeling of the content of the examination paper, you can access and look at examination papers and Examiners’ commentaries for the last three years on the VLE. The paper includes two sections, with individual questions having the same format within each section. In Section A (40 per cent of the total marks), you must answer all eight questions. Usually, these are with a ‘True/False? Explain’ format. In this section you are expected not only to provide an answer, but also to briefly justify it on the basis of the relevant theory. In answering short questions, you are not expected to derive, analytically, the relevant models in explaining your answers; a verbal or graphic (non-analytical) approach is sufficient. An important point to remember is that, on average, no more than eight minutes should be spent on any individual short question: a good allocation of time among individual questions is always one of the key factors for a successful exam response. In Section B (carrying 60 per cent of the total marks), you have a choice of three out of six long questions. Each long question is usually divided into three parts, generally reflecting the following structure: 11 EC2065 Macroeconomics • Part (a) is quite general, requiring an illustration of the relevant theory or model • Part (b) is a straightforward application of the relevant theory or model • Part (c) is a more specific application or extension of the theory or model. You should note that, in Section B, you are expected to be as precise as possible in your answers and to derive, formally, the relevant models, besides using a graphic and verbal approach. However, you are advised not to spend more than 35 minutes on any individual long question. When you prepare for the examination you should try not only to gain knowledge of the topics in the syllabus, but also to acquire an ability to apply the relevant ideas to address specific questions. You should be careful to avoid mechanically reproducing algebra without providing the economic intuition of the models and their implications. It is also important to avoid leaving any individual questions unanswered. Bear in mind that examination questions often refer to topics covered in more than one chapter of the subject guide. As a result, it is essential that you develop a good understanding of the connections between different topics and, in particular, how to employ different tools and theories to answer questions about specific macroeconomic issues. I will help you in successfully developing this skill, as I have included in the subject guide many activities in which you are asked to think and comment about the alternative views of macroeconomic theories, and their related policy prescriptions. Remember, it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered. 12 Chapter 2: The IS–LM model Chapter 2: The IS–LM model Aims of the chapter The focus of the chapter is on the IS–LM model, set out by Hicks (1937) in response to Keynes’ The general theory of employment, interest and money (1936) for analysing the aggregate demand and macroeconomic stabilisation policy in a closed economy and with fixed prices. The IS– LM model integrates the goods and the money markets and considers under what conditions output and the interest rate are simultaneously in equilibrium; what factors may determine short-run fluctuations; and how macroeconomic policy can be employed to stabilise the economy in the short run. Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • list and discuss the key equations of the IS–LM model • describe the determinants of the intercept and the slope of both the IS and the LM curves • calculate the equilibrium level of output and the interest rate in a closed economy with fixed wages and prices • evaluate how any change in the variables and the parameters of the IS–LM model alters the equilibrium levels of output and the interest rate • show how fiscal and monetary policies contribute to the determination of output and the interest rate in the short run, and their use as tools for macroeconomic stabilisation • illustrate and exlain the Keynesian view of short-run fluctuations in economic activity. Essential reading Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ: Prentice Hall, 2012) Chapters 3–5. Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 9–11, Chapter 19 (pp.466–77). Mankiw, N.G. Macroeconomics. (Worth, 2012) Chapters 11–12. Further reading Hoshi, Takeo and A. K. Kashyap ‘Japan’s financial crisis and economic Stagnation’, Journal of Economic Perspectives 18(1) 2004, pp.3–26. Ludvigson, Sydney C. ‘Consumer confidence and consumer spending’, Journal of Economic Perspectives 18(2) 2004, pp.29–50. Romer, David ‘Keynesian macroeconomics without the LM curve’, Journal of Economic Perspectives 14(2) 2000, pp.149–69. Works cited Hicks, J.R. ‘Mr Keynes and the classics: a suggested interpretation’, Econometrica 5(2) 1937, pp.147–59. 13 EC2065 Macroeconomics Keynes, John M. The general theory of employment, interest and money. (London, 1936) Chapter 12 ‘The state of long term expectations’. Introduction If you are using Blanchard and Johnson you should read Chapters 3–5 and make sure you have a clear understanding of how to apply the IS–LM model to the US recession in 2001 (Chapter 5). If you are using Dornbusch et al. you should read Chapters 9–11, including the application of the IS–LM model to the US recessions from the early 1980s to the recent crisis, and the German economy after unification (Chapter 11). You should also make sure that you understand the discussion in this chapter of the liquidity trap in the context of the recent crisis. You may additionally find it useful to read Sections 19.1 through 19.3 on the application of the IS–LM model to the recent ‘Great Recession’ and to the Great Depression. If you are using Mankiw, you should read Chapters 11 and 12; make sure that you understand the application of the IS–LM model to the Great Depression and to the financial crisis and economic downturn of 2008–09. At this initial stage of the course you may find it very useful to revise some basic national income accounting, as well as the definitions of key macroeconomic variables such as GDP, inflation and unemployment. Essentially, these topics are covered in Chapter 2 and Appendix 1 at the end of the textbook in Blanchard and Johnson; Chapters 1 and 2 in Dornbusch et al.; and Chapter 2 in Mankiw. You have already encountered the IS–LM model in the EC1002 Introduction to economics subject guide. As a result, you may benefit from revising the chapters on the goods market, the money market, and general equilibrium in that subject guide before studying the material of this chapter. The IS–LM model combines the goods market, which determines the equilibrium level of output, with the money market, which determines the equilibrium level of real money, in order to determine under what conditions they are simultaneously in equilibrium, and to assess the role that fiscal and monetary policies may have in explaining real output fluctuations. The model focuses on the assessment of aggregate demand in the short run, and in a closed economy. The short run is defined as the period of time during which the price level is fixed (there is no inflation), in the sense that it does not change in response to variations in other macroeconomic variables. Recall that the price level can be thought of as sluggish or sticky variable, since it does not respond immediately to a macroeconomic disturbance. Instead the adjustment builds up gradually, and it is fully completed after several years. In this respect, the long run is a period of time long enough for prices to be considered fully flexible, whereas the medium run is the period of time over which the price level completes its adjustment to macroeconomic disturbances. The closed economy assumption means that the model is studied without taking into account the effect of foreign trade on domestic aggregate demand. Therefore, the IS–LM model is useful in analysing the effects of stabilisation policy on real output and the real interest rate, but it cannot be employed to assess issues related to inflation, long-run unemployment, and the exchange rate. Because great attention is given to fiscal policy, it is important that you have a clear understanding of some basic assumptions about the role of the government in the economy, the links existing among different fiscal variables, and the standard fiscal policy jargon. Here is a quick 14 Chapter 2: The IS–LM model summary. The government provides public goods and services (e.g. health, education, roads, defence) that the private sector would either underproduce or not produce at all. The government also redistributes resources among households and firms. These activities can be financed either by levying taxes on households and firms, or by issuing debt, or by issuing money. The relationship between public spending, taxes, debt and money is summarised by the government budget constraint (GBC), an accounting identity that for every generic period t can be written as: Gt + itBt–1 – Tt = ∆Bt + ∆Mt where Gt is government spending in goods and services during year t; Bt–1 is government debt at the end of year t–1 or, equivalently, at the beginning of year t; it Bt–1 measures the interest payments on government debt made by the end of period t at the interest rate it;1 Tt computes tax revenue net of transfers to households and firms during year t; the term ∆Bt = Bt – Bt–1 is the change in debt during year t; and the term ∆Mt = Mt – Mt–1 is the change in money supply during year t. In the rest of this chapter we will assume that the government cannot create money to finance public spending, hence we will set ∆Mt= 0. We will return to the role and implications of money financing in Chapters 12 and 13 of the subject guide. The difference between government spending and tax revenue, Gt–Tt, is referred to as the primary budget deficit. The term Gt + itBt–1 – Tt is instead called the total budget deficit, as it includes interest spending. The standard interpretation of the GBC is that any difference between total spending and tax revenue must be balanced with a corresponding change in the stock of debt. The government runs a balanced primary budget when public spending is entirely financed through taxes, that is Gt = Tt. We say that a balanced budget expansion or contraction of the fiscal sector occurs when taxes and government spending either increase or decrease by the same amount. The term it Bt–1 implies that the government issues bonds at the beginning of each year and makes interest payments on that debt at the end of the year. For this reason, at the end of any period t interest spending is given by the product of the outstanding stock of debt at the beginning of that period, Bt–1 , and the interest rate that applies in period t, it. 1 The IS–LM model: key assumptions As stated in the introduction, the IS–LM model determines under what conditions output and the interest rate are simultaneously in equilibrium in the short run. Output is determined in the goods market, which refers to the trade market of all goods and services produced in an economy. The Keynesian cross model, which you have already encountered in course EC1002 Introduction to economics, describes the goods market equilibrium under the following assumptions: • All firms produce the same goods, which are then used by consumers for consumption and residential investment, by firms for fixed assets investment, or by the government. • Firms are willing to supply any amount of goods at the existing price level. • The economy is closed. The second assumption is important because it implies that in the IS–LM model aggregate supply has no effect on the equilibrium level of income, which is determined by aggregate demand.2 This assumption will be relaxed in Chapters 3 and 4 of the subject guide when we will study the AD–AS model. The closed economy assumption will instead be relaxed in Chapters 7 and 8, which focus on open economies. The interest rate is determined in the money market. The Keynesian Liquidity Preference theory, which you have already encountered in According to the Keynesian theory, in the short run firms can change production at the existing price level because the marginal product of labour is constant as a result of spare capacity in the labour market. This means that firms can hire new workers at the existing wage, which leaves average costs (and thus prices) unaffected. 2 15 EC2065 Macroeconomics EC1002 Introduction to economics, describes money market equilibrium under the following assumptions: • The financial market includes only two assets: money and bonds. • Money is a liquid asset, in the sense that it can be used to purchase goods and services, and pays no interest.3 • Bonds are issued by the government, cannot be used for transactions, but pay a positive nominal interest rate i. 3 At this stage of the course, you can think of money as currency, which consists of all coins and notes in circulation in a country. • Real wealth is fixed in the short run. Bonds are defined as assets that pay a fixed amount of money (face value) at a specific period of time (maturity).4 Individuals buy bonds at a price lower than the face value. The difference between the price and the face value of a bond is the gain for the bond holder. Since the face value is fixed, the lower the price of a bond the higher is the gain for the holder. The rate of return from investment in bonds, the nominal interest rate, is calculated by dividing the gain from bonds by the current price. Analytically, the relationship between the interest rate and the price of a bond is written as: i= PB − PB PB = PB PB More precisely, bonds that pay only a specific amount of money at maturity are called zero-coupon, or discount bonds. In contrast, bonds that also pay specific amounts of money (coupons) at regular intervals of time before maturity, are defined as coupon bonds. 4 − 1, where PB indicates the face value of the bond and PB is the current price of bonds. Thus, the interest rate and the price of bonds are, by construction, inversely related: an increase in the price of bond, PB, is equivalent to a reduction in the interest rate. It is important that you clearly understand the difference between income and wealth. Individuals earn income essentially from three sources: labour, in the form of wages, real assets, in the form of rent, and financial assets, in the form of interest and dividends. Income can either be spent to purchase goods and services or saved to buy new assets. Wealth is defined as the net value of all assets held by an individual, including their human capital.5 If the level of consumption of an individual exceeds their income, then this individual is defined as a net borrower. Finally, it is important that you note the equilibrium conditions in the financial market. These state that the demand for money, Md, must be equal to the supply of money, Ms: Md = Ms and that the demand for bonds, Bd, must be equal to the supply of bonds, Bs: Bd = Bs In general, we know from Walras’ law that if there are n markets and the first n–1 of these are in equilibrium, then the nth market must be in equilibrium too. This means that we can choose to ignore one market in the model, knowing that equilibrium there will be assured whenever it holds generally elsewhere. For this reason, we ignore the bond market in what follows, and make use only of the money market equilibrium condition. The IS–LM model: behavioural equations and identities The IS–LM model is based upon six behavioural equations, each describing the determinants of one of the macroeconomic variables considered by the model: consumption, investment, tax revenue, government spending, money demand and money supply. I will here give a short description of each equation, under the assumption that variables are linearly related. 16 We will return on the distinction between income and wealth in Chapter 9 of the subject guide. 5 Chapter 2: The IS–LM model Consumption, C, is defined as the value of goods and services purchased by households. The linear consumption function, which depends positively on income, Y, and negatively on taxes, T, can be written as: C = c0 + c1 (Y–T) c0 ≥ 0, 0< c1<1 (2.1) where the term Y–T indicates disposable income. The parameter c0 measures the level of consumption affected by factors other than disposable income, such as borrowing, sale of real and financial assets, etc. The value of c0 depends also upon consumers’ spending habits and consumer confidence about current and future spending opportunities. The parameter c1 is the marginal propensity to consume, namely the increase in consumption resulting from one unit increase in disposable income. Since 0 < c1<1, an increase in disposable income cannot be either entirely saved, c1= 0, or entirely consumed, c1= 1. In turn, the value 1– c1 measures the marginal propensity to save, namely the increase in saving resulting from an extra unit of disposable income. Investment spending includes three broad categories: fixed business investment carried out by firms, (i.e. purchases of newly produced real assets, such as plant and machinery), residential investment carried out by households (i.e. purchases of newly produced real estate properties such as houses), and inventory investment (i.e. unsold goods and services and/ or unused materials). Demand for investment depends positively on income (sales) and negatively on the real interest rate, r, and it can be written as: I = I + b1 Y – b2r, b1 ≥ 0, b2 ≥ 0 (2.2) where Ī is a constant that computes the effect on investment of any variable other than income and the interest rate, whereas b1 and b2 measure the sensitivity of investment to income and the interest rate, respectively. Note that in economics, the symbol i normally indicates the nominal interest rate, whereas the symbol r is used to indicate the real interest rate. Nominal and real interest rates are linked by the Fisher equation: i = r + �, which shows that the nominal interest rate is equal to the sum of the real interest rate and the rate of inflation, �.6 Since the Keynesian theory assumes prices to be constant in the short run, the rate of inflation is equal to zero, which implies that the real and the nominal interest rates are equal in the short run, i = r. For this reason we can replace r with i in the demand for investment equation when solving the model. Beware, Blanchard and Johnson and Dornbusch et al. use the symbol i to indicate the real interest rate in the IS–LM model, whereas Mankiw uses the symbol r. Tax revenue depends upon the structure of the tax system. In general, taxes can be levied either at fixed amounts (lump-sum taxes), or at specific rates on income and consumption (proportional income and consumption taxes). Consequently, the linear tax function can be written as: (2.3) T = T + τ 1Y + τ 2 C, τ 1 ≥ 0, τ 2 ≥ 0 This is an approximate version of the equation only. A more detailed discussion on the Fisher equation and, more generally, on the relationship between inflation, nominal and real interest rates will be provided in Chapter 10 of the subject guide. 6 where T indicates tax revenue raised through lump-sum taxes, and τ1 and τ2 measure the average tax rates on income and consumption, respectively. Government spending refers to the demand for goods and services of the public sector and it can be generally described by the equation: (2.4) G = G + g1Y + g2 C , 17 EC2065 Macroeconomics where G represents the fixed component of government spending, while g1and g2 measure changes in public spending proportional to variations in income and consumption, respectively. The demand for money, Md, is positively related to income and negatively related to the nominal interest rate. The higher the level of transactions, the more money is demanded for consumption and investment by individuals, firms and the government. The interest rate can be regarded as the opportunity cost of holding money. The higher the interest rate, the higher is the cost of holding money rather than bonds, and thus the lower is money demand. Analytically, real money demand is described as: d M = h 0 + h1Y − h 2 i, P h1 ≥ 0, h2 ≥ 0 (2.5) where P indicates the price level, which is constant in the IS–LM model, h0 measures the level of demand for money independent of income and the interest rate, and the parameters h1 and h2 measure the sensitivity of money demand to income and the interest rate respectively. Note that equation (2.5) shows that demand for money is ultimately a demand for real balances, Md P , rather than nominal balances, Md. The underlying assumption behind this specification is that individuals are free from money illusion, namely the tendency of individuals to think of currency in nominal terms rather than taking into account its purchasing power. The supply of money, Ms, is assumed to be independent from the interest rate and directly controlled by the central bank. The central bank can change money supply through open market operations. An expansionary open market operation occurs when the central bank buys bonds to increase the money supply. When the central bank buys bonds from the private sector, the excess demand for bonds raises the price of bonds, in turn reducing the interest rate. This reduction in the opportunity cost of holding money simutaneously increases money demand. In contrast, a contractionary open market operation occurs when the central bank sells bonds. As a result of excess supply the bond price falls, the interest rate increases, and money demand decreases. Analytically, real money supply, Ms P is written as: Ms M = P , P (2.6) where M is the level of nominal money supply chosen by the central bank. The description of the IS–LM model is completed by three key identities that define the links between aggregate demand and the equilibrium level of income. Aggregate demand (Z) is equal to the sum of consumption, investment and government spending: (2.7) Z = C + I + G. Since aggregate income must always equal aggregate expenditure in a closed economy, we have: (2.8) Y = Z. Combination of (2.7) and (2.8) gives the fundamental income identity for a closed economy: (2.9) Y = C + I + G, which states that in equilibrium aggregate income must be equal to the sum of the components of aggregate demand. 18 Chapter 2: The IS–LM model Income accounting in a closed economy The equilibrium output in the goods market can be alternatively retrieved from the equality between saving and investment in the loanable funds market.7 Consider again the income identity in equation (2.9): Y = C + I + G. Next, move C and G to the left-hand side of the equation and add and subtract T to obtain: (Y – T – C) + (T – G) = I. The term on the left hand side is the total saving of the economy. In particular, S = Y – T – C indicates private saving, measured by the excess of income over taxes and consumption, whereas T – G is public saving, measured by the primary budget surplus.8 Therefore, the equilibrium output in the goods market can be alternatively determined by the condition ‘saving equals investment’: (2.10) S + T – G = I. At this stage, make sure you are familiar with the concept, already encountered in EC1002 Introduction to economics, of the ‘paradox of thrift’ (or ‘paradox of saving’) which states that an exogenous increase in saving, equivalent to lower consumption at any given income level, leads to a lower equilibrium level of output and unchanged aggregate saving so long as the interest rate stays constant. This is consistent with the original description of the goods market provided by Keynes in the General Theory, which you have already encountered in 02 Introduction to economics. Mankiw uses the Loanable Funds market approach as well to derive the IS curve. 7 Be careful with the notation, if you are using Mankiw, as he uses the symbol S to indicate national saving (the sum of private and public saving), rather than private saving alone as in Blanchard and Johnson and Dornbusch et al. 8 Equation (2.10) gives an alternative way of writing the income identity in a closed economy, by relating private saving to the budget deficit and investment. The identity states that, in a closed economy, investment can be financed by a combination of private and public saving. In addition, changes in any of these three variables must necessarily affect at least one of the other two. However, the identity is silent about the determinants of changes in saving and investment, as well as the extent of their effect on other macroeconomic variables. Activity 2.1 In May 2008 The Economist Intelligence Unit predicted that in Singapore the budget deficit would increase by 1 per cent of GDP (Source: Economic and financial indicators, The Economist, 31st May, 2008). What can you infer from this prediction about private saving and investment in Singapore? The IS curve The IS curve represents combinations of income and the interest rate, such that the goods market is in equilibrium. Analytically the IS curve is computed by replacing in the income identity (2.9) the behavioural equations for consumption, investment, tax revenue and government spending. The resulting equation has to be solved for the interest rate as a function of income, as the IS curve is always plotted in the income–interest rate space. Before deriving the IS curve, I will simplify equations (2.3) and (2.4) by assuming that government spending is exogenous (g1 = g2 = 0) whereas taxes do not depend on consumption (τ2= 0). We then have: i = * 1 1 − c1 (1 − τ 1 ) − b1 * (c − c1 T + I + G ) − Y b2 b2 0 (2.11) 19 EC2065 Macroeconomics In the above expression the symbols i* and Y* denote equilibrium values. Note we have used the assumption of fixed prices to replace the real interest rate r with the nominal rate i. The slope of the IS curve in absolute terms is negatively related to the marginal propensity to consume, c1, the responsiveness of investment to output, b1, and the interest rate, b2; it is positively related to the tax rate, τ1. The larger the marginal propensity to consume, the flatter the IS curve, since a given increase in investment caused by a reduction in the interest rate, will then deliver a larger increase in income via the multiplier. Similarly, the more interest-sensitive investment spending is, the flatter is the IS curve, since a given reduction in the interest rate causes a relatively large increase in investment spending, which results in a larger increase in equilibrium income. An increase in b1 makes the IS curve flatter, since investment spending responds more to income for any given interest rate, and this amplifies the multiplier effect. Conversely, tax rate increases make the IS curve steeper as they dampen the multiplier effect of higher aggregate income on consumer expenditure. The intercept of the IS curve depends upon the level of autonomous spending, c0 − c1 T + I + G . An increase (reduction) of autonomous spending shifts the IS curve upward (downward). Note also that the position of the IS curve is affected by the responsiveness of investment to the interest rate: the larger b2 the smaller the intercept of the IS curve. If the central bank controls the interest rate, the equilibrium level of income moves along the IS curve. An increase (decrease) in government spending raises aggregate demand, thus shifting upwards (downwards) the IS curve. The effect of changes in taxation depends upon the structure of the tax system. If taxes are levied as lump-sums, then tax changes can only change the position of the IS curve, without altering its slope. However, if taxes are levied as a proportion of consumers’ income, any tax policy change has an effect on the slope of the IS curve. Activity 2.2 Consider an economy described by the following equations: Aggregate consumption: C = 400 + 0.2(Y – T ) Aggregate investment: I = 120 – 10i Government sector: G = T = 100 a. Calculate the equilibrium level of income at any given level of interest rate. b. What is the effect of an increase in the interest rate on the equilibrium level of income? c. Suppose the government increases lump-sum taxes T to 200. How does this affect the equilibrium level of income? d. Suppose instead that the government raises all its revenue by levying a proportional tax on consumers’ income at the rate τ = 0.3, setting lump-sum taxes to zero. Discuss what would be the effect in this case of an increase in the tax rate from 0.3 to 0.4 on the equilibrium. 20 Chapter 2: The IS–LM model Activity 2.3 In January 2008, fear of an imminent economic recession convinced the US central bank (Federal Reserve) to cut the interest rate twice: initially by 0.75 of a percentage point and subsequently by 0.5 of a percentage point. a. Employ the IS curve in equation (2.11) to predict the likely effect of this policy on the equilibrium level of income under the two following assumptions: (i) investment spending is insensitive to changes in the interest rate and (ii) investment spending is very sensitive to changes in the interest rate. b. Can you think of any reason why investment spending could be relatively insensitive to the interest rate? The LM curve The LM curve comprises combinations of the interest rate and income, for which the money market is in equilibrium. Analytically, the LM curve is computed combining the equations for money demand (2.5) and supply (2.6). The resulting equation has to be solved for the interest rate as a function of income, since the LM curve is always plotted in the income-interest rate space. This yields the following equation: i * = M h1 * h0 − + Y. h2 P h2 1 (2.12) The slope of the LM curve depends on the sensitivity of money demand to income and the interest rate, as measured by the coefficient h1/h2. The more money demand is sensitive to income, relative to the interest rate, the steeper the LM curve. If money demand does not respond to the interest rate, h2=0, the LM curve is vertical. A vertical LM curve is often referred to as the classical case. In contrast, if money demand is very sensitive to the interest rate, h 2 = ∞, the LM curve is horizontal. In this case it is not possible for the central bank to change the equilibrium interest rate through variations in the money supply. The case of a horizontal LM curve is often referred to as a liquidity trap. Monetary policy affects the position of the LM curve. An expansionary monetary policy shifts the LM curve downwards, since it increases the liquidity in the money market and reduces the interest rate for any given level of income. In contrast, a contractionary monetary policy shifts the LM curve upwards, as it reduces the liquidity in the money market and increases the interest rate at any given level of income. It may be useful to recall that, at this stage of the subject, the conduct of monetary policy is based upon the following simplifying assumptions: 1. The central bank has direct control over money supply through open market operations. 2. The government issues bonds on behalf of the central bank; the central bank does not directly issue bonds, but can only create money to buy bonds issued by the government. 3. Individuals are always willing to trade bonds at some price (i.e. bond demand from the private sector is unlimited). To understand the link between monetary policy and money supply, you may find it convenient to consider the simplified central bank balance sheet in Table 2.1. The central bank’s assets are represented by bonds, while the central bank’s liabilities are represented by the currency (money) 21 EC2065 Macroeconomics held by the public. To increase the money supply, the central bank has to purchase new bonds. This increases both assets (through the additional bonds) and liabilities (through the new currency created and exchanged for bonds). To reduce the money supply, the central bank sells bonds for existing currency. This operation reduces assets (through the sale of bonds) and liabilities (through the reduction of currency held by the general public). Central Bank Assets Liabilities Bonds Money Table 2.1: Central bank balance sheet in a closed economy. A more accurate description of the central bank’s balance sheet and the mechanism of money creation will be provided in Chapter 11 of the subject guide. Activity 2.4 Consider the LM curve for an economy that is either in the liquidity trap or in a classical case situation. In both cases: a. Calculate the equilibrium interest rate if this is possible. If not, explain why not. b. Describe the position of the LM curve in income – interest rate space. c. Discuss the effect of a monetary expansion on the LM curve. Equilibrium in the IS–LM model The IS–LM model determines combinations of the interest rate and income that simultaneously satisfy the equilibrium condition in the goods market and in the money market. Analytically, the equilibrium level of output and the interest rate are computed by combining the IS equation in (2.11) with the LM equation in (2.12). For instance, if we replace the interest rate in the IS equation with the right-hand side of the LM equation, the equilibrium level of income is calculated as: * Y = 1 1 M h2 b2 b (c 0 − c 1 T + I + G ) − h h0 − P h b + h [1 − c (1 − τ ) − b ] . 1 2 2 2 1 1 1 2 Note that the policy variables G and M both increase the equilibrium level of income. Tax policy affects Y* negatively through the term c1 T and the term c1 τ1. Therefore, expansionary fiscal and monetary policies increase the equilibrium level of income. Conversely, fiscal and monetary contractions reduce the equilibrium level of income. Alternatively, you can compute the equilibrium level of the interest rate by replacing the income level in the IS equation with the level of income from the LM equation. This yields the following expression for the equilibrium interest rate: * 1 − c 1 (1 − τ 1 ) − b1 h1 i = (c 0 − c 1 T + I + G ) + M h0 − P h1 , b 2 h1 + h 2 [1 − c 1 (1 − τ 1 ) − b1 ] which shows that fiscal expansions and monetary contractions increase the interest rate, whereas fiscal contractions and monetary expansions reduce the interest rate. Table 2.2 summaries the effects of monetary and fiscal policy on equilibrium output and the interest rate. 22 Chapter 2: The IS–LM model Fiscal policy Monetary policy Expansionary Contractionary Expansionary Contractionary Output + - + - Interest rate + - - + Table 2.2: Monetary and fiscal policy in the IS–LM model. The table shows that the effect of fiscal policy, on output and the interest rate, is symmetric in the sense that an expansionary fiscal policy increases both output and the interest rate, while a contractionary fiscal policy reduces both variables. In contrast, monetary policy has an asymmetric effect on output and the interest rate: an expansionary monetary policy increases output while reducing the interest rate, whereas a contractionary monetary policy reduces output while increasing the interest rate. Activity 2.5 Consider an economy in which the price level is equal to one and the goods and money markets are described by the following equations: Aggregate consumption: C = 400 + 0.2(Y – T) Aggregate investment: I = 80 + 0.5Y – 10i Government sector: G = T = 100 Money demand: Md = 100 + Y – 50i Money supply: Ms = 100 a. Calculate the equilibrium level of income and interest rate, and describe your solution with a graph. b. Compute the equilibrium level of consumption and investment. c. Suppose government spending increases to 200. Compute the fiscal policy multiplier (hint: this is the increase in Y divided by the increase in G). Fiscal and monetary policy in the IS–LM model Figure 2.1 provides a graphical illustration of the effect of fiscal and monetary policy in the IS–LM model. In each panel, the initial equilibrium is the point E1, which corresponds to the level of income Y1 and interest rate i1. Panel A shows that a fiscal expansion affects both the goods and the money market. In the goods market, the increase in aggregate demand resulting from the fiscal expansion raises the equilibrium level of income. Since the money supply is fixed, the increase in income increases money demand, which can only be accommodated by an increase in the interest rate. In turn, the increase in the interest rate causes a fall in investment spending (crowding out effect), which partially offsets the initial increase in income. The final equilibrium position is indicated in the graph by point E2, but, in general, depends upon the slope of the LM curve relative to the IS curve. Conversely, Panel B shows that a fiscal contraction reduces the equilibrium levels of income and interest rate. Note that the fiscal contraction reduces aggregate demand and income in the goods market. The fall in income causes a contraction in money demand, and money market equilibrium is restored only by a fall in the interest rate. In turn, the fall in the interest rate stimulates investment spending and contributes to partially offsetting the initial reduction in income. 23 EC2065 Macroeconomics Panel C shows that a monetary expansion shifts the LM curve downwards. At the initial level of income, the interest rate drops from i1 to i3, since the expansionary monetary policy operation raises the price of bonds and reduces the interest rate. The fall in the interest rate stimulates investment spending and increases output. Ultimately, the equilibrium converges to point E2. In general, the flatter the IS curve, the greater the monetary policy stimulus on output. Panel D shows how the IS–LM equilibrium adjusts as a result of a monetary contraction. B: Fiscal contraction LM E2 i2 E1 i1,3 i1,3 E3 E1 E3 E2 IS2 Y2 Y3 IS2 C: Monetary expansion LM1 i3 E1 i1 LM2 i2 i2 Y1 Y2 Y3 Income IS1 Income D: Monetary contraction Int.rate Y1 0 Int.rate LM i2 IS1 i3 Int.rate Int.rate A: Fiscal expansion LM2 E3 LM1 E2 i1 E1 E2 E3 IS Y1,3 Y2 Income IS Y2 Y1,3 Income Figure 2.1: IS–LM model: fiscal and monetary policy. The effectiveness of monetary and fiscal policy – on the interest rate, income, and unemployment – crucially depends on the relative slopes of the IS and the LM curves. Broadly speaking, the flatter (steeper) the IS curve is, the more (less) effective is monetary policy on output and unemployment, relative to the interest rate. On the other hand, the flatter (steeper) the LM curve is, the more (less) effective is fiscal policy on output and unemployment relative to the interest rate. Figure 2.2 illustrates four extreme cases. A liquidity trap occurs when the public is prepared to hold any amount of money at the current interest rate. This implies that money demand is horizontal in the real money– interest rate space, and monetary policy is ineffective because changes in the money supply do not alter income and the interest rate. As a consequence, the LM curve is horizontal. If the economy is in a liquidity trap, fiscal policy is very effective, as there is no crowding out effect on investment following a fiscal expansion (Panel A). The classical case occurs when money demand is entirely unresponsive to the interest rate, so that the LM curve is vertical (Panel B). This is consistent with the classical quantity theory of money, which states that nominal income, PY, is entirely determined by the money supply. In this case, if we assume that the price level is fixed then a monetary expansion has a one-to-one effect on real income, whereas fiscal policy has no effect on income because the fiscal expansion causes the interest rate to rise, reducing investment spending one-for-one with the rise in government spending.9 The effectiveness of monetary policy depends upon the slope of the IS curve. If investment is fully sensitive to the interest rate, then the IS curve 24 You should note, however, that a typical classical model of the entire economy does not assume that prices are fixed. When they are not, changes to the money supply may only have the ‘nominal’ effect of changing the price level, P. 9 Chapter 2: The IS–LM model Int. rate A: Fiscal expansion and horizontal LM E1 i1,2 LM E2 Int. rate is horizontal. This implies that an expansionary monetary policy will exert all its effect (Panel C). Vice versa, if investment is completely insensitive to the interest rate the IS curve is vertical, which implies monetary policy ineffectiveness (Panel D). B: Fiscal expansion and vertical LM i2 E2 i1 E1 IS2 IS1 0 Y1 Y2 IS2 LM Y1,2 Income LM2 E2 E1 IS Int. rate Int. rate i1,2 i1 i2 Y1 Y2 Income D: Monetary expansion and vertical IS C: Monetary expansion and horizontal IS LM1 IS1 Income IS E1 LM1 LM2 E2 Y1,2 Income Figure 2.2: Fiscal and monetary policy effectiveness. Policy mixes The IS–LM model shows that fiscal and monetary policies can be used either in isolation, or simultaneously, to influence key macroeconomic variables, such as the real interest rate and output. Since output and employment are positively correlated, that is employment increases (decreases) when output increases (decreases), fiscal and monetary policy also influence the unemployment rate. It is important that you know how to employ the IS–LM model to prescribe the appropriate policy mix to achieve a specific macroeconomic outcome. For instance, if the government and the central bank plan to increase output, without changing the interest rate, this goal can be achieved through a combination of expansionary fiscal policy and expansionary monetary policy. The expansionary fiscal policy increases both output and the interest rate, while the expansionary monetary policy increases output, but reduces the interest rate (Figure 2.3, Panel A). Another example occurs when policy-makers want to reduce the interest rate, while keeping the level of output unaffected. This goal can be achieved through a combination of expansionary monetary policy, which reduces the interest rate and increases output, and a contractionary fiscal policy, which will further contribute to the reduction in the interest rate while reducing output (Figure 2.3, Panel B). 25 EC2065 Macroeconomics Int. rate i2 i1,3 B: Fiscal contraction and monetary expansion LM1 E2 E3 E1 Int. rate A: Fiscal and monetary expansion LM1 LM2 IS2 i1 i2 E1 E2 i3 E3 IS1 Y1 Y2 Y3 Income LM2 IS2 Y2 Y1,3 IS1 Income Figure 2.3: Fiscal and monetary policy mix. Activity 2.6 Consider the economy described in the previous activity. Suppose that the government increases public spending from 100 to 200 with no change in taxes. a. Compute the new equilibrium level of output, under the assumption that the central bank adjusts Ms to keep the interest rate constant at i = 22.4. b. Compute the new equilibrium level of output, under the assumption that the central bank keeps money supply constant at M = 100. c. Compute the fiscal policy multiplier in each of the two cases above, and discuss your result. Solutions to activities Activity 2.1 It is difficult to infer the likely effects of this forecast on private saving for two reasons. First, under the identity in equation (2.10), the increase in the budget deficit may be compensated by a fall in investment, leaving private saving unchanged, or it may lead to a one-for-one increase in private saving, if investment is unaffected, or a combination of both effects such that the excess of private saving over investment (S–I) matches the budget deficit increase. The second reason why it is difficult to make predictions about the likely response of private saving is that the identity in equation (2.10) refers to a closed economy and this assumption does not appropriately describe Singapore’s economy. In fact, in an open economy an increase in the budget deficit may lead to a one-for-one fall in the trade balance, leaving unaffected both private saving and investment. We will return to these issues in Chapter 7 of the subject guide. Activity 2.2 a. The equilibrium level of income at any given interest rate is obtained as: Y = 600 – 10i + 0.2Y = 750 – 12.5i. b. The equilibrium level of income is negatively related to the interest rate: ∂Y = − 12.5, which shows that, if the interest rate increases by 1 ∂r percentage point, then income reduces by 12.5 units. c. If the government raises its revenue entirely through lump-sum taxes, then an increase in taxation reduces the equilibrium level of income at any given interest rate. Numerically, the new equilibrium level of income at any given interest rate is: Y = 725 – 12.5i. d. If the government raises its revenue entirely with a proportional income tax with rate τ = 0.3, then the equilibrium level of income at any given interest rate is approximately given by: Y = 721 – 11.63i. After the increase in the tax rate, the 26 Chapter 2: The IS–LM model equilibrium level of income becomes approximately: Y = 705 – 11.63i. Hence, the tax rate increase reduces the equilibrium level of income at any given interest rate. Note that the increase in the tax rate also reduces the response of the equilibrium level of income to changes in the interest rate. Activity 2.3 a. In the IS curve equation (2.11), changes in the interest rate affect output through investment spending, which mainly includes fixed business investment from firms and residential investment from households. In principle, the more investment spending reacts to changes in the interest rate, the more the interest rate cut should stimulate investment, thus increasing aggregate demand and output. If investment spending is insensitive to interest rate changes, the IS curve is relatively steep, so a given interest rate cut determines a small increase in income. Conversely, if investment spending is very sensitive to changes in the interest rate, the IS curve is relatively flat, so the same interest rate cut determines a larger increase in income. b. Investment may be relatively insensitive to interest rate changes if, for example, banks do not pass the interest rate cut to customers, or if borrowing transaction costs, such as mortgage fees, are relatively high. Activity 2.4 a. The LM equation in (2.12) shows that when the economy is in a liquidity trap the equilibrium interest rate is zero. Analytically, this can be seen from: h 1 M h0 + 1 Y * = 0. − h2 → ∞ h 2 h2 P h2 lim i * = lim h2 → ∞ In the classical case, the sensitivity of money to the interest rate is zero, h2 = 0. Analytically, the implications for the equilibrium interest rate can be seen from the LM by taking the limit: h2 → 0 h2 →0 { ( M 1 h − + h1 Y h2 0 P {( * lim i = lim * This object will equal +∞ whenever M < h0+h1Y *, and −∞ whenever P M > h +h Y *. 0 1 P Since infinite interest rates are not an equilibrium outcome, the only possible equilibrium occurs when M = h0+h1Y *. In this case the value of the nominal P interest rate remains undetermined, but there is a unique real money supply that can obtain for any given output level. This reflects the fact that both the supply and the demand for money are perfectly inelastic in the classical case so that the price of money, the nominal interest rate, is not tied down in equilibrium. b. The result in a. implies that when the economy is in a liquidity trap the LM curve is positioned on the horizontal axis of the income – interest rate space, corresponding to a zero interest rate. In contrast, in the classical case the LM curve is vertical in the income – interest rate space, and it intercepts the horizontal axis at . * 1 M – h0 Y = h1 P ( ( c. Recall that money supply affects the position of the LM curve through the term –1/ h2 × M/P. Since, in a liquidity trap, the coefficient –1/h2 equals zero, changes in the quantity of money do not shift the LM curve. The public is prepared to hold any amount of money at a zero interest rate, which implies that a change in money supply cannot affect the equilibrium interest rate and income. Monetary policy is very effective in the classical case. In particular, if h1 = 1, the increase in the equilibrium 27 EC2065 Macroeconomics level of income, following a monetary expansion, is equal to the increase in the real money supply. Activity 2.5 a. The equilibrium level of income and the interest rate are computed by solving the IS–LM system: IS : Y * = 400 + 0 . 2 Y * − 0 . 2 × 100 + 80 + 0 . 5Y *− 10 i * + 100 LM : 100 = 100 + Y * − 50 i *. Y * = 1120 This yields the solution . i * = 22 . 4 To draw the graph, note that both IS and LM curves must pass through the equilibrium point. In addition, the IS curve intercepts the vertical axis when * * Y = 0 ⇒ i = 56, whereas the LM curve passes from the origin of the income – interest rate space (see below). * b. In equilibrium, consumption equals C = 400 + 0 . 2 × 1120 − 20 = 604; whereas investment equals I *= 80 + 0 . 5 × 1120 − 10 × 22 . 4 = 416. c. After the increase in government spending, the IS–LM system becomes: IS : Y * = 400 + 0 . 2 Y *− 0 . 2 × 100 + 80 + 0 . 5Y * − 10 i * + 200 LM : 100 = 100 + Y *− 50 i * which yields the equilibrium values of income and interest rate Y * = 1320 . * i = 26 . 4 The fiscal policy multiplier equals 2 ( i.e. (1320 – 1120)/100). 56 IS Interest rate LM 22.4 0 1120 Income Activity 2.6 a. The new equilibrium level of output is obtained by solving the IS–LM system, with the additional requirement that the interest rate is constant: i * = 66 − 0 . 03 Y * Y * ≅ 1453.3 . ⇒ * i * = 22 . 4 i = i = 22 . 4 b. The new equilibrium level of output is computed by solving the new IS–LM system, which includes the new IS equation and the original LM equation, since that is computed keeping the money supply fixed at M = 100. As determined in the previous activity in equilibrium: 28 Chapter 2: The IS–LM model Y * = 1320 . * i = 26 . 4 c. Under the assumption of a constant interest rate, the fiscal policy multiplier is given by: ∆Y ∆G = 1453 . 3 − 1120 100 ≅ 3 .3 In contrast, under the assumption of constant money supply, the fiscal policy multiplier is equal to 2 (see previous activity). Fiscal policy is more effective in the first case because, by expanding the money supply to keep the interest rate constant, the central bank neutralises the crowding out effect on investment from the fiscal expansion. A reminder of your learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • list and discuss the key equations of the IS–LM model • describe the determinants of the intercept and the slope of both the IS and the LM curves • calculate the equilibrium level of output and the interest rate in a closed economy with fixed wages and prices • evaluate how any change in the variables and the parameters of the IS–LM model alters the equilibrium levels of output and the interest rate • show how fiscal and monetary policies contribute to the determination of output and the interest rate in the short run, and their use as tools for macroeconomic stabilisation • illustrate and explain the Keynesian view of short-run fluctuations in economic activity. Sample examination questions Section A 1. In the IS–LM model, an increase in the money supply will always have a positive impact on the level of output. True or false? Explain your answer. 2. In the IS–LM model, if the demand for investment becomes less responsive to changes in the interest rate, both monetary and fiscal policy will become more effective. True or false? Briefly explain your answer. Section B 1. Suppose that, in a closed economy with fixed prices, investment depends not only on the real interest rate, but also on the level of output. Would you expect the effect of output on investment to be positive or negative? Explain. If the effect of output on investment is assumed to be positive, how would the value of the multiplier be affected? If the effect is assumed to be positive, how would the slope of the IS curve be affected? 29 EC2065 Macroeconomics 2. Consider a closed economy with fixed prices and wages and underutilised capacity (refer to the IS–LM framework). What combination of fiscal and monetary policy can produce a higher level of output without affecting the interest rate, while keeping the government budget balanced? Be specific about what instruments could be used to implement the necessary policies. Under what conditions could the use of monetary policy, alone, be ineffective in the short run (i.e. it would not affect the level of output)? Under what conditions could the use of fiscal policy alone be ineffective in the short run? 3. Suppose that, in a closed economy with fixed prices, consumption depends not only on disposable income but also on the interest rate. If the effect is assumed to be negative, how would the value of the multiplier be affected, assuming that the central bank is controlling the nominal interest rate? If the effect is assumed to be positive, how would the slope of the IS curve be affected? 30 Chapter 2: The IS–LM model Guidance on answering the sample examination questions Section A 1. The statement is false. In a closed economy, if money demand is highly sensitive to the interest rate, the LM curve is horizontal, and its position is not affected by changes in the money stock (liquidity trap). Also, if investment demand is insensitive to the interest rate, the IS curve is vertical, and output is unaffected by an increase in the money supply. 2. The statement is false: fiscal policy becomes more effective (intuitively, the crowding out effect is now smaller), but monetary policy is less effective (intuitively, changes in the money supply and the interest rate will now have a smaller impact on investment). Graphically, the IS curve becomes steeper. Section B 1. The effect of output, on investment demand, can be expected to be positive on the basis of accelerator-type models of investment demand, whereby firms seek to maintain an optimal relationship between the capital stock and the level of output. In addition, current output could be taken by firms as an indicator of the future profitability of investment projects. If the effect of output on investment is assumed to be positive, the value of the expenditure multiplier rises, since the multiplier will now reflect the endogenous response of both consumption and investment. If the effect of output on investment is assumed to be positive, the IS curve becomes flatter, reflecting the larger sensitivity of equilibrium income to changes in expenditure. 2. Balanced budget fiscal expansion and monetary expansion. You should be explicit about what instruments could be used. Liquidity trap (to be explained), investment demand insensitive to the interest rate. Vertical LM (classical case). Horizontal IS (fully sensitive investment). A good answer should illustrate the economic intuition behind each case. 3. If the central bank is holding the interest rate fixed (by varying Ms), the value of the multiplier is unaffected. This can be argued either formally, deriving the formula for the expenditure multiplier, or intuitively, since the multiplier cannot be affected by changes to interest sensitivity so long as the interest rate is fixed. If the effect of the interest rate on consumption demand is assumed to be positive, the IS curve is steeper, as the positive effect on consumption partially offsets the (negative) effect of the interest rate on investment. 31 EC2065 Macroeconomics Notes 32 Chapter 3: Unemployment and the AD–AS model Chapter 3: Unemployment and the AD–AS model Aims of the chapter This chapter explores the short- and long-run determinants of unemployment, output and the price level. We begin by describing the labour market and the different components of unemployment, in order to identify appropriate macroeconomic policies to reduce each of them. Next, we derive the aggregate supply (AS) and the aggregate demand (AD) curves and discuss alternative views about the slope of each curve in the short run. The two curves are then combined to form the AD–AS model, which is used to describe business-cycle fluctuations and assess to what extent macroeconomic policy can be employed to stabilise the economy in the short run. Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • explain the mechanism underlying the determination of the equilibrium real wage and unemployment rate in the labour market • recognise the main types and causes of unemployment, and the appropriate macroeconomic policies to reduce them • derive aggregate supply under imperfect competition in the labour and product markets, and discuss the alternative interpretation of the AS relationship • compute the aggregate demand curve from the IS–LM model, and clarify the determinants of its slope and position • employ the AD–AS model in order to assess the determinants of output, the price level and the interest rate over the business cycle • appraise how monetary and fiscal policy can be used as stabilisation tools in response to demand and supply shocks. Essential reading Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ: Prentice Hall, 2012) Chapters 6, 7 and 8 (pp.193–94). Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 5, 7.1–7.5 and 10.4. Mankiw, N.G. Macroeconomics. (Worth, 2012) Chapters 7, 10, 12.2 and 14.1. Further reading Ball, Laurence and N.G. Mankiw ‘The NAIRU in theory and practice’, Journal of Economic Perspectives 16(4) 2002, pp.115–36. Blanchard, O. ‘European unemployment: the evolution of facts and ideas’, NBER working paper, No. 11750, 2005. Davis, Steven J., R.J. Faberman and J. Haltiwanger ‘The flow approach to labor markets: new data sources and micro-macro links’, Journal of Economic Perspectives 20(3) 2006, pp.3–26. 33 EC2065 Macroeconomics Lucas, Robert ‘Understanding business cycles’, in K. Brunner and A. Meltzer (eds) Stabilization of the domestic international economy. 5, pp.7–29. Also in Estrin, S. and A. Marin Essential reading in economics. (Basingstoke: Macmillan Press, 1995) first edition [ISBN 9780312125110] Chapter 16. Zarnowitz, Victor ‘Theory and history behind business cycles: Are the 1990s the onset of a golden age?’ Journal of Economic Perspectives 13(2) 1999, pp.69–90. Introduction If you are using Blanchard and Johnson you should read everything in Chapter 6, including the end chapter appendix, and Chapter 7, including the focus box on the empirical estimates on money neutrality. At this stage, you may want to read also Chapter 13, which incorporates technological progress within the AD–AS framework and looks at the effect of technology shocks on unemployment and wage distributions. You are strongly advised to read also the focus box on European unemployment in Chapter 8. If you are using Dornbusch et al., you should read Sections 1 to 5 in Chapter 7 for unemployment. Section 4 in Chapter 10 and the whole of Chapter 5 cover the relevant material of the syllabus for the AD–AS model. If you are using Mankiw, you should read everything in Chapter 7 for unemployment. Chapter 10, Section 2 of Chapter 12 and Section 1 of Chapter 14 together cover the relevant material for the AD–AS model. You may find the material in Chapter 14 rather selective, and for this reason you are advised to do some supplementary reading from the relevant sections of Blanchard and Johnson or Dornbusch et al. on this topic. This chapter is divided into two parts. The first part focuses on the labour market under imperfect competition and shows how to determine the equilibrium real wage and natural rate of unemployment. There are four types of unemployment: classical (real wage), frictional (search), structural (mismatch), and cyclical (Keynesian) unemployment. The sum of classical, frictional and structural unemployment determines the socalled natural unemployment rate, which is broadly defined as the average unemployment rate in the medium run. Understanding the alternative components of unemployment is important, as it ultimately allows us to correctly identify appropriate macroeconomic policies to reduce them. Note that the guide defines as classical the unemployment caused by wage rigidities in the labour market. This is in contrast to frictional unemployment, which is caused by the time necessary to search and find a job, and structural unemployment, which is caused by the mismatch between workers’ needs and skills and job requirements. Blanchard and Johnson are not explicit about this distinction, so you may want to rely either on the guide or upon the other two textbooks. Also be aware that Dornbusch et al. and Mankiw distinguish unemployment only as frictional and structural, as they treat classical unemployment as part of structural unemployment. The second part of this chapter focuses on the description of the AD–AS model, in order to assess the determinants of output and the price level in the short and the long run. The AS curve is computed from the labour market equilibrium condition, whereas AD is derived from the equilibrium condition in the IS–LM model. Attention is given to the economic theories underpinning the alternative slopes of the AS and the AD curves. Finally, the AD–AS model is employed to explain business-cycle fluctuations, and to assess how monetary and fiscal policy can be used to stabilise the economy in the short run. 34 Chapter 3: Unemployment and the AD–AS model It is very important that you are able to analyse the AD and the AS curves both analytically and graphically, and to interpret how changes in any variable or parameter of the two curves will affect their slope or position. Confusion may arise about the slope of the short-run AS curve. In the IS–LM model we took a very simplified view of price stickiness and considered a situation in which prices are fixed. In this context, the shortrun AS is represented by a horizontal line in output-price space. However, the appropriate view of price stickiness implies that prices slowly adjust, in the short run, and the AS curve is positively sloped in output–price space. The steepness of the AS curve determines the degree of price rigidity: the flatter the AS curve is, the slower the price adjustment mechanism. The labour market: main definitions The labour market includes three categories of individuals: employed, unemployed and inactive. The term employed refers to a person who is currently working. Unemployed refers to a person who is not working and is seeking a job. Inactive denotes a person able to work but not seeking a job. The labour force, L, is the sum of employed, N, and unemployed, U, people, and it is defined analytically as: L = N + U. The sum of the labour force and the inactive, I, defines the population of working age PW, as: PW = L + I = N + U + I. The unemployment rate u is the ratio between unemployed and the labour force: U, (3.1) u= L whereas the employment rate e is defined as the ratio between employed and the population of working age: N . (3.2) e = PW Equations (3.1) and (3.2) show that there is not a one-for-one relationship between changes in the rates of unemployment and employment, as these two variables are connected by the so called participation rate, PR, defined as the ratio between the labour force and the total population of working age: L . (3.3) PR = PW These definitions imply that: u = 1− e , PR which shows that an increase in employment reduces the unemployment rate to the extent that it is not offset by a rise in the participation rate. This result is obtained by manipulating the unemployment rate as follows: u = U L = L− N L =1− N L =1− N PW PW L =1− e 1 PR . The empirical evidence shows that the participation rate is not constant over time, but it tends to increase during expansions and to fall during recessions. The latter occurs because when the unemployment rate is high, some unemployed people give up their job search and cannot be counted as unemployed any more. These people are known as discouraged 35 EC2065 Macroeconomics workers, namely people who do not look for work, but who would take work if it was offered to them. Because workers change their status over time, the labour market can be characterised in terms of worker flows between the three states of employed, unemployed and inactive. A specific unemployment rate can be the outcome of a very active labour market with a high number of separations and hires, or of a stagnant (sclerotic) labour market with relatively few separations and hires. Labour market mobility is measured by the proportion of unemployed leaving unemployment in a specific period of time. The inverse of this measure defines the average duration of unemployment, namely the average length of time people spend in unemployment. The empirical evidence suggests five basic stylised facts about unemployment. First, the unemployment rate varies across countries and over time. In the US the unemployment rate rose until the mid-1980s, and fell afterwards. In Europe the unemployment rate was relatively low during the 1950s and the 1960s, but it increased over the 1970s and the 1980s, and has been above the US rate over the last 20 years. Second, unemployment is negatively correlated with the business cycle: it sharply increases during recessions and it falls during expansions. Third, the duration in unemployment also varies across countries and over time, and it is correlated with the business cycle. In particular, unemployment duration rapidly increases during recessions, whereas it reduces during economic expansions. Fourth, the proportion of unemployed workers finding jobs is low during downturns when unemployment is high. Finally, the proportion of employed workers losing their jobs is high during recessions when the unemployment rate is high. Activity 3.1 Consider country A, in which there are 10 million unemployed people. Over a month 1 million unemployed people find a job and 4 million become inactive. Country B has 10 million unemployed people and over the same period of time, 4 million unemployed people find a job and none becomes inactive. Compute the size of total flows out of unemployment (as a percentage of unemployment) and the average duration of unemployment in both countries. Labour market and classical unemployment In a competitive labour market the equilibrium real wage ensures equality between workers’ labour supply and firms’ labour demand. Panel A in Figure 3.1 describes the labour market in employment-real wage space. The labour force is fixed and indicated by the vertical line L. Labour supply, LS, is positively sloped because workers are ready to substitute leisure for labour as the real wage increases (substitution effect).1 Labour demand, LD, is negatively sloped because firms demand labour until the marginal product of labour equals the real wage. An increase in the employment level reduces the marginal product of labour, and can be supported in equilibrium only by a corresponding fall in the real wage. The competitive real wage, WCE / P , determines the level of employment N, and, in turn, the level of unemployment U = L – N. In a competitive labour market, the real wage always adjusts to clear any excess of labour supply and/or demand. 36 1 For simplicity we have assumed the absence of an income effect, namely the tendency of highincome workers to reduce labour supply when their wage increases. Chapter 3: Unemployment and the AD–AS model Wage rigidities are defined as the failure of the real wage to adjust to clear the labour market. More precisely, Panel B in Figure 3.1 shows a wage rigidity holding the real wage above the competitive level, resulting in a level of unemployment higher than the competitive one. The unemployment caused by such wage rigidities is called classical or real wage unemployment, and it is denoted in the figure with the symbol UCL. It is the difference between the number of workers who are willing to work at the given real wage, Ns, and the number who are able to find work, N. There are four main theories of wage rigidities and classical unemployment: minimum-wage, collective bargaining, insiders-outsiders and efficiency wages. A: Competitive labour market equilibrium WCE /P LD L UCL Real wage Real wage LS B: Wage rigidity N Employed L W/P WCE /P LD U 0 LS 0 N U NS Employed Figure 3.1: Labour market and classical unemployment. Minimum-wage legislations set a legal minimum compensation that firms must pay to their employees. Minimum wage laws result in a real wage higher than the market clearing wage for those workers with low marginal productivities and equilibrium wages, such as low-skilled and young workers, who tend to receive part of their compensation as job training and apprenticeships. There is an ongoing debate on whether or not minimum wage laws are beneficial for the labour market and the economy as a whole. Supporters argue that minimum wages increase average living standards, create an incentive to work, do not increase public spending, and stimulate consumption by increasing the purchasing power of low-income people who tend to spend their entire wages. Opponents of minimum wages believe that they ultimately increase unemployment among young or unskilled workers, and should be replaced by income tax credits. Low-income households can deduct the tax credit from their tax payments and, if the credit exceeds the tax bill they can also receive a money refund. The tax credit does not raise firms’ costs and is less likely to deter them from hiring. However, it has the disadvantage of increasing government spending, especially during economic slowdowns. In many countries wages are the outcome of collective bargaining between unions, firms’ associations and the government. The outcome of the negotiation is known as wage accord, which consists of setting a specific level for the real wage, then leaving firms free to decide how many workers to hire at this wage. Collective bargaining results in wage rigidities since the power of unions can push the negotiated real wage above the equilibrium wage. Efficiency wage theories argue that labour productivity is related to worker compensation, and paying a wage above the market-clearing level improves employee morale, thus increasing production. For this reason, firms may be willing to pay a real wage that exceeds the equilibrium wage in order to boost profits. A high wage may also be beneficial for firms in 37 EC2065 Macroeconomics that it reduces the incentive for workers to quit, and thereby the cost of advertising, screening, hiring and training new workers. The final source of wage rigidity arises from the potential conflict of interest between different groups of workers: insiders and outsiders. Insiders are those workers already employed by firms, who are interested in keeping real wages high. This clearly contrasts with the interest of those unemployed – outsiders – since a wage reduction would increase their chances of employment. A wage rigidity occurs if, within a union, the bargaining power of insiders is greater than that of outsiders, as in this case the insiders can keep the real wage above the equilibrium level. Hysteresis Hysteresis in the natural rate of unemployment occurs when the unemployment rate remains very high over a prolonged period of time (persistent unemployment). Several theories can be advocated to explain this phenomenon. The first view is the human capital decumulation theory. Unemployment reduces both the quality of the labour force (loss of skills) and the attitude of the unemployed towards their likelihood of finding a job (discouragement). Consequently, the quality and quantity of human capital that contributes towards overall production in an economy declines when unemployment is high. This may affect the long-term unemployed, people who have been out of work for long periods of time, and young labour force entrants who lack experience during the formative years of their life. The second explanation of hysteresis in the natural rate is related to the insider-outsider theory described at the end of the previous section. In essence, when workers become unemployed they are no longer insiders and become outsiders. Consequently, the unemployed do not have any influence on the wage and employment negotiations of the remaining insiders. This prevents the real wage from being reduced enough to increase employment, in turn allowing high unemployment rates to persist over long periods of time. The third explanation of hysteresis in the natural rate is the physical capital stock theory. This explanation is based on the empirical evidence that high unemployment occurs during economic recessions with very low physical capital formation. If capital and labour are complements in the production function, low capital formation leads to low labour demand, which in turn increases the natural unemployment rate. This is because lower capital stock implies a lower marginal product of labour at any given employment level. Hysteresis in the natural unemployment rate occurs under this theory because after an economic recession it takes a long time to rebuild the capital stock, hence for the full employment level to rise. Frictional and structural unemployment The unemployment rate is affected by the degree of mobility in the labour market, which is characterised by people continuously finding and losing jobs. The effect of labour force dynamics on the unemployment rate can be formalised by denoting with l the fraction of employed people losing their jobs in a specific period of time, and with f the share of unemployed people finding a job over the same period of time. If the unemployment rate is constant over the given horizon, and if we assume for simplicity that the participation rate is fixed at 100 per cent then it must be true that: 38 Chapter 3: Unemployment and the AD–AS model ∆ u = 0 ⇔ lN = fU , which states that a constant unemployment rate over a specific period of time can only occur if the number of employed people losing their jobs equals the number of unemployed people finding new jobs during that period. The definition of labour force, L = N + U, can be substituted into the above to obtain: l ( L − U ) = fU. After dividing both sides of this expression by L and solving for u, the unemployment rate becomes: 1 , u= (3.4) 1+ f / l which shows that the unemployment rate increases as the rate of job finding reduces, or the rate of job losses rises. Equation (3.4) implies that any policy aiming at reducing the steady-state rate of unemployment must either reduce the rate of job losses or increase the rate of job finding. In this context, the unemployment rate can have two very different sources. Frictional unemployment is caused by the time it takes workers to search and find a job. Structural unemployment is instead the outcome of a mismatch between, on the one hand, workers’ needs and characteristics and, on the other hand, vacancy requirements. Factors that determine structural unemployment are job locations, since job vacancies and unemployed people may be located in different regions, and workers’ skills, since workers may be either over- or under-qualified to undertake available jobs. Thus, the longer it generally takes workers to search and find a job, the higher will be frictional unemployment, whereas the higher the degree of mismatch, the higher will be structural unemployment. Activity 3.2 Discuss which of the three types of unemployment – classical, frictional and structural – each of the following policies can help to reduce: a. an increase in the number of job centres b. an increase in the number of retraining programmes c. a reduction in unemployment benefit d. a reduction in minimum wages and trade union power. The natural rate of unemployment The natural unemployment rate is defined as the sum of the three components of voluntary unemployment: classical, frictional and structural unemployment. It is a measure of the average or mediumrun unemployment rate, around which an economy fluctuates over the business cycle. In the short run, the actual unemployment rate may differ from the natural rate: during expansions the actual unemployment rate is lower than the natural rate, whereas during recessions it is higher. The difference between the actual and the natural rate of unemployment is defined as cyclical or Keynesian unemployment. An important way to analyse the natural unemployment rate is by use of the WS–PS model. This requires two modifications to the previous analysis of the labour market. First, the labour market has to be described in unemployment–real wage space. In this space, the labour market is characterised by a decreasing labour supply schedule and an increasing labour demand schedule. Second, imperfect competition is introduced in both the labour and product market, to evaluate how this affects labour 39 EC2065 Macroeconomics demand, labour supply, and the real wage. In this context, the natural unemployment rate is defined as the equilibrium unemployment rate in a labour market with imperfect competition.2 Under imperfect competition, the labour supply curve is replaced by the wage-setting relation, WS, which takes into account the bargaining of workers in wage negotiations, whereas the labour demand curve is replaced by the price-setting relation, PS, which takes into account firms’ power to set the price level above marginal cost. Blanchard and Johnson provide the following analytical description of the WS and the PS curves: e WS : W = P F (u,z), PS : P =( 1 + µ)W, (3.5) where W indicates the nominal wage, Pe is the expected price level, u is the unemployment rate, z measures structural and institutional factors that contribute to wage determination (i.e. the level of unemployment benefits, labour market protection, minimum wage legislations, etc.) and u is the markup, which reflects the degree of firms’ market power. The function F is assumed to be decreasing in u, as higher unemployment reduces workers’ ability to bargain for a high real wage. You should refer to Chapter 6 in Blanchard and Johnson for a comprehensive description of the WS–PS model. I will point out three things about the WS–PS model. First, under perfect competition both z and µ equal zero and the WS and the PS curves coincide with the competitive market labour supply and demand curves, respectively. Second, the slope of the PS curve is more generally likely to be positive in unemployment– real wage space. However, the labour market can also be described under an assumption that the marginal product of labour is constant, which results in the PS curve being horizontal. This is the dominant assumption in Blanchard and Johnson. Third, if F(u, z) is linear and equal to 1 + z – αu, then the WS curve can be written as: (3.6) W = Pe (1 + z – αu), where α is the response coefficient of the nominal wage to an increase in unemployment. The WS–PS model can be employed to compute, analytically, the natural rate of unemployment un. To this end, note that the natural unemployment rate is a medium-term concept, which holds when P = Pe. That is it is calculated under the assumption that price expectations turn out to be correct. Under this assumption, the nominal wage in equation (3.5) can be replaced with the nominal wage in equation (3.6) to obtain: 1 = ( 1 + z − α un ) (1 + µ ). This expression can be solved for the natural unemployment rate un as follows: un = µ+z (l+µ) , α(l+µ) (3.7) which shows that increases in both z and µ raise the natural unemployment rate. If µ is close to zero then this is well approximated by: µ+z un ≅ α The concept of a natural unemployment rate implies natural levels of employment and output. The natural level of employment, Nn, is given by: Nn = L(1 – un). 40 While this model will do a good job at capturing factors that affect classical and structural unemployment it focuses on the labour market at a given point in time, and so will not be so useful for studying the flows into and out of unemployment that make up the frictional component of the natural rate. 2 Chapter 3: Unemployment and the AD–AS model If output is produced according to the production function: Y = AN, (3.8) where A indicates the level of technology, then substitution of the natural level of employment into the production function gives the natural level of output: Yn = ANn = AL(1 – un). (3.9) Activity 3.3 Explain why the phenomenon of hysteresis implies the existence of a relationship between natural and cyclical unemployment, so that macroeconomic policies that aim at reducing cyclical unemployment can also indirectly affect the natural rate of unemployment. Activity 3.4 Consider an economy in which firms’ markup over cost is 10 per cent and the WS relation is given by equation (3.5), with z = 0.01 and α = 1. Assume that the marginal product of labour is constant. a. Compute the real wage and the natural unemployment rate. b. Calculate how the equilibrium real wage and the natural unemployment rate change if the markup increases to 15 per cent. Discuss your result. c. Keeping the markup at 15 per cent, calculate how the equilibrium real wage and the natural unemployment rate change if the bargaining power of unions increases so that z = 0.02. Discuss your result. Aggregate supply The AS relation describes how the price level adjusts over time in response to changes in aggregate demand and income. There are several approaches to the determination of the AS curve. Blanchard and Johnson combine the WS and the PS curves and solves for the price level. This yields the AS curve in equation (7.2) of Blanchard and Johnson’s textbook.3 This expression looks quite different from the more compact form for the AS curve used by Dornbusch et al. and Mankiw, which is written as: P = Pe + λ [Y − Yn ]. (3.9a) This equation states that the deviation of the actual price level from the expected price level, P – Pe, is proportional to the deviation of output from its natural level, Y – Yn. The definition of the natural level of unemployment implies that along the AS curve the price level equals its expected value, P = Pe, when output equals its natural level, Y = Yn. If the current level of output exceeds the natural level, Y > Yn, then the current price level exceeds its expected level, P > Pe. In fact, we will see below that the AS curve derived by Blanchard and Johnson can also be written in this form. 3 For more details on the analytical derivation of the AS curve from the WS–PS model, see Blanchard and Johnson pp.154–56. Alternatively, the AS relation can also be solved for output to obtain the so-called surprise-supply relation: Y = Yn + µ(P – Pe), where µ = 1/λ > 0 and the term P – Pe indicates surprise inflation. This relation shows that output exceeds the natural level to the extent that there is surprise inflation in the economy (i.e. the actual price level exceeds the expected one). 41 EC2065 Macroeconomics The parameter λ in equation (3.9a) measures the slope of the AS curve, namely how quickly the price level changes in response to variations in the output gap. There are three possible scenarios, as illustrated in the first three panels of Figure 3.2. Under the assumption of the IS–LM framework prices are fixed and the AS curve is horizontal (panel A). In the long run (more than 5–10 years) prices are fully flexible and the AS curve is vertical at the natural level of output (panel B). This is because the long-run equilibrium, in the labour market, is defined in real terms, and changes in the price level have no effect on the natural rate of unemployment, and thus the natural level of output. The long-run AS curve is denoted in the guide as LRAS. In the short run, nominal rigidities, and/or imperfect information, make the AS curve positively sloped (panel C). The short-run aggregate supply curve is denoted in the guide as SRAS.4 The position of the SRAS curve is determined by all the factors that contribute to equilibrium in the labour market. In particular, an increase in the expected price level makes workers bargain for higher wages (for any given unemployment rate). The increase in the wage raises the actual price that firms set. As a result, an increase in the expected price level causes the AS curve to shift upwards (Figure 3.2, panel D). A: AS with fixed prices B: Long run AS Price level Price level LRAS AS 0 0 Output C: Short run AS D: Increased price expectations 0 A Yn Output SRAS2 Price level Price level SRAS Pe Yn Output Pe2 Pe1 0 A2 SRAS1 A1 Yn Output Figure 3.2: The aggregate supply curve. The AS relation in equation (3.9a) shows that the extent to which output deviates from its natural level for any given deviation of prices from expectations depends upon the steepness of the SRAS, as determined by the magnitude of the coefficient λ. The smaller is λ, the more variable output becomes relative to prices. There are four theories that explain why output may deviate from its natural level in the short run: the sticky-wage model, the worker-misperception model, the sticky-prices model, and the imperfect information or Lucas ‘islands’ model. Each of these theories will be discussed in the following four sections. It is important that you note how each theory explains the positive slope of the AS curve as a result 42 The horizontal AS curve is also referred to as the ‘Keynesian’ supply curve, whereas the LRAS is also referred to as the ‘Classical’ supply curve. 4 Chapter 3: Unemployment and the AD–AS model of a market imperfection: the sticky-wage and the worker-misperception models focus on imperfections in the labour market, whereas the stickyprices and the imperfect information models focus on imperfections in the product market. Activity 3.5 Is the following statement true or false: ‘The aggregate supply curve is positively sloped because when the price level increases firms want to sell more goods?’ Discuss your answer. The sticky-wage model The sticky-wage model is grounded upon two assumptions. First, nominal wages are sticky in the sense they cannot adjust quickly when the economic conditions change, since they are fixed over long periods of time. Second, collective bargaining determines only the level of the nominal wage, whereas employment is determined by firms’ labour demand, because workers agree to provide as much labour as the firms wish to buy at the predetermined wage. This implies that, once the real wage has been set according to the expected price level, then an increase in the price level above the expected value leads to a fall in the real wage and increases labour demand. In turn, the increase in employment raises output, at least until the next wage negotiation. Analytically, the stickywage model is described by three equations: e Actual real wage: W = W × P ; Pe P P W W − e ; P P Labour demand: N − Nn = − Output: Y – Yn = A(N–Nn). The first equation shows that the actual real wage W/P deviates (above or below) from the predetermined real wage W/Pe to the extent that the expected price level differs (lower or higher) from the actual price level, Pe/P. The second equation shows that labour demand is inversely related to the real wage. An increase in the price level above the expected level increases employment, as it reduces real wages. The final equation shows that output is above the natural level to the extent that firms hire a number of workers higher than the natural employment level. The sticky-wage model predicts that if after the negotiation the actual price level equals the expected price level, P = Pe, then employment equals its natural level, N = Nn, and consequently output equals its natural level, Y = Yn . If, however, after the wage negotiation the price level is higher than the expected one, P – Pe > 0, then it must be true that output exceeds its natural level, Y – Yn > 0, since firms can employ a number of workers in excess of the natural employment level, N – Nn > 0, at least until the next wage negotiation. Vice versa, an unexpected fall in the price level raises the real wage, making labour more expensive. The higher real wage induces firms to reduce employment, and the reduced employment leads to a fall in output. When contracts are renegotiated, workers accept lower nominal wages to restore the original real wage, so employment rises. Therefore, the sticky-wages model predicts that the longer the period over which wages are negotiated, the flatter the SRAS. In addition, the model predicts that real-wage fluctuations are negatively related to output fluctuations. 43 EC2065 Macroeconomics The worker-misperception model The worker-misperception model assumes that wages are fully flexible, unlike the sticky-wage model, but workers have imperfect information, in that they suffer from money illusion, so they temporarily mistake nominal wage increases for real wage increases. Firms have perfect information and their demand for labour depends on the actual real wage, which is written as: LD = LD(W/P). Analytically, the supply of labour is described as: LS = LS(W/Pe), which shows that the quantity of labour supplied by workers depends upon their expected real wage. This can also be written as: W W P = × e , e P P P which shows that the expected real wage is given by the product between the actual real wage and the misperception ratio P/Pe. If (P/Pe) >1 the actual price level is higher than expected. Vice versa, (P/Pe) < 1 the actual price level is lower than expected. The expression for the expected real wage can be substituted into the labour supply curve to obtain: W P LS = L S × e , P P which shows that labour supply depends upon the degree of workers’ misperception of the price level P. Consequently, the position of the economy following an increase in P depends upon whether or not workers anticipate the increase in the price level. If they do, then (P/Pe) = 1: neither labour supply nor labour demand change. The nominal wage rises proportionally with the price level so that real wage, unemployment and output remain unchanged. If workers fail to anticipate the price-level increase, then firms can offer higher nominal wages which workers mistake for higher real wages. This causes an increase in labour supply, and allows firms to temporarily raise output above the equilibrium level, at least until workers realise that the real wage has not risen, so they revise their expectations and reduce labour supply. The worker-misperception model implies an AS curve that is positively sloped in the short run. In particular, for given price expectations the more elastic are the labour supply and demand schedules, the flatter will be the SRAS. The WS–PS model that Blanchard and Johnson use to derive the AS curve in equation (7.2) of his textbook can be thought of as a more complex version of this worker-perception model, in which the labour supply relationship is replaced by the WS curve and the labour demand relationship by the PS curve. Here we show how that model can deliver an AS curve that is algebraically equivalent to (3.9a). ►Optional material: First of all we will reconcile the two descriptions of the AS curve by showing that the compact form used by Dornbusch et al. and Mankiw is equivalent to the expression derived from the WS–PS model in Blanchard and Johnson. We will then use this compact form to assess the AD–AS model in the rest of the chapter. 44 ►This is more advanced material for those of you who wish to explore ideas further; there is no requirement for you to read these sections Chapter 3: Unemployment and the AD–AS model First, combine the linear WS curve in equation (3.6) with the PS curve to obtain the following expression for the price level: e P = (1 + μ ) P (1 + z − α u). Second, use equation (3.9) to write the AS curve in the output-price space as follows: Y . P = (1 + µ) Pe 1 + z − α 1 − AL (3.10) Equation (3.10) is equivalent to the AS curve in equation (7.2) of Blanchard and Johnson, with the only difference that we assumed a linear WS curve. The AS curve in equation (3.10) shows that the price level and output are positively related. The mechanism of price adjustment includes the following four steps. First, an increase in output leads to an increase in production which increases employment. Second, higher employment results in lower unemployment. Third, the reduction in unemployment leads to higher nominal wages through wage bargaining. Fourth, the increase in the cost of production, due to higher nominal wages, forces firms to raise prices above the expected level Pe. When the unemployment rate is at the natural level ( P = Pe ⇔ u = un ), the PS equation implies: 1 1 . = 1+ µ = Yn 1 + z − αun 1+ z − α 1− AL Using this, equation (3.10) can be written as: 1 + z − α 1 − e P =P 1 + z − α 1 − Y AL . Yn AL Subtracting Pe from both sides in the above and rearranging gives: α (l + µ) AL (Y – Y which yields the compact form of the AS relation: α (l +µ) where λ = Pe . AL n ( P − Pe = Pe , P = Pe + λ [ Y −Yn ], ►End of optional material The sticky-price model The sticky-price model assumes that some firms cannot quickly change prices as a result of variations in aggregate demand, because it is costly to alter prices once they have been published in catalogues, menus and price lists (menu costs). In particular, the aggregate price level can be analytically described as: P = sPe + (1 − s) [P+ α ( Y − Yn )], where 0 ≤ s ≤ 1 is the share of firms with sticky prices setting the price level according to their expectations; (1 – s) is the share of flexible price firms, which can immediately change the price level in response to an increase in demand above the natural level of output; and α > 0 is the response coefficient of flexible prices to demand. If we first subtract P(1–s) 45 EC2065 Macroeconomics from both sides of the above and then divide by s, the price level under the sticky-price model becomes: (1 − s ) α ( Y − Yn ). s This equation shows two features of the sticky-price model. First, a high expected price level leads to a high actual price level; since firms that set the price in advance expect a high price level, they will set high prices in order to face future high costs. These high prices cause all other firms also to set high prices. Second, the effect of changes in output on the price level depends upon the proportion of firms with flexible prices, as measured by the parameter (1 – s)/s. The lower s is, the steeper the SRAS, since deviations of output from its natural level cause a greater share of firms to change their prices. P = Pe + Activity 3.6 The empirical evidence in the US suggests that real wages are mildly pro-cyclical, since they tend to increase when the economy expands. Discuss whether or not the predictions of the sticky-wage model and the sticky-price model, about the correlation between real wages and output, are consistent with this evidence. The Lucas islands model ► Optional material: The Lucas islands or the imperfect information model considers an economy which includes many (N) little producers each working and producing on isolated islands. In any period t, the output produced by each individual i, Yit, depends positively on the difference between the local price on their island, Pit, and the expected aggregate price level given the information currently available, Et[Pt]. Analytically, this is written as: i i i Yt = Yt + β (Pt − Et [Pt ]), β >0 where Y t i is the average output produced by individual i and the operator Et–j[Pt], for j ≥ 0, denotes the expectation conditional on information available until period t–j of the price level in period t. By definition, the aggregate price level is given by the average price level across all islands: Pt =( ∑ N i=1 Pt )/N. i Local producers have imperfect information, in that they are only aware of the price of the product that they produce. Consequently, in any period t they forecast the aggregate price level by taking a linear combination of the price on their island and their expected price level given the information available until the previous period: i Et [ Pt ] = θ Pt + (1 − θ )Et–1 [Pt ], where the operator Et–1[Pt]denotes the expectation conditional on information available until period t–1 of the price level in period t, and θ is the weight attached to the local price. The latter is given by: σ2 , θ= 2 σi + σ 2 where σ2 and σi2 denote the variance of the aggregate and the local price levels, respectively. The supply curve of producer i can then be re-written as: Yti = Yti + β (1− θ )(Pti − Et–1 [ Pt ]). i N Consequently, the aggregate supply, Y t = ( ∑ Y t ) / N , is obtained as: i=1 46 ►This is more advanced material for those of you who wish to explore ideas further; there is no requirement for you to read these sections. Chapter 3: Unemployment and the AD–AS model σ2 Yt = Yt + β 2 i 2 σ + σi i (Pt − Et–1 [ Pt ]). This can be solved for P as: 2 +σ −1 σ Pt = E t − 1 [ Pt ] + β i 2 σi 2 (Yt − Yt ) The model distinguishes absolute changes in the price level, which occur when all prices of produced goods increase by the same proportion, from relative changes in the price level, which occur when the price of some goods increase more than others. A relative change in the price level makes the producers of the more expensive goods better off, as their price is increasing relative to the overall price level. Both the real and the nominal income earned by these producers increase. When an absolute change in the price level occurs, all producers are affected equally and only their nominal incomes increase, while real incomes remain constant. Imperfect information means that producers cannot distinguish relative changes in the price of the product that they produce from changes in the overall price level. Because of imperfect information, when the producer sees an increase in Pti, they do not know whether this is caused by goods increasing in price relative to all other goods or by general inflation, but the producer will always attach some positive probability to it being a relative price change. As a result, the producer works more and this increases the level of output even when the only change is a rise in the general price level. The Lucas islands model predicts that the higher the volatility of relative prices by comparison with aggregate prices, the flatter the SRAS. Activity 3.7 Consider the sticky-wage, the sticky-price, the worker-misperception, and the Lucas islands models. Discuss the source of imperfection that generates the positive slope of the AS curve under each model. Does the labour market clear under any of these models? ◄ End of optional material. Aggregate demand The AD relation defines combinations of the price level and income such that the goods and money markets are simultaneously in equilibrium. Analytically, the AD relation is obtained by substituting into the equation for the IS curve the equilibrium interest rate determined from the LM curve.5 Using the IS and the LM curve defined in equations (2.11) and (2.12) in Chapter 2 of the subject guide, the AD relation can be written as: h 2b 2 1 M h 1 × (c 0 − c 1 T + I + G ) − 0 + h1b 2 + h 2 [1 − c 1 (1 − τ 1 ) − b1 ] b 2 h2 h2 P This is a very generic and (apparently) complicated expression. However, if you set m = [1 − c 1 (1 − τ 1 ) − b1 ] to indicate the parameters of the * Y = . 5 For a detailed description of the derivation of the AD curve from the IS–LM model, see Blanchard and Johnson pp.156–69. multiplier and A= (c 0 − c 1 T + I + G ) to denote the level of autonomous spending, then the AD curve can be written in the more compact form: h2b2 h 1 M * 1 , Y = A− 0 + × h1b 2 + h 2 m b 2 h2 h 2 P which can be further rearranged as: 47 EC2065 Macroeconomics h2b2 h b2 M 1 A− 0+ h1b 2 + h 2 m b 2 h 2 ( h1b 2 + h 2 m ) P * Y = (3.12) Equation (3.12) gives the basic equation for the AD curve in a closed economy. There are several things that you may want to bear in mind at this stage. First, note that in equation (3.12), unlike equation (2.12) in Chapter 2, the price level is not fixed. The AD curve evaluates the goods and money market equilibrium conditions in the short run, during which prices are sticky but not entirely fixed. Second, equation (3.12) shows that the position of the AD curve depends on the level of autonomous spending, and it is generally affected by fiscal policy and monetary policy (T, G, M, τ1) and private sector behaviour, as summarised by the parameters c0, c1, b1, b2, h1 and h2. In particular, fiscal and monetary expansions shift the AD curve upwards, as they increase equilibrium income in the IS-LM model. Conversely, fiscal and monetary contractions shift the AD curve downwards. Figure 3.3 displays the link between the IS–LM model and the AD curve. Panel A shows that a fiscal expansion shifts the IS curve to the right, thus increasing the equilibrium level of income from Y1 to Y2. At any price level P, the AD curve shifts horizontally, to the right, by the same increase in output implied by the IS–LM model. Panel B shows that a reduction in consumer confidence – as measured by the parameter c0 – shifts the AD curve to the left, so that the reduction in income at any price level P in the AD diagram is equal to the reduction in the equilibrium level of income observed in the IS–LM diagram. i2 i1 B: Fall in consumer confidence LM A2 A1 IS2 Interrest rate Interrest rate A: Fiscal expansion i1 i2 LM A1 A2 IS1 IS1 P Y1 Y2 A2 A1 P AD1 0 Y1 Y2 0 Income Price level Price level 0 IS2 Y2 Y1 A1 A2 AD2 Income Income AD2 0 Y2 Y1 AD1 Income Figure 3.3: The AD curve. Finally, it is important that you have a clear understanding of the theoretical explanations provided for the negative slope of the AD curve. To this end remember that the AD curve is derived from the simultaneous equilibrium in the goods and the money markets. The variable that links these two market is the interest rate, which affects investment in the goods markets, through the parameter b2, and money demand in the money market, through the parameter h2. In general this results in a negatively-sloped AD curve because of the Keynes effect: when the price level rises the value of 48 Chapter 3: Unemployment and the AD–AS model Ms P falls. In order for the money market to clear, the opportunity cost of holding money must then rise – that is, the interest rate must increase. The increase in the interest rate reduces demand for investment and, in turn, output. There are two situations in which this mechanism fails to work. In both cases, the AD curve is vertical. The first case occurs when investment does not respond to changes in the interest rate, (i.e. b2 = 0). The AD curve is vertical because, in this case, the increase in the interest rate due to a rise in the price level is not transmitted to output, as demand for investment does not respond to changes in the interest rate. Consequently, output does not change as the price level changes. The AD curve is also vertical when the economy is in a liquidity trap (i.e. h2 = ∞). In this case, a rise in the price level still reduces real money balances. However, this has no effect on this interest rate because the demand for real money balances is perfectly elastic. Thus variations in the price level have no effect on investment and output. Yet even in these extreme cases it has been argued that the AD curve may have a negative slope. This is because of the so-called Pigou or wealth or real balances effect. Suppose the level of consumption itself depends upon the level of real balances. Then when the price level increases, the real value of money falls, in turn reducing consumer spending and output. As a result, a change in the price level will have a direct effect on aggregate demand, through consumption. In particular, an increase in real money balances due to a reduction in prices causes a rightward shift in the IS curve, alongside the usual downward shift of the LM curve. To the extent that consumption depends upon real balances, the Pigou effect compounds the Keynes effect. Consequently, the AD curve is flatter with the Pigou effect than under the Keynes effect alone. In addition, under the Pigou effect the AD curve is negatively sloped regardless of the sensitivity of investment and money demand to changes in the interest rate. Therefore, with the addition of the Pigou effect, the AD curve cannot be vertical.6 Activity 3.8 Discuss the impact on the slope and/or the position of the AD curve of a change in: i. the marginal propensity to consume, and ii. the sensitivity of money demand to the interest rate. In an open economy a change in the price level affects aggregate demand through a third channel: the real exchange rate effect. We will discuss this channel further in Chapter 7 of the subject guide. 6 The AD–AS model The AD and the AS relations can be employed to determine the general equilibrium in the economy, namely the price and output levels that simultaneously clear the goods, the money and the labour markets. In the short run equilibrium occurs when the AD curve equals the SRAS. This may occur at any price and output level. In the long run, the economy is in equilibrium when the AD curve equals the LRAS. Because in the long run output is fixed at its natural level, the long-run equilibrium is consistent with any price level along the LRAS. The short-run equilibrium condition determines the actual price level as well as the actual level of output, whereas the long-run equilibrium condition determines the long-run price level alone, since long-run output is determined within the labour market. In the short run, the actual price level normally differs from the expected level. For this reason, the short49 EC2065 Macroeconomics run equilibrium is not stable over time, and output adjusts until P = Pe. More precisely, if the actual price level exceeds the expected one, wage setters increase their wage demands as their price expectations increase, which in turn shifts the SRAS upwards. This process of medium-run adjustment continues until the SRAS equals the AD curve at P = Pe (i.e. until the economy reaches the long-run equilibrium). It is very important that you are able to describe both graphically and using words the adjustment mechanism in the AD–AS model. This is described in great detail in any of the main textbooks, so I will not provide any further discussion in the guide. The important thing to note at this stage is that the economy has a built-in adjustment mechanism, so that output returns, sooner or later, to its natural level once either a negative or a positive shock hits the economy. Activity 3.9 Consider an economy in which the AD curve is: Y = 10 + G – P, and the AS curve is P – Pe = 0.5(Y – Yn), where G indicates government spending, P is the actual price level, Pe is the expected price level, Y is actual GDP, and Yn is the natural level of GDP. In addition G = 50 and Yn = 25. a. Calculate the expected price level at the long-run equilibrium. Plot in output–price level space (i) the aggregate demand curve; (ii) the short-run aggregate supply curve (SRAS), assuming price expectations are consistent with long-run equilibrium; and (iii) the long-run aggregate supply (LRAS) curve. b. Suppose the economy starts from its equilibrium position, and an adverse demand shock reduces aggregate demand by five units at each price level. Compute the new AD curve and calculate the new short-run levels of output and price. c. Briefly, describe why the economy adjusts to a new long-run equilibrium, and calculate the expected price level at the new long-run equilibrium. Monetary and fiscal policy in the AD–AS model The AD–AS framework is, mostly, employed to assess the effectiveness of macroeconomic policy as a tool to stabilise the economy over the business cycle. I will briefly state in the guide the main results, as extensive discussion is provided in all three textbooks in the Essential reading list. A first important prediction of the model is known as classical dichotomy, which states that in the long run all real variables in the economy, such as aggregate real output, unemployment and real wages, are determined independently of monetary policy, which can only affect the long-run price level. Consequently, the AD–AS model predicts that in the long run monetary policy is neutral, in the sense that it can only alter output, unemployment and the interest rate in the short run. In the long run a monetary expansion results in an increase in the equilibrium price level alone, since the increase in the price level fully offsets the initial nominal money supply expansion. In the short run, monetary policy can still affect cyclical unemployment: long-run neutrality does not imply that monetary policy is useless. A monetary expansion increases output and reduces the interest rate in the short run, therefore it can be successfully employed to speed up the recovery from a recession. Moreover, by reducing more quickly cyclical unemployment, an expansionary monetary policy can also, indirectly, influence the natural unemployment rate, by limiting the increase in unemployment due to hysteresis arising from the dependence of the natural unemployment rate on the history of cyclical fluctuations. 50 Chapter 3: Unemployment and the AD–AS model The AD–AS model predicts that, in contrast with monetary policy, fiscal policy is non-neutral, as it affects the long-run equilibrium interest rate and thus demand for investment. A fiscal contraction reduces both output and the price level in the short run. Contemporaneously, the fall in the price level increases the real money supply, in turn reducing the equilibrium interest rate in the money market. This is compounded by the usual reduction in interest rates that follow a fiscal contraction in the IS–LM model. The result is an increase in the demand for investment, offsetting some of the fall in output. In the long run the fiscal contraction has no aggregate effect on output, which returns to its natural level as price expectations adjust. But the effect on investment remains: it has filled the gap left by lower government expenditure. The AD–AS model suggests that macroeconomic policy can be effectively employed as a tool for economic stabilisation (demand management or fine-tuning policy). Macroeconomic fluctuations can be regarded as the outcome of demand (IS and LM) shocks, namely unexpected changes in the private sector demand for consumption and investment. These shocks cause output to deviate, temporarily, from its natural level, and the actual price level to differ from the expected level. As discussed at the end of the previous section, the market already has an adjustment mechanism which tends to stabilise the economy in the medium run. However, monetary and fiscal policy can be employed to accelerate the medium run adjustment and, therefore, reduce macroeconomic fluctuations. Finally, you need to be aware that the magnitude of demand shocks, and, in turn, the effectiveness of macroeconomic policy as a stabilisation tool in the short run, ultimately depend upon the degree of price flexibility, as represented by the slope of the SRAS. In principle, if prices are extremely flexible (SRAS relatively steep) macroeconomic actions are relatively ineffective, but the effects of demand shocks will also be less problematic as the economy is able to adjust quickly on its own. In contrast, the flatter the SRAS is, the greater the destabilising effects of macroeconomic shocks, and also the greater the effectiveness of macroeconomic policy as a stabilisation tool. Activity 3.10 Consider the economy described in the previous activity. Suppose that, as the economy is hit by the negative demand shock, the government increases public spending by two units. Compute and discuss the effect of this policy in the short and in the long run. Supply shocks Supply shocks are unexpected changes in the position of the AS curve. A negative supply shock, such as an increase in the price of oil or other raw materials, increases the price level for any value of output. A positive supply shock, such as the discovery of a new and more efficient production technology, reduces the price level for any level of output. It is important that you have a good understanding of: i. how supply shocks may affect the economy over the business cycle, and ii. to what extent macroeconomic policy can (and should) be employed in response to supply shocks. Panel A in Figure 3.4 describes a (permanent) negative supply shock. The economy is initially in equilibrium at point A, where output equals the natural level Yn,1, the actual price level P1 corresponds with the expected price level Pe1, and the interest rate – in the IS–LM diagram – equals i1. The 51 EC2065 Macroeconomics negative supply shock increases firms’ production costs, inducing them to set higher prices. This results in the SRAS shifting upwards from SRAS1 to SRAS2. Contemporaneously, in the labour market the PS curve falls down, reflecting lower labour productivity which results in a permanent increase in the natural unemployment rate. The increase in the natural unemployment rate leads to a fall in the natural level of output to Yn,3, with the LRAS shifting to the left from LRAS1 to LRAS3. The new short-run equilibrium is at point B, which entails higher output relative to the new long-run level, Y2 > Yn,3, and a new price level P2 which is higher than the expected price level Pe1. The SRAS begins to shift upwards until it reaches the new long-run equilibrium at C. Contemporaneously, in the IS–LM diagram the increase in the price level reduces real money balances, and the LM curve shifts upwards until it reaches the new equilibrium position at C. In sum, a negative supply shock reduces output, increases the price level, and raises the interest rate. Panel B in Figure 3.4 describes a (permanent) positive supply shock. The economy is initially in equilibrium at point A, where output equals the natural level Yn,1, the actual price level P1 corresponds with the expected price level Pe1, and the interest rate – in the IS–LM diagram – equals i1. The positive supply shock reduces firms’ production costs, causing a lower aggregate price level to be set. This results in the SRAS shifting downwards from SRAS1 to SRAS2. Contemporaneously, in the labour market the PS curve shifts upwards, resulting in a permanent fall in the natural unemployment rate. The reduction in the natural unemployment rate leads to an increase in the natural level of output to Yn,3, with the LRAS shifting to the right from LRAS1 to LRAS3. The new short-run equilibrium is at point B, which entails lower output relative to the new long-run level, Y2 < Yn,3, and a new price level P2 which is lower than the expected price level P e1. The SRAS begins to shift downwards until it reaches the new long-run equilibrium at C. Contemporaneously, in the IS–LM diagram, the fall in the price level raises real money balances and the LM curve shifts downwards until it reaches the new equilibrium position at C. Therefore, a positive supply shock increases output, reduces the price level and decreases the interest rate. Note that, in general, the AD and the IS curves are also likely to respond to supply shocks. An increase in the price of oil may lead firms to reduce demand for investment and may also determine a fall in consumption, as it redistributes income from oil consumers to oil producers. Public spending may also be affected as governments may decide to increase investment in energy-efficient projects or pursue investment in alternative sources of energy. Positive supply shocks are also likely to affect the AD and the IS curves, even though this depends on the source of the shock. On the one hand, a shock resulting in a widespread diffusion of new discoveries and inventions increases the likely rate of future growth, and, in turn, raises consumer and business confidence. This type of shock is likely to increase current consumption and demand for investment, and thus to cause a rightward shift in the IS and AD curves. In contrast, a positive supply shock due to a new technology that makes firms more efficient may lead to a fall in labour demand, and undermine consumer confidence. As a result, both the IS and AD curves would shift to the left. 52 Chapter 3: Unemployment and the AD–AS model A: Negative supply shock B: Positive supply shock LM1 LM2 LM1 C i3 i2 i1 Interest rate Interest rate LM3 A A i1 i2 i3 C IS 0 0 SRAS3 LRAS1 C SRAS1 B A Pe1 = P1 Output LRAS1 SRAS2 Price level Price level Pe3 = P3 P2 IS Output LRAS3 Pe1 = P1 P2 Pe3 = P3 SRAS1 LRAS3 SRAS2 A SRAS3 B C AD 0 Yn,3 Y2 Yn,1 LM2 LM3 Output AD 0 Yn,1 Y2 Yn,3 Output Figure 3.4: Supply shocks and medium-run adjustment. An important question is whether, and to what extent, macroeconomic policy can be used in response to supply shocks. Positive supply shocks increase output and reduce the price level, which is not regarded as a negative outcome, as most people like higher output and lower prices. The issue is more complicated for negative supply shocks, since they lead to stagflation, that is a period of economic recession accompanied by an increase in the price level. Fiscal or monetary expansions would help the recovery of output, but also further increase the price level. Vice versa, fiscal and monetary contractions would contribute to reducing the price level, but would further depress output. We will return to this difficult trade-off in Chapter 12. Activity 3.11 Consider an economy that starts at the natural level of output. Assume that the economy is hit by a permanent adverse supply shock. i. What is the effect on the unemployment rate in the short and the long run? ii. How is the real wage affected by the shock? Assume now that the adverse supply shock is temporary. i. What is the effect on the unemployment rate in the short and the long run? ii. How is the real wage affected by the temporary adverse supply shock? Solutions to activities Activity 3.1 This activity points out that a shorter average duration of unemployment does not necessarily imply that more unemployed people find a job. In country A the average ∆U 1+ 4 flow is: = = 0 .5 ; U 10 and the duration of unemployment is: 1/0.5 = 2 months. In country B the average 4 ∆U = = 0 .4 ; flow is: 10 U and the duration of unemployment is: 1/0.4 = 2.5 months. Therefore, even though more unemployed people find a job in country B, the duration of unemployment is longer than in country A. 53 EC2065 Macroeconomics Activity 3.2 An increase in the number of job agencies improves information about job vacancies. This facilitates the matching between unemployed people and jobs, thus reducing frictional unemployment. An increase in retraining programmes helps to reduce the mismatch between the skills of the unemployed and those people required by new jobs, thus reducing structural unemployment. In principle, a reduction in unemployment benefits can help to reduce frictional unemployment by raising the incentives for the unemployed to search for work. A reduction in minimum wages and trade union power can help to reduce classical unemployment. Activity 3.3 Hysteresis is the increase in the share of long-term unemployed people during economic recessions. This may be the outcome of a loss of skills by unemployed people, a discouraged workers effect, or insider workers’ pressure to refrain from wage reductions during recessions. The higher cyclical unemployment is, the higher the probability that the unemployed lose skills, abandon searching for jobs, and reduce their bargaining power relative to the employed. Consequently, the higher cyclical unemployment is the greater the likelihood of hysteresis effects. For this reason, demand-management policies, which aim at reducing actual unemployment, may also reduce unemployment persistency and thus, indirectly, reduce the natural rate of unemployment. Activity 3.4 a. The real wage is obtained from the PS relation as follows: W P = 1 1+ µ = 1 1 + 0 .1 ≅ 0 . 91. This can be substituted into the WS relation to compute the natural unemployment rate as follows: W P 1 W 1+ z − ≅ 1 + 0 . 01 − 0 . 91 = 0 . 1 α P = 1 + z − αu n ⇔ u n = b. The increase in the markup reduces the equilibrium real wage to: W P = 1 1+ µ = 1 1 + 0 . 15 ≅ 0 . 87. Consequently, the natural unemployment rate increases to: un = 1 W 1 + z − ≅ 1 + 0 . 01 − 0 . 87 = 0 . 14. α P The increase in the markup reduces labour demand, as the PS curve shifts downward. This fall in labour demand increases unemployment and reduces the real wage. c. Since the marginal product of labour is assumed to be constant, the increase in the unions’ bargaining power does not affect the equilibrium real wage. However, the natural unemployment rate rises to un = 1 W 1 + z − ≅ 1 + 0 . 02 − 0 . 87 = 0 . 15. α P The greater is unions’ power, the higher is the wage set by wage setters, at any level of unemployment. However, the equilibrium wage is fixed at the level determined by the PS relation. For this reason labour demand falls as z rises, and the natural unemployment rate increases just sufficiently for workers to continue bargaining for the original real wage of 0.87 in equilibrium. 54 Chapter 3: Unemployment and the AD–AS model Activity 3.5 This activity clarifies the difference between the AS curve and the supply curve that you have encounterd in other 200 courses. The AS curve plots the combinations of the price level and output consistent with equilibrium in the labour market, given the expected price level. It slopes upwards because higher output implies a lower unemployment rate, which leads to higher wages and, thus, to a higher price level. The AS curve does not slope upwards because firms want to supply more goods when the price level is higher. Activity 3.6 The sticky-wage model predicts that the real wage should be counter-cyclical. An unexpected increase in the price level reduces real wages, as nominal wages are rigid. In turn, the reduction in the real wage raises labour demand and increases employment and output. In contrast, sticky-price theories suggest that the real wage should be neither pro-cyclical nor counter-cyclical: departures of output from its natural level are caused by rigidities in the price of goods, not labour. This means that the sticky-price model comes closer to explaining the mild pro-cyclicality of US real wages, though it must still rely on other factors to fully account for the data. Activity 3.7 The sticky-wage and the worker-misperception models focus on imperfections in the labour market: the former assumes that nominal wages adjust slowly, whereas the latter assumes that workers confuse nominal wage changes with real wage changes. The sticky-price and the imperfect information models focus on imperfections in the product market: the sticky-price model assumes that the prices of goods adjust slowly, whereas Lucas’s model assumes that producers confuse changes in the aggregate price level with changes in the local price level. The labour market clears under the sticky price and the Lucas model, whereas it does not clear under the sticky-wage model. Under the worker-misconception model the labour market clears but at an equilibrium that workers will no longer be content to uphold once their misconceptions about the price level have been remedied. Activity 3.8 An increase in the marginal propensity to consume, as measured by the parameter c1, increases the value of the Keynesian multiplier, corresponding to a reduction in the object m in (3.12). This causes the AD curve to become flatter, as output is now more sensitive to changes in real money balances. The curve will also shift out slightly, though this effect will be offset somewhat by a reduction in the value of A (in which c1 features negatively). The sensitivity of money demand to the interest rate, as measured by the parameter h2, affects the slope of the LM curve. The less sensitive money demand is to the interest rate, the steeper the LM curve. As shown in equation (3.12), this parameter affects both the slope and the position of the AD curve: the less sensitive money demand is to the interest rate, the bigger the change in income implied by a given change in the price level, and the flatter the AD curve. It can also be shown that higher values for h2 increase the constant term in (3.12), shifting the AD curve outwards. An important special case occurs when h2 = ∞. In this case the economy is in a liquidity trap so that the LM curve is flat and the AD curve is entirely vertical. A change in the price level affects real money balances but has no effect on output and the interest rate. 55 EC2065 Macroeconomics Activity 3.9 a. In the long run P = P e and Y = Yn. Imposing these conditions in the AD curve yields the expected price level: Yn = 10 + G − P e 25 = 10 + 50 − Pe ⇔ Pe = 35. The AD curve is obtained from P = 10 + G – Y, which has slope –1 and intercepts the vertical axis at P = 60. The LRAS is vertical at Yn = 25. The SRAS passes through the point (Yn , Pe) = (25,35) and intercepts the vertical axis at P = 22.5. b. The new AD curve is obtained as: P = 10 + G − Y − 5 P = 5+G −Y P = 55 − Y . The new short-run equilibrium is computed by solving the system: SRAS : P = 35 + 0. 5 (Y − 25 ) , AD : P = 55 − Y P which yields: Y 33. 3 21. 7 c. The expected price level at the new long-run equilibrium is computed by imposing P = Pe and Y = Yn in the AD curve P = 55 – Y, which yields: Pe = 55 – 25 = 30. The economy adjusts because at the short-run equilibrium of part b the actual price level is below its expected value, which must result in expectations changing over time. Activity 3.10 The increase in public spending partially offsets the fall in demand due to the reduction in consumer confidence. As a result, the new AD curve is obtained as: P = 57 – Y The new short-run equilibrium is computed by solving the system: SRAS : P = 35 + 0.5 ( Y − 25 ) . AD : P = 57 − Y P = 34 which yields: . Y = 23 In the long run the economy converges to the natural level of output. The new expected price level is obtained from the AD curve P = 57 – Y, which yields: P e = 57 – 25 = 32. Therefore, the government intervention contains the loss in output due to the adverse demand shock, and contributes to reducing the business cycle fluctuation. Activity 3.11 A permanent adverse supply shock raises the unemployment rate in the short run, and it also permanently increases the natural unemployment rate. Recall that as a result of the shock the PS curve shifts downwards, because of lower productivity. As a result, the real wage permanently falls following the adverse supply shock. If the shock is only temporary, the unemployment rate will increase only in the short run; in the long run it returns to the natural rate. The behaviour of the real wage depends on the model of aggregate supply used, but it falls only in the short run if at all. 56 Chapter 3: Unemployment and the AD–AS model A reminder of your learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • explain the mechanism underlying the determination of the equilibrium real wage and unemployment rate in the labour market • recognise the main types and causes of unemployment, and the appropriate macroeconomic policies to reduce them • derive aggregate supply under imperfect competition in the labour and product markets, and discuss the alternative interpretation of the AS relationship • compute the aggregate demand curve from the IS–LM model, and clarify the determinants of its slope and position • employ the AD–AS model in order to assess the determinants of output, the price level and the interest rate over the business cycle • appraise how monetary and fiscal policy can be used as stabilisation tools in response to demand and supply shocks. Sample examination questions Section A 1. ‘The introduction of employment protection legislation (making it harder for firms to dismiss workers) lowers the rate of unemployment.’ True or false? Briefly explain your answer. 2. ‘If there is a real balance effect then the classical dichotomy and the neutrality of money cannot hold.’ True or false? Briefly explain your answer. 3. ‘If a component of government expenditure is automatically increased when output falls then the AD curve becomes steeper.’ True or false? Briefly explain your answer. Section B 1. Answer each of the following: a. Why is the aggregate demand curve downward-sloping? b. Under what circumstances could the aggregate demand curve be vertical? c. What are the implications of proportional taxes, as opposed to lump-sum taxes, for the sensitivity of output to aggregate demand shocks and the cyclical behaviour of the government budget? 57 EC2065 Macroeconomics Guidance on answering the sample examination questions Section A 1. The statement is false. This is because the effect of the introduction of employment protection legislation on the unemployment rate is, in principle, ambiguous. On the one hand, employment protection legislation could reduce the unemployment rate, as it can lead firms to keep more workers employed than they would have otherwise done. On the other hand, the introduction of employment protection legislation could increase the unemployment rate, since it should reduce the propensity of firms to hire. This is because they fear that such decisions will be difficult to reverse in the future. 2. The statement is true. If consumption depends upon real balances, then the relative values of M and P, which are nominal variables, will have a long-run impact on aggregate consumption, a real variable. This is inconsistent with the classical dichotomy, which requires that real variables should be independent of nominal variables. 3. The statement is true. If a component of government expenditure responds negatively to changes in output, then the income multiplier falls. This makes the AD curve steeper. Section B 1. a. In a closed economy, the negative slope of the aggregate demand curve reflects the fact that a rise (fall) in the price level implies a lower (higher) real money stock and, under normal conditions, a lower (higher) level of output in equilibrium (via the Keynes effect). An alternative explanation of the negative slope of the AD curve is provided by the Pigou effect, which assumes that aggregate consumption depends on real money balances. Consequently, a fall in the price level increases real money balances, and thus aggregate consumption and output. b. The aggregate demand curve would be vertical either in the liquidity trap case (LM horizontal) or if investment is insensitive to the interest rate (IS vertical), abstracting from wealth effects and foreign trade. (For more details, see the section entitled ‘Aggregate demand’ in this chapter of the guide). c. Proportional income taxes imply a lower income multiplier and thus lower responsiveness of the economy to demand shocks (the AD curve is steeper and shifts by less for any given change in the autonomous components of expenditure). On the other hand, in the presence of proportional taxes, as opposed to lump-sum taxes, the budget deficit becomes counter-cyclical. 58 Chapter 4: Inflation and the Phillips curve Chapter 4: Inflation and the Phillips curve Aims of the chapter This chapter focuses on the links between output and inflation in the long run and over the business cycle. We revise the Phillips curve and how economists’ view of the inflation–unemployment trade-off has changed over time. Next, we exploit the link between the Phillips curve and the SRAS to revisit the AD–AS model in output-inflation space. This yields a complete new model of inflation, which is employed to assess the likely impact of disinflation policies under alternative assumptions about the mechanism of expectations formation. Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • illustrate the derivation of the Phillips curve and discuss its alternative interpretations • describe the links between the Phillips curve, Okun’s law, and the SRAS relation • employ the AD–AS model in output-inflation space to describe the behaviour of the economic system in the long run and over the business cycle • list and discuss the different costs and benefits of inflation • illustrate the quantity theory of money, and its long-run implications for monetary policy • discuss the relevance of the Lucas critique, and the role of rational expectations within disinflation policy • describe the short- and long-run implications for macroeconomic policy of inflation expectations. Essential reading Blanchard, O. and D.R. Johnson Macroeconomics. (Upper Saddle River, NJ: Prentice Hall, 2012) Chapters 8 (including end-of-chapter appendix), 9 and 24.2. Dornbusch, R., S. Fischer and R. Startz Macroeconomics. (New York: McGrawHill, 2011) Chapters 6, 7.1–7.2 and 7.6–7.8, 11.1–11.2 and 19.2–19.3. Mankiw, N. G. Macroeconomics. (Worth, 2012) Chapters 5.1, 5.5, 12.3 and 14.2. Further reading Barsky, Robert, B., and L. Kilian ‘Oil and the macroeconomy since the 1970s’, Journal of Economic Perspectives 18(4) 2004, pp.115–34. Svensson, Lars E. O. ‘Escaping from a liquidity trap and deflation: The foolproof way and others’, Journal of Economic Perspectives 17(4) 2003, pp.145–66. Tobin, James. ‘Inflation and unemployment’, American Economic Review 62(1) 1972, pp.1–18. Also in Estrin, S. and A. Marin, Chapter 11. 59 EC2065 Macroeconomics Introduction If you are using Blanchard and Johnson, the relevant material on the Phillips curve is in Chapter 8 (including the appendix). Section 2 in Chapter 9 covers the relevant material on liquidity traps, and the difficulty of providing policy stimulus in the face of a very severe recession such as that which followed the recent global financial crisis. The rest of the chapter discusses the financial aspects of the crisis in more detail, and is optional. Finally, you should read Section 2 in Chapter 24 on the costs and benefits of inflation. If you are using Dornbusch et al., Chapter 6 includes the relevant material on the Phillips curve. Chapter 7 discusses the links between inflation and unemployment in the first two sections, whereas Sections 6 to 8 focus on the optimal inflation rate. You should also read the first two sections in Chapter 11, as they include some discussion about monetary policy effectiveness when the economy is in a liquidity trap, including a description of unconventional measures taken by the Federal Reserve in the USA when interest rates reached zero in the wake of the 2008 crisis. Sections 2 and 3 in Chapter 19 look at the Great Depression and are optional. If you are using Makiw, Section 1 of Chapter 5 sets out the basic quantity theory of money, while the relevant material on the costs and benefits of inflation is contained in Section 5 of Chapter 5. Section 3 of Chapter 12 discusses the effects of deflation in the context of the Great Depression, and the role of stabilisation in the context of the more recent financial crisis. Make sure that you read the box explaining the liquidity trap. Chapter 14.2 covers the relevant material on the Phillips curve. The material for this chapter is treated in a rather selective way in Mankiw, and you may want to integrate some of the reading from either Blanchard and Johnson or Dornbusch et al. This chapter covers the section of the syllabus on the determination of the inflation rate and the assessment of disinflation policy. It begins by revising the definition of the inflation rate and the alternative versions of the Phillips curve. It is very important that you have a good understanding of the empirical evidence on the inflation-unemployment trade-off before and after the 1970s, and that you can relate the changes in the empirical evidence to the alternative analytical formulations of the Phillips curve. We focus on the link between the Phillips curve and the SRAS relation, and show how they are related through the so-called Okun’s law. This allows us to revisit the AD–AS model within output-inflation space. The new framework provides a more plausible description of the economy over the business cycle, as it predicts that economies during downturns should go through a phase of disinflation, rather than deflation as predicted by the basic AD–AS model developed in the previous chapter. Throughout the discussion, we emphasise that business-cycle fluctuations are automatically dampened by movements in the inflation rate, and that the effectiveness of the adjustment mechanism, in turn, increases with the degree of price flexibility. We have also seen, in the previous chapter, how monetary and fiscal policy can be employed to further reduce economic fluctuations and to speed up the adjustment mechanism. The inflation model developed in this chapter is then employed to analyse the role and the effectiveness of a disinflation policy. We revise three alternative views of the model. The traditional view is based upon the assumption that the mechanism adopted by the private sector to form 60 Chapter 4: Inflation and the Phillips curve inflation expectations is backward looking (adaptive expectations). In this case, disinflation can only be achieved at the cost of high unemployment in the short run. We explain how the traditional approach was challenged by the famous ‘Lucas critique’, which argued against the use of backwardlooking models to predict the likely effects of policy changes. The second model of disinflation is based upon Lucas’s view that if the private sector has rational expectations then disinflation can be achieved at zero cost, provided that monetary authorities are credible. Finally, we discuss the Fischer–Taylor view of disinflation policy in the presence of nominal rigidities, which shows that disinflations could be costly even with credible monetary authorities. The chapter concludes by focusing on situations which can explain persistence in business-cycle fluctuations, by considering the role played by inflation expectations during recessions, and when economies are in liquidity traps. It is essential, at this stage of your study, that you understand the difference between the level and the growth rate of a variable, and, in the specific case of this chapter, the different roles played by the price level and the inflation rate. The level of a variable indicates the value that it takes in a specific period of time. The growth rate indicates the speed at which the level changes over time. Inflation is defined as a persistent increase in the price level (i.e. a positive growth rate of prices). Note also that an assumption that expected inflation equals lagged inflation is not equivalent to an assumption that the expected price level equals the price level. The two only coincide if the lagged inflation rate is zero. The inflation rate and the Phillips curve The relationship between inflation and unemployment is known as the Phillips curve. It follows from the AS relationship that we studied in the previous chapter. As we saw there, there are at least four different ways to understand aggregate supply. Here we focus on the WS–PS approach presented by Blanchard and Johnson, which is an advanced version of the worker misperception model. Chapter 14 of Mankiw shows how the Phillips curve follows from alternative models of aggregate supply. We start with equation (7.2) in Blanchard and Johnson, which is reported below for convenience: Pt = Pte(1+μ)(1 + z – αut). The appendix at the end of Chapter 8 in Blanchard describes how to derive from the above expression the following (approximate) expression for the inflation rate: (4.1) t = te + (µ + z) – αut, which can alternatively be written as: πt = πte – α(ut – un), where πt is the actual inflation rate in period t, πte is the expected inflation rate in period t, and we have used the approximation from (3.7): αun ≅ μ + z. The solution to equation (4.1) depends upon the mechanism by which expectations are formed. In the special case of adaptive expectations, inflation is forecast according to an autoregressive equation, te = θ t − 1 for some parameter θ, and the inflation rate becomes: t = θt − 1 − α (u t − u n ), (4.2) which shows that the current period rate of inflation is a function of the previous period rate of inflation as well as the deviation of unemployment 61 EC2065 Macroeconomics from its natural rate. It is essential that you are aware that equations (4.1) or (4.2) give two functional forms for the determinants of the inflation rate, and very important that you fully understand how changes in any of the parameters of the two expressions affect the inflation rate.1 The Phillips curve was first discovered by Alban William Phillips2 in 1958. Phillips observed an inverse empirical relationship between the annual rate of inflation and the annual unemployment rate in the United Kingdom from 1861 to 1957. The same negative relationship was found by Robert Solow and Paul Samuelson in the US using data from 1900 to 1960. The inflation–unemployment trade-off also held throughout the 1960s, with the constant decline of the unemployment rate in that period being associated with a steady rise in the rate of inflation.3 It is essential that you are aware of the differences between the original and the modern Phillips curves, as well as the reasons behind the breakdown of the Phillips curve which occurred at the end of the 1960s.4 The original Phillips curve is analytically obtained by setting πet = 0 in equation (4.1) or, alternatively, θ = 0 in equation (4.2). This yields the expression: (4.3) t = ( μ + z ) − α u t , which suggests that there is a linear relationship between unemployment and inflation, with negative slope equal to α and intercept given by μ + z. The coefficient a measures the extent of the trade-off between unemployment and inflation and has a very important policy interpretation: a macroeconomic policy that reduces the unemployment rate by 1 per cent increases inflation by α per cent. Conversely, a policy aiming at reducing inflation by 1 per cent results in an increase in unemployment of 1/α per cent. The modern Phillips curve allows instead for the expected inflation rate to be different from zero. It is obtained by rewriting equation (4.1) as: e t − t = − α (u t − u n ) , (4.4) which shows that the current inflation rate depends upon the expected inflation rate and the deviation of unemployment from its natural rate. Under adaptive expectations, expected inflation is proportional to past inflation, and the Phillips curve is analytically described by equation (4.2). Figure 4.1 gives a graphical analysis of the properties of the Phillips curve in equation (4.4). Panel A shows that the curve is downward-sloping in unemployment-inflation space, and that expected inflation is constant along the Phillips curve at the rate π e, which occurs when ut = un. Panel B shows that, given the natural unemployment rate, any increase in expected inflation shifts the Phillips curve upwards, one-for-one. Panel C shows the effect of an economic expansion on the Phillips curve. The economy starts from the equilibrium position A1. After the expansion the unemployment rate falls below the natural rate, u1 < un, and the economy moves to point B along the original Phillips curve, PC1. At point B actual inflation exceeds expected inflation, π2 > π 1e. As a result, inflation expectations increase. For the case illustrated, the new level of inflation expectations is πe2 = π2, corresponding to the curve PC2. Long-run equilibrium is now possible only at the point A2, with a higher rate of inflation than originally and unemployment back at the natural rate. Therefore, the modern Phillips curve predicts that after an economic expansion, inflation and the unemployment rate both increase as the economy returns to the natural unemployment rate. Conversely, panel D shows that as a result of an economic recession unemployment is higher than the natural 62 For further details, see Section 8.1 in Blanchard and Johnson. 1 2 William Phillips studied sociology at LSE from 1946 before becoming interested in economics. He was offered a teaching position at LSE in 1949 and became Professor of Economics in 1958. 3 The empirical evidence about the Phillips curve is well documented in all three main textbooks. You should look carefully at Figures 8.1–8.5 if you are using Blanchard and Johnson, Figures 6.2–6.4 and 6.6 if you are using Dornbusch et al., and Figure 14.3 if you are using Mankiw. Section 8.2 in Blanchard and Johnson provides an accurate description of the history of the Phillips curve, and you should refer to this chapter for any further detail. 4 Chapter 4: Inflation and the Phillips curve rate and expected inflation falls, which leads the Phillips curve to shift downwards. While the economy recovers from a recession both inflation and the unemployment rate decrease, until unemployment returns to its natural rate. From a policy perspective, equation (4.4) implies that the attempt of policy makers to maintain the unemployment rate permanently below the natural rate leads to ever-increasing inflation, since expected inflation will continue to rise, and the Phillips curve will continue to shift upwards. Consequently, macroeconomic polices aimed at keeping output permanently above its natural level are ultimately unsustainable because they yield an ever-increasing inflation rate. Furthermore, panel C in Figure 4.1 helps to explain the empirical breakdown of the original Phillips curve during the 1970s. Throughout that period, continuous changes in inflation expectations caused the Phillips curve to shift over time, so that econometricians were, ultimately, collecting inflation and unemployment rate observations from different Phillips curves. Therefore the 1970s data could not display the stable inflation–unemployment trade-off observed until the 1960s. B: Increase inflation expectations Inflation Inflation A: Phillips curve e e2 PC2 e1 PC un Unemployment C: Upward shift D: Downward shift A2 B A1 PC2 PC1 0 u1 un 0 Unemployment PC1 Inflation Inflation 0 2 = e2 e1 PC1 PC2 e1 2 = e2 un Unemployment 0 A1 A2 B un Unemployment u1 Figure 4.1: The modern Phillips curve. Activity 4.1 Show that if output is produced according to the function Yt = ANt then the Phillips curve in equation (4.4) is equivalent to the SRAS relation π t = π te + λ (Yt − Y n ) , for some parameter l. Okun’s law Okun’s law is the name given to the relationship between changes in the unemployment rate and percentage changes in aggregate output. Okun’s relation can be written as: Yt − Y n = − γ (u t − u n ), Yn which posits that if unemployment is one percentage point higher than its natural level, then aggregate output is γ per cent lower than its natural level. The above can be equivalently written as: Yt − Y n = − δ (u t − u n ), (4.5) 63 EC2065 Macroeconomics where the coefficient δ = γY n measures how deviations of unemployment from the natural rate affect the output gap. ► Optional material: Analytically, Okun’s law can be derived starting from the following generic aggregate production function: γ Yt = AN t , where A indicates technological progress, Nt employment, and γ is a parameter indicating the returns to scale of labour. The definition of employment, Nt = L(1– ut), can be substituted into the production function to obtain: γ γ Y t = AL (1 − u t ) . Taking the logarithm of the above expression yields: ln Yt = ln A + γ ln L + γ ln (1 − ut ) ≅ ln A + γ ln L − γ ut , where we have used the approximation ln (1 − ut ) ≅ − ut.5 At the natural level of output it must be true that: ln Yn ≅ ln A + γ ln L − γ un. Subtracting this expression from the previous one yields: Since ln Yt − ln Y n = − γ (u t − u n ). ln Yt − ln Y n ≅ Yt − Y n Yn the expression for Okun’s law is obtained. End of optional material◄ In general, since it relates output and unemployment, Okun’s law translates the upwards-sloping SRAS curve into the downwards-sloping Phillips curve in equation (4.4), or vice versa. Since Okun’s law in equation (4.5) implies that: 1 u t − u n = − (Yt − Y n ), δ the SRAS relation can be written as: e t− t = α δ (Yt − Y n ), or equivalently: e t − t = λ (Yt − Y n ), which shows that Okun’s law ultimately relates the slope of the SRAS and the Phillips curves. Consequently, it is easy to distinguish the shortrun Phillips curve (SRPC), which is negatively sloped and described by equation (4.4), from the long run Phillips curve (LRPC), which is vertical in inflation-unemployment space at ut = un. Figure 4.2 gives a graphical representation of the relation between the Phillips curve and aggregate supply. Panel B shows that for a given level of expected inflation, �e1, output can exceed its natural level (Y2 > Yn) only temporarily, since in the long run the SRAS curve shifts upwards, from SRAS1 to SRAS2. Correspondingly, panel A shows that the inflation– unemployment trade-off can only be temporary. Attempts to sustain an unemployment rate below the natural level, u2 < un, lead to increased inflation in the short run. In the long run actual inflation settles at the higher expected rate, as the short-run Phillips curve shifts upwards from SRPC1 to SRPC2. Therefore, there is no inflation-unemployment trade off in the long run. 64 ►This is more advanced material for those of you who wish to explore ideas further; there is no requirement for you to read these sections. 5 This is valid so long as the unemployment rate is reasonably close to zero. Chapter 4: Inflation and the Phillips curve A: Phillips curve B: Aggregate supply LRAS B e2 A2 A1 e1 SRPC2 Inflation Inflation LRPC A2 e2 e1 0 u2 un Unemployment rate A1 SRAS2 SRPC1 B SRAS1 0 Yn Y2 Output Figure 4.2: Phillips curve and aggregate supply. The theoretical version of Okun’s law, derived in equation (4.5), is slightly different from the empirical version sometimes taken to data, given by: u t − u t − 1 = − β ( g Yt − g Yn ) (4.6) where gYt and gYn are growth rates of actual and natural output. This version of Okun’s law states that changes in the unemployment rate over a specific period of time depend upon the difference between the actual and the natural growth rate of output. The unemployment rate is unchanged if output grows at the natural rate. The focus of the empirical analysis is on estimating β. In the USA, the empirical estimates, based on annual data, suggest that β = 0.4, (i.e. a one percentage point fall in the unemployment rate is approximately associated with a 2.5 per cent increase in output). However, this result is not constant across countries and over time. For instance, over the period 1960–1980 the estimated β was about 0.15 in the United Kingdom, and 0.02 in Japan, whereas in the subsequent period 1980–2003 the estimated β increased to 0.54 in the United Kingdom, and to 0.12 in Japan. The magnitude of β depends on how firms adjust their labour demand in response to production fluctuations, which in turn is affected by the degree of job security and labour market regulation. In principle, low estimates of β are associated with high levels of job security. Therefore the increase in the values of β estimated in the United Kingdom and Japan could be explained by labour market reforms aimed at weakening the legal restrictions on hiring and firing, undertaken in both of these two countries since the early 1980s. Activity 4.2 Assume that aggregate output is produced according to the production function Y = N. Determine the coefficient of Okun’s law in this case. Discuss your result. The AD–AS model (revisited): long run The aggregate demand relation was derived in equation (3.12) of the previous chapter, and it is rewritten in a more compact form below as: M , Y = B +φ P where the coefficient B = h2b2 h 1 A− 0 h1b 2 + h 2 m b 2 h2 captures the effects of fiscal policy and private sector shocks on the position of the AD curve, and the parameter 65 EC2065 Macroeconomics φ = b2 ( h1b 2 + h 2 m ) measures the response of aggregate demand to changes in nominal money and the price level or, equivalently, changes in the real money supply. Suppose for simplicity that B ≅ 0 holds. Then we can take logorithms of both sides of the AD relationship for periods t–1 and t, to obtain: ln Yt − lnYt − 1 = ln M t − ln M t − 1 − (ln Pt − ln Pt − 1 ), which is equivalent to: g Yt = g Mt − πt. (4.7) This equation expresses aggregate demand in terms of growth rates showing that the growth rate of real output, gYt, is equal to the difference between the growth rate of the nominal money supply, gMt, and the inflation rate, �t. As a result, real output grows to the extent that growth in the nominal money supply exceeds inflation, gMt – �t > 0, or, equivalently, to the extent that the real money supply grows. We can now employ the Phillips curve of equation (4.4), the empirical Okun’s law of equation (4.5), and the aggregate demand relationship in (4.7), to provide a full and new description of the behaviour of the economy in the long run and over the business cycle. In the long run, the following propositions are true: 1. By definition, the unemployment rate is constant and equal to the natural rate: ut = un. 2. The growth rate of output is constant and equal to the natural rate: gy = gy t n 3. The inflation rate is entirely determined by the growth rate of the nominal money supply. Aggregate demand implies that: π t = gM − gY n t where gy is a constant. n 4. The inflation rate is constant only if the central bank maintains a constant growth rate of the nominal money supply, gM =gM: t π t = π t −1 = π = g M − g Y n . 5. A constant inflation rate is consistent with the unemployment rate being equal to the natural rate, and actual inflation being equal to expected inflation. In fact, the Phillips curve shows that: e π t = π t −1 = π = π ⇒ u t = u n . This analysis implies that in the long run inflation is entirely determined by monetary policy. The natural rate of unemployment and the natural level of output are determined by equilibrium in the labour market. In other words, money is neutral in the long run, in the sense that nominal money growth has no long-run effect on real variables, such as output, investment and unemployment. Activity 4.3 Show that the proposition of long run money neutrality can be obtained by assuming constant output and money velocity in the equation of the quantity theory of money. 66 Chapter 4: Inflation and the Phillips curve The AD–AS model (revisited): short run The behaviour of the economy over the business cycle is described in Figure 4.3. Panel A considers the adjustment mechanism after an economic expansion. Suppose the initial equilibrium is at point A1: output is at the natural level Yn, the rate of nominal money growth equals the inflation rate, actual inflation equals expected inflation, π1 = π1e , and the equilibrium interest rate, in the IS–LM diagram, equals i1 Suppose, next, that the economy is hit by a positive demand shock, caused for example by an expansionary monetary policy. As a result, the LM curve shifts downwards and the interest rate reduces to i1' , output increases to Y1', and the short run equilibrium moves to A1' on the SRAS1.6 Okun’s law implies that the increase in output causes the unemployment rate to fall below the natural rate. From the Phillips curve it follows that inflation begins to increase. The demand equation in (4.7) shows that the increase in inflation reduces real money growth, which shifts the LM curve upwards until the natural level of output is restored. Contemporaneously, also the Phillips curve and the SRAS shift upwards until the economy returns to its long-run equilibrium position at point A2, where expected inflation is in line with the higher inflation rate π2 = π2e . Panel B shows the adjustment of the economy to a negative shock, caused by a monetary contraction. The economy starts from an equilibrium position at A1, at which output is at its natural level. Next, the demand shock reduces output below its natural level and unemployment increases above the natural rate. The short run equilibrium in the economy shifts to point A1' along the initial SRAS (Phillips) curve.7 The Phillips curve predicts that inflation will begin to decline, and this increases the growth rate of the real money stock. The increase in the growth rate of real money shifts the LM curve downwards until the natural level of output is restored. Contemporaneously, inflation declines as the SRAS (Phillips) curve shifts downwards to point A2, where the expected inflation rate equals the lower inflation rate π2 = π2e . There is an essential point that needs to be clarified at this stage. Even though, from a graphical point of view, the adjustment mechanism in the revised AD–AS model looks similar to that described in the previous chapter of the subject guide, the two mechanisms are conceptually very different. In the basic AD–AS model developed in the previous chapter, with no inflation and a fixed money supply, an adverse shock drives output below its natural level and causes a decline in the price level, which in turn increases the real money supply.8 The increase in the real money supply shifts the LM curve to the right until the natural level of output is restored. Therefore, this adjustment mechanism implies that while the economy recovers from a recession the price level decreases (i.e. the economy experiences a deflation). The problem with this type of adjustment mechanism is that deflation is seldom observed in the real world. In contrast, the adjustment mechanism developed in this chapter exploits the Phillips curve in equation (4.4), which implies that during recoveries from recession economies experience disinflation (i.e. a decrease in inflation, which is a hypothesis consistent with the empirical evidence). 6 Note that Figure 4.3 assumes that the price level increases as a result of the monetary expansion in the very short run. If the price level did not change following the monetary expansion, the LM curve would have shifted further down and the short-run equilibrium would have been to the right of point A1' . For further comments, see Figure 7.8 in Blanchard and Johnson. 7 As in panel A, it is assumed that the price level falls as a result of the monetary contraction. If the price level did not, the LM curve would have shifted further up and the shortrun equilibrium would have been to the left of point A1' . Recall that the AD–AS model developed in the previous chapter assumes that the nominal money stock is constant, which implies that the price level is also constant in the medium run. In other words, that version of the AD–AS model assumed the inflation rate to be equal to zero. 8 67 EC2065 Macroeconomics A: Expansion B: Contraction LM1’ LM1 A’1 i’ IS 0 IS Output LRAS SRAS2 ’1 A’1 A1 AD2 Inflation SRAS1 1 = e1 A1 0 A2 2 = e2 1 = e1 ’1 Yn Y1’ SRAS1 A1 A’1 SRAS2 A2 2 = e2 AD1 AD2 AD1 0 LM1 A’1 i 1’ i1 Output LRAS Inflation Interrest rate i1 Interest rate LM1’ A1 0 Output Y1’ Yn Output Figure 4.3: AD–AS model (revisited) and business cycle. Activity 4.4 Consider the economy described by the following equations: u t − u t − 1 = − β ( g Yt − g Yn ) Okun’s law Phillips curve t − t −1 = − (u t − u n ) Aggregate demand g Yt = g Mt − t Consider the following estimates for the USA, the United Kingdom, and Japan: β gYn un πt USA 0.4 3% 5% 4% United Kingdom 0.54 3% 6% 2% Japan 0.12 5% 2% 0.1% The first column gives the estimated slopes of Okun’s law, the second gives the average growth rates of output, the third the estimated natural unemployment rates, and the last column lists actual inflation rates. Assume that unemployment has been equal to the natural rate in periods t–1 and t. Compute in each country: a. The growth rate of output in period t. b. The growth rate of the money supply in period t. c. Suppose that in period t+1 the growth rate of the money supply increases by 1 per cent in each country. Calculate in each country the short- and long-run effects of this policy on output growth and inflation. Costs and benefits of inflation Economists normally distinguish between the costs of expected inflation and the costs of unexpected inflation. Expected inflation is an increase in price level that is perfectly anticipated by the private sector and is, therefore, taken into account in economic transactions. The costs arising from anticipated inflation are ‘shoe-leather’ costs, menu costs, changes in relative prices, and tax distortions. When inflation rises, the nominal interest rate increases, thus increasing the cost of holding money. For this reason people want to hold less money and make more trips to banks in order to withdraw small quantities of cash. The cost of these trips is 68 Chapter 4: Inflation and the Phillips curve normally referred to as shoe-leather costs. Menu costs are the costs of updating catalogues, vending machines, cash registers, etc., due to the general increase in the price level. If the price of some goods increases more than others, then inflation changes relative prices of goods, thus altering consumption patterns. If price increases between different goods are staggered, so that the price of one may increase some months after another in response to the same general inflationary trend, then relative prices in the economy are likely to be constantly changing, and this can be a source of inefficient resource allocation. Finally, inflation causes tax distortions to the extent that the tax system is not perfectly indexed. The rise in inflation may increase taxpayers’ nominal incomes. If tax brackets are not updated to take into account inflation, some people are taxed more as a result only of a nominal, rather than a real, increase in income. Unexpected inflation refers to unanticipated future increases in the price level, which are not taken into account in economic transactions. The main costs arising from unanticipated inflation are due to the redistribution of wealth between debtors and creditors. Wealth redistributions arise because inflation erodes the real value of assets and liabilities fixed in nominal terms, such as money, long-term bonds, fixed-term mortgages, saving accounts, insurance contracts, and fixed pensions. Unanticipated inflation implies that debtors (mortgage holders or bond issuers) pay less than expected in real terms, and creditors (mortgage issuers or bond holders) receive less than initially anticipated. For this reason, the higher the inflation variability is, the higher the price uncertainty faced by creditors and debtors, and the more likely are these unexpected wealth redistributions. Moreover, the empirical evidence suggests that high inflation rates are often associated with higher inflation volatility, which increases the likelihood of unexpected, and potentially large, wealth redistributions. Of course, wealth redistributions are not a ‘cost’ for everybody: debtors are likely to welcome unexpected inflation as it increases their net wealth. Although this discussion might suggest that the ideal inflation rate should be zero, most economists believe that the optimal rate is instead positive, though low. This is because a low inflation rate brings at least three types of benefits to an economy. First, inflation brings positive revenue to the government through the printing of money – seignorage – which can be used either to lower the budget deficit or to decrease other taxes. The seignorage income is, however, quantitatively very low unless the inflation rate is very high. Second, a positive rate of inflation allows central banks to achieve low if not negative real interest rates, which could help the recovery from an economic recession. Finally, positive actual and expected inflation allows firms to cut real wages without reducing nominal wages, by ensuring that workers’ nominal wages increase less than the inflation rate (money illusion). Activity 4.5 Consider two countries A and B. In both countries firms’ net revenue Pr is equal to the difference between income and the cost of borrowing, as described by the following equation: Pr = y – ik where y denotes real income, i is the nominal interest rate, and k is capital borrowed by firms to finance production. In both countries a corporate income tax is levied at the rate τ on firms’ real income. However, the government in country A allows firms to deduct nominal interest payments from this income before taxing it whereas the government in country B allows firms to deduct only real interest payments on borrowing. 69 EC2065 Macroeconomics a. Calculate the after-tax net revenue in both countries. b. Use your results to argue that firms in country B should be more averse to inflation than firms in country A. c. Use your results to show that the government of country A will be less willing to tolerate domestic inflation than the government of country B. Costly disinflation policy The Phillips curve in equation (4.2) suggests that in order to reduce the inflation rate an economy must go through a period of low output and high unemployment. Panel B in Figure 4.3 shows that if the central bank wants to reduce the inflation from a high rate �1 to a lower rate �2, this can only be achieved at the cost of an economic recession, Y'1 < Yn. In other words, the model suggests that disinflation is costly: any policy aimed at reducing the inflation rate in the medium run comes at the cost of higher unemployment in the short run. The sacrifice ratio is a measure of the cost of disinflation policy. It computes the cumulative loss in employment required to achieve a given reduction in the price level, measured as a proportion of the achieved reduction in inflation. Analytically, the sacrifice ratio, SR, is written as: u − un u − un . SR = − t =− t t − t −1 ∆ t For example, suppose that the Phillips curve in equation (4.2) is estimated to be given by: 1 (u t − u n ) , 2 where the time subscript t indicates end-of-year observations. Therefore, the estimated Phillips curve suggests that a 1 per cent annual reduction in inflation, �t – �t–1 = –1, requires a 2 per cent short-run loss in terms of unemployment, ut– un = 2. In other words, the sacrifice ratio implied by the estimated Phillips curve is equal to: t − t −1 = − SR = − ut − un ∆ t =− 2 –1 = 2. The total cost of a disinflation policy can be measured by multiplying the sacrifice ratio by the number of percentage points by which the central bank wishes to reduce inflation. For instance, if the sacrifice ratio is 2, then reducing inflation by 5 percentage points requires a cumulative increase in the unemployment rate 10 percentage points above the natural rate. Although policy-makers cannot affect the overall cost of disinflation policy, which is ultimately determined by the slope of the Phillips curve, they have control over the length of the resulting recession, which ultimately depends upon how quickly the central bank wants to reduce inflation. This is illustrated in Figure 4.4, which considers an economy in which the central bank wants to reduce the inflation rate from 5 to 3 per cent, assuming a sacrifice ratio of 2. Panel A shows that if the central bank wants to achieve the lower inflation target in one year, then the economy has to go through a one year deep recession (point B) with unemployment 4 per cent higher than the natural level. Alternatively, panel B shows that if the central bank wants to adopt a more gradual approach and reduce inflation by one percentage point per year (points B and C), the economy will go through a two-year recession, with unemployment 2 per cent higher than the natural level each year. Ultimately, the speed of the adjustment and the length of the recession depend upon central bank preferences. Note also that the linearity of the 70 Chapter 4: Inflation and the Phillips curve Phillips curve implies that the sacrifice ratio for reducing inflation, from 5 to 3 per cent, is independent of the speed of the adjustment. As a result, a cold-turkey or shock therapy policy, which consists of rapidly reducing the rate of inflation to the new low level, yields the same sacrifice ratio of a more gradual policy, which entails a longer period of disinflation. This result does not hold if the Phillips curve is non-linear. The empirical evidence suggests that the Phillips curve may be convex, which implies that the inflation-unemployment trade-off changes with the unemployment rate and, in particular, that inflation becomes less sensitive to changes in unemployment the higher the unemployment rate. Activity 4.6 Consider an economy in which the unemployment rate is at the natural rate and the inflation rate is 10 per cent. Suppose that the domestic central bank wants to reduce inflation to 5 per cent. Starting from year t the central bank reduces the money supply in such a way that unemployment remains above the natural rate by one percentage point each year. After 5 years the inflation rate reaches the new target of 5 per cent. Compute the sacrifice ratio of this policy. What is the slope of the Phillips curve of this economy, assuming that it is linear? A: Cold-turkey policy B: Gradual policy A5 e= 5 PC ( = 5) e A3 =3 e 0 LRPC B PC (e = 3) un un + 4 Unemployment rate Inflation Inflation LRPC A5 e= 5 B e= 4 =3 e PC (e = 5) PC (e = 4) PC (e = 3) un un + 2 Unemployment rate A3 0 C Figure 4.4: Costly disinflation policies. Disinflation policy In the mid-1970s, the economist Robert Lucas challenged the traditional view that inflation could only be reduced at the cost of higher unemployment and that the speed of the deflation had no effect on the sacrifice ratio. Lucas first argued that the use of a model such as the AD–AS with adaptive expectations to predict the consequences of a disinflation policy is bound to provide misleading forecasts, since the estimated Phillips curve and Okun’s law depend on historical data, and policy changes are likely to alter the observed relationships between variables. In particular, policy changes may alter both the response of unemployment to output, and inflation expectations, thus changing both the slope and the position of the Phillips curve. This argument is known as the Lucas critique. Lucas went on to argue that a disinflation policy could be costless, if monetary authorities are credible and people have rational expectations. In the Phillips curve of equation (4.2) expected inflation is based on lagged inflation. Consequently, disinflation automatically leads to short-run high unemployment. However, rational expectations do not consider past inflation, but are formed according to the best predictions that the private sector could make about the future evolution of the price level given the information available about the state of the economy and economic policy. The Phillips curve in equation (4.4) suggests that if the central bank could convince wage 71 EC2065 Macroeconomics setters that it intended to reduce inflation in the future, wage setters might expect inflation to be lower in the future than in the past. If the central bank announces a lower inflation target, and wage setters find it credible, disinflation could be achieved without any short-run increase in the unemployment rate. In other words, the sacrifice ratio is zero when monetary authorities are credible, and the policy prescription arising from Lucas’ view is that central banks can and should pursue fast disinflation policies. Analytically, the Lucas argument is illustrated by combining the Phillips curve in equation (4.4), e t − t = − α (u t − u n) with expectations given by: te = . where is the inflation target announced by the central bank. Therefore, if the inflation target is credible, the Phillips curve is described by: t − = α(Ut – Un). This suggests that monetary authorities can have full control over the position of the Phillips curve, provided that (i) their policy actions (and announcements) are credible and (ii) people incorporate the target inflation rate into their expectations. Figure 4.5 gives a graphical illustration of costless disinflation policy by considering an economy in which, as in Figure 4.4, the central bank wants to reduce the inflation rate from 5 to 3 per cent. If monetary policy is credible, once the central bank announces the new lower inflation target, the Phillips curve immediately shifts downwards and the economy adjusts to the new equilibrium at A3, in which actual inflation equals the lower 3 per cent target. In contrast to the Lucas argument, Stanley Fischer and John Taylor have argued that the presence of nominal rigidities implies that even credible disinflations could be costly. Fischer emphasised that inflation is already built into existing wage agreements and cannot be reduced without cost. Taylor pointed out that wages are not all set simultaneously, but instead are staggered over time. The existence of staggered contracts implies that wages (and hence prices) can adjust only slowly to changes in policy. As a result, a too-rapid reduction in nominal money growth would lead to a less than proportional decrease in inflation. The consequent decline in the real money stock would lead to a recession and an increase in the unemployment rate. The policy prescription arising from the nominal rigidities view is that the central bank should implement disinflation policies slowly. Analytically, the Fischer–Taylor view implies that the inflation target announced by the central bank affects inflation expectations only partially, and the mechanism of expectation formations is described by: e t = λ + (1 − λ ) t −1 where the parameter λ can be thought of as meaning the extent of central bank credibility. If λ = 1, then monetary policy is entirely credible and disinflation can be pursued at zero cost. Vice versa, λ = 0 implies that monetary authorities are not credible and disinflation policy is costly. 72 Chapter 4: Inflation and the Phillips curve Inflation LRPC = 5 A5 = 3 A3 PC(e = 5) PC(e = 3) 0 un Unemployment rate Figure 4.5: Costless disinflation policy. Activity 4.7 Consider an economy in which the current inflation rate is 5 per cent and the government is planning to undertake a policy to reduce inflation to 2 per cent in one year. Suppose that the government estimates the Phillips curve to be: π t− π te = − (u t − un ), where time subscripts refer to annual data. In addition, the government believes that inflation expectations are formed according to: e t = λ + (1 − λ ) t − 1 , but it does not know the exact value of λ. a. Compute the range of likely costs of the disinflation policy that the government is about to undertake. Discuss your result. b. Aside from the exact value of λ, is there any other factor that makes the final outcome of the planned policy uncertain? Depression, liquidity trap, and deflation The revised AD–AS model can be employed to describe the effect that inflation expectations may have on business cycle fluctuations. In particular, the model developed in this chapter can explain why recessions can turn into economic depressions (i.e. prolonged periods in which output is below its natural level and the unemployment rate is persistently higher than the natural rate). Panel A in Figure 4.6 illustrates the basic adjustment mechanism following an adverse demand shock which reduces output below the natural level at A1. In this situation the AD–AS model predicts that the economy will go through a phase of disinflation which increases real money balances. The increase in real money balances shifts the LM curve downwards until the economy converges back to the natural level of output at a lower interest rate. To understand why the recession described in panel A may turn into a depression, recall that the IS curve responds to changes in the real interest rate, whereas the LM curve responds to the nominal interest rate. In addition, the Fischer effect implies that the real interest rate is equal to the difference between the nominal interest rate and the expected inflation rate, which may also be affected by negative demand shocks. Consider the case depicted in panel B of Figure 4.6. Suppose an adverse demand shock drives output below its natural level and the unemployment rate above the natural rate, so that the economy moves to A1. The Phillips curve predicts that inflation falls, so that the real money supply rises and under the basic adjustment mechanism this tends to move the economy from A1 to A2. However, the fall in inflation leads also to a fall in expected inflation, which tends to increase the real interest rate for any given nominal rate. The increase in the real interest rate tends to reduce output, as it shifts the IS curve to the 73 EC2065 Macroeconomics left and equilibrium to point B. Therefore, the net adjustment effect is, in principle, ambiguous, as it depends on whether the LM effects dominate the IS effects. The economy could adjust along the new IS curve and return to the natural level of output at a slower pace than that predicted in panel A. A: Recession B: Depression A1 i1 i2 i3 LM2 LM3 IS1 LM1 Interest rate Interest rate LM1 i1 i2 IS1 D: Liquidity trap and deflation LM1 LM2 LM3 IS2 IS1 Interest rate Interest rate A2 Y2 Y1 Yn Output 0 C: Liquidity trap IS1 B LM2 IS2 Y 1 Y2 Yn Output 0 A1 LM1 ∆e < 0 A1 A2 A1 A2 0 Y1 Y2 Yn Output 0 Y2 Y1 Yn Output Figure 4.6: Economic depressions, liquidity trap, and deflation. Alternatively, the economy could also continue to diverge from the natural level of output, since the increase in unemployment leads to a further fall in inflation which may reduce expected inflation even more, and in turn cause the IS curve to shift further away from equilibrium. In this scenario the effectiveness of monetary policy is limited by the fact that the nominal interest rate cannot fall below zero. In other words, monetary expansions are ineffective after the equilibrium nominal interest rate reaches zero, since the economy falls into a liquidity trap.9 As already described in Chapter 2 of the subject guide, when the market clearing nominal interest rate is zero, the extra liquidity generated by a monetary expansion ends in a trap in the sense that people are indifferent between holding their wealth in money and bonds at the zero nominal rate. This situation implies that the segment of the LM curve corresponding to a zero nominal interest rate is flat in output-interest rate space. An increase in the nominal money supply shifts the entire LM curve to the right, so that the horizontal segment at the zero nominal interest rate gets even longer. This situation is illustrated in panel C of Figure 4.6. The short-run equilibrium is described by the intersection between the IS and the LM curves at point A1, so that the short run equilibrium level of output Y1 is lower than the natural level of output. Suppose a monetary expansion shifts the LM curve to the right, so that the new equilibrium level of output Y2 corresponds to a zero nominal interest rate.10 Once the economy reaches the new equilibrium at A2 any further monetary policy has no power to stimulate the economy, as an increase in the nominal money supply cannot reduce the nominal interest rate further, and output does not increase further than Y2. The adjustment mechanism becomes even more complicated when people begin to expect deflation. Panel D in Figure 4.6 shows the case of an economy that is in a liquidity trap and in recession. Suppose that the economy has been in recession for some time, so that after a period of disinflation the price level begins to decrease (deflation). The deflation 74 9 Note that the liquidity trap does not have to be at zero interest rate, but can occur when the interest rate is positive but very low, as it was during the Great Depression and more recently in Japan. As pointed out in the previous note, a liquidity trap can occur when the interest rate is positive but very low. For this reason, the diagram in panel C could also have been drawn to reflect an LM curve with a horizontal part at a low, but not zero interest rate. 10 Chapter 4: Inflation and the Phillips curve may lead the private sector to expect prices to further decrease in the future. As a result, the real interest rate increases, in turn reducing investment spending. The increase in the real interest rate shifts the IS curve to the left, creating the possibility of a prolonged economic downturn. In this situation the economy gets into a vicious cycle: monetary policy is powerless and low output leads to more deflation, which in turn further reduces output via the real interest rate. Activity 4.8 Consider an economy which is in long run equilibrium. Suppose that the central bank increases the growth rate of the money supply. Discuss the short-run effects of this policy on: a. the actual and the expected inflation rate b. the position of the IS curve c. the position of the LM curve d. the equilibrium level of income and the nominal interest rate. Solutions to activities Activity 4.1 Recall that if output is produced according to Yt = ANt the unemployment rate is related to output through Y ut = 1 − t AL Y Y As a result, the Phillips curve is written as: t − te = − α 1 − t − 1 + n , AL AL Y Y e which yields: t − t = α t − n . AL AL α , we have the desired result. If we define λ = AL Activity 4.2 Okun’s law can be derived by noting that Yt = Nt = L (1 − ut), so: Yt – Yn = – L(ut– un) or: Yt – Yn Yn = Thus the coefficient is –L Yn 1 (ut – un) = – (1 – un) 1 (1 – un) (ut – un) , which will be close to one for small values of un. This is consistent with the result (in the optional material) that if the production function satisfies Y = ANλ then the coefficient in Okun’s law will approximately equal λ. Here λ = l. Activity 4.3 The quantity theory of money states that nominal GDP is proportional to the nominal money stock. Its central equation is written as: Pt Yt = V t Mt , where P is the price level, Y is real GDP, M is the money stock, V is money velocity, and all variables are observed in period t. Taking the logarithm of both sides in the above expression yields: ln Pt + ln Yt = ln Vt + ln M t . 75 EC2065 Macroeconomics After taking the same relationship at t–1 and subtracting, we have: ln Pt − ln Pt − 1 + ln Yt − ln Yt − 1 = ln V t − ln V t − 1 + ln M t − ln M t − 1 , or equivalently: t + g Yt = g Vt + g Mt , where gVt is the growth rate of velocity. Under the assumption that real GDP and the velocity of money are constant over time, gYt = gVt= 0, the quantity theory of money implies: t = gMt , which posits that inflation is only determined by changes in the money stock. This is consistent with the classical dichotomy prediction that money growth cannot affect real GDP growth. Activity 4.4 a. Consider the case of the USA. With a constant unemployment rate between t–1 and t, Okun’s law suggests that output will have grown at the natural rate of 3 per cent. Similar logic gives for the United Kingdom gYt = 3% and for Japan gYt = 5%. b. The growth rate of the money supply is computed from the aggregate demand relation. In the USA: g Mt = g Yt + t = 3 % + 4 % = 7 %. In the United Kingdom: gMt = gYt + t = 3 % + 2 % = 5 %. Finally, in Japan: gMt = 5 % + 0 . 1 % = 5 . 1 %. c. The increase in money supply growth in the long run raises inflation one-for-one in all countries, with no effect on output and unemployment. Outcomes in period t+1 can be determined by solving the system of three simultaneous equations given by Okun’s law, the Phillips curve and the aggregate demand relationship, given the specified values for gyn, un and πt, and the values for gMt+1 and ut implied in parts a and b. For the USA, gMt+1 = 8%, which gives: πt+1 ≅ 4.3% and gyt+1 ≅ 3.7%. For the UK, gMt+1 = 6%, which implies πt+1 ≅ 2.4% and gyt+1 ≅ 3.6%. For Japan, gMt+1 = 6.1%, giving πt+1 ≅ 0.2% and gyt+1 ≅ 5.9%. Activity 4.5 a. Since in country A firms can deduct the nominal cost of borrowing, their after tax revenue is: Pr A = ( y − ik )(1 − τ ) . In country B firms are only allowed to deduct the real interest payments on debt. If i = r + �, then their after tax revenue is: PrB = y − ik − τ ( y − rk) = y − ik − τ ( y − ik + k) = ( y − ik) (1 − τ ) − τ k. b. The difference between the two after tax revenues is PrB − PrA = −τ k which shows that firms in country B are relatively worse off the higher is inflation. For this reason, they can be expected to be more inflation-averse than firms in country A. c. The tax revenue of the government of country B is τ(y – ik + πk) = τ(y – rk). The revenue of the government of country A is instead τ(y – rk – πk). Thus government revenues are reduced by inflation in country A, whereas in country B they are not. Activity 4.6 The sacrifice ratio is given by: SR = − 5 ∆u =− =1 . ∆ −5 As a result, the slope of the Phillips curve in the economy is equal to –1, since a 1 per cent annual reduction in inflation increases unemployment 1 per cent above the natural rate. 76 Chapter 4: Inflation and the Phillips curve Activity 4.7 a. If λ = 1, then the disinflation policy is costless as the private sector will entirely embody the lower inflation target into its expectations. If λ = 0, then the estimated Phillips curve predicts: 2 − 5 = −(ut − un ) , which implies a sacrifice ratio: SR = − ∆u ∆ = − (5 − 2 ) (2 − 5 ) =1 As a result, the economy should go through a recession with unemployment 3 per cent above its natural rate. Since the government does not know the true value of λ it can only expect a cost – in terms of higher unemployment – ranging from zero to 3 per cent. b. The estimates of the government are correct as long as the implementation of the policy does not alter the estimated slope of the Phillips curve. The use of the estimated Phillips curve to predict the likely effects of the disinflation policy potentially incurs the Lucas critique. Activity 4.8 a. The increase in money supply growth should raise both actual and expected inflation, particularly if expectations are rational. b. The increase in expected inflation implies that the IS curve shifts upwards in income– nominal interest rate space. However, the IS curve does not shift in income–real interest rate space. c. In the short run, real money balances are likely to increase due to the faster money supply growth, causing the LM curve to shift downward. d. Income is likely to increase in the short run. The effect on the nominal interest rate is in principle ambiguous: the nominal interest rate tends to increase because of the IS effect, but it tends to reduce because of the LM effect. A reminder of your learning outcomes Having completed this chapter, and the Essential reading and activities, you should be able to: • illustrate the derivation of the Phillips curve and discuss its alternative interpretations • describe the links between the Phillips curve, Okun’s law, and the SRAS relation • employ the AD–AS model in output-inflation space to describe the behaviour of the economic system in the long run and over the business cycle • list and discuss the different costs and benefits of inflation • illustrate the quantity theory of money, and its long-run implications for monetary policy • discuss the relevance of the Lucas critique, and the role of rational expectations within disinflation policy • describe the short- and long-run implications for macroeconomic policy of inflation expectations. 77 EC2065 Macroeconomics Sample examination questions Section A 1. ‘An economy undergoing deflation cannot have a negative real interest rate.’ True or false? Briefly explain your answer. 2. ‘Inflation is still costly even when it is fully anticipated.’ True or false? Briefly explain your answer. Section B 1. Answer each of the following: Suppose the government or central bank has announced an inflation target, and that the actual rate of inflation exceeds the target in a particular year, but was below target in the previous year. Using some of the theories that have been put forward to explain the short-run Phillips curve, discuss how the level of unemployment in the short term could be affected by the following: a. whether expectations are formed rationally or not b. inflation has been very volatile in the past c. there is a large rise in the prices of oil and other commodities. 78 Chapter 4: Inflation and the Phillips curve Guidance on answering the sample examination questions Section A 1. The statement is true. The real interest rate equals the difference between the nominal interest rate and the inflation rate. The nominal interest rate cannot be negative, so the real rate can only be negative if inflation is positive. 2. The statement is true. There are at least four costs associated with anticipated inflation: ‘shoe-leather’ costs, menu costs, changes in relative prices, and tax distortions (for further details, see the section entitled ‘Costs and benefits of inflation’ in this chapter of the subject guide). Section B e 1. The Phillips curve is described by the equation t − t = − α (u t − u n ) which means that deviations of the unemployment rate from its natural level depend upon the gap between actual and expected inflation. Note that if we denote the inflation target with , we know from the information provided that current inflation is higher than the target, t > , whereas previous period inflation was below the announced target, t −1 < . a. Lucas’s argument on the cost of disinflation policy implies that if expectations are rational and the target announced by the central bank is credible, then expected inflation equals the inflation target and unemployment must currently be below the national rate since actual inflation is above target. If expectations are not rational but adaptive, then inflation expectations will coincide with lagged inflation. Since this is below target, in this case unemployment must be even further below the natural rate in the short term. If expectations are rational then the central bank knows that current inflation above target can be dealt with by a costless disinflation in the future, whereas adaptive expectations imply that this can only be achieved at the cost of future employment (the magnitude of which depends on the slope of the Phillips curve). Note that even under rational expectations and policy credibility, the disinflation policy may be costly in the presence of nominal rigidities and staggered contracts (Fischer and Taylor model of disinflation). b. High inflation volatility is often associated with high inflation. However, the effect of past inflation volatility on unemployment in the short run depends again on whether or not the private sector has rational expectations and the new inflation target announced by the central bank is credible. In general more volatile inflation should make people worry of forming their inflation expectations by a simple adaptive process (for further details, see the section entitled Disinflation policy in this chapter of the subject guide). c. A large rise in the prices of oil and other commodities typically increases unemployment in the short run. Such price increases shift up the short-run AS curve, and together with reduced demand, this leads to higher unemployment, at least in the short term. These effects are greater the more sudden and the more pronounced are the price increases, and are amplified by the impact of higher prices on consumer and business confidence. 79 EC2065 Macroeconomics Notes 80
