Download Talk: Macro Equilibrium

Macroeconomic Theory and
Policy
Lecture 7
Macroeconomic Equilibrium: IS-LM
and AD-AS Analysis
1
What is macroeconomic equilibrium?
Is an Economy always in equilibrium?
Macroeconomic general equilibrium is characterised by
• prices that clear goods markets
• wage rates that clear labour markets
• interest rates that clear the capital markets
• exchange rates that clear the foreign exchange markets
• Disequilibrium may result when these prices are not free to
change because of institutional or policy reasons.
• IS-LM model explains how such disequilibrium (Gaps
between Demand and supply) may exist and could be
mitigated using deliberate policy actions.
2
Micro-Foundation to Macro:
General Equilibrium with a representative household and firm
Market p and w such that
Y=C
Wage payment, wL
LD = LS
LS +L = Lbar
KD =KS
Labour supply, L
Trade
Px X-PmM= CA
CA+KA =0
Government
Households
Max U(C,L)
Economy
ROW
Payments for goods
Max U = c φ l 1−φ
l + h =1
s
pc = wh s + π
c ≥ 0; l ≥ 0; h s ≥ 0
Supply of Goods
G =T = t*Y +tw*wL+tr+rk
Firms
Max π(LS)
Max π = py − wh d
( )
y≤ h
d α
y ≥ 0; h ≥ 0
d
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Classical view
• Ideas of Adam Smith (1776), Ricardo (1817), J. B. Say,
Malthus (182) Mill (1873), Marshall (1925)
• Invisible hand sets prices to equate demand and supply.
• No excess demand or no excess supply can persist. No glut
or shortages in goods market.
• No unemployment or labour pressure in the labour market.
• Money is neutral (quantity theory of money).
• Prices proportional to money supply.
• It is long run view.
• Balance budget recommended.
• Laisser faire: minimum government is the best
government.
• Downward sloping aggregate demand and vertical supply
curve
4
Classical economy:
How perfectly flexible prices guarantee macroeconomic
equilibrium in IS-LM Framework
AS
M(D)
IS
LD
i
i=i*
W
LM
LS
L
IS-LM: goods and money
Labor market
Money market
(M/P)
F(Y)
Y
P
Y
Output
L
Output to output , Y
Price level and money supply
5
Keynesian Revolution (Short run analysis)
• Gaps between supply and demand may persist for a log
time.
• Markets (prices) may not work automatically itself because
of deficiency in demand: massive unemployment labour
and under utilisation of capital is possible.
• Cost of waiting to return to the natural level; irresponsible
to do so.
• Balancing budget is stupid and dangerous policy.
• Active role by government can mitigate deficiency in
private demand (consumption and investment).
• Positive role of fiscal policy and monetary policy.
• Multiplier effect of demand on output
• Aggregate supply is horizontal in the short run.
• Animal spirits – importance of expectations.
6
Keynesian economy: flexed prices and possibility of
underemployment equilibrium
IS
LD
S
i
i=i*
W
M(D)
LM
LM
LS
L
IS-LM: goods and money
Labor market
Money market
(M/P)
F(Y)
P
Y
Y
Output
L
Output to output , Y
Price level and money supply
7
Open Economy Model: Equilibrium in Six
Different Markets
Balance of Payment analysis: Graphical approach
Labour Market
LD
LS
Goods and Money
Money market
IS
AS LM
MD MS
Wage
i
Domestic bonds
BS
BD
i
Foreign Bonds
i*
Foreign Exchange
i
Interest rt
L
Y
M/P
DB
FB
exchange rate
Output
Y
Employment
Output
P
Price
Real money balance
Portfolio allocation
e
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Keynesian Economist’s view on Economic
Policy
• Automatic equilibrium is not guaranteed. Animal spirits
not the rational choices dominate the economy.
• Unemployment may persist for a long period if the
deficiency in demand continues.
• Active policy can play a very positive role, because of
rigidity in the markets, particularly in the labour market
(minimum wage laws, unions, and efficiency wages).
• Also because of the monopolistic powers of the firms.
• Active policy can fine tune the economy and correct the
market failure.
9
New Classical View of Fluctuation and Growth an Dconomy
Y
yt = y0 e gt
β
Y = A Kα L
t
t t t
1982
1992
2003
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LAS
RE
i3
i2
i1
LM(P2)
LM1(P1)
LM (P0)
IV
Price Feedback: Monetarists
III
II: LM curve: Hicksian
Crowding out
i0
I: IS curve
IS1
IS0
o
y0
y1
y2
y3
A Simple Overview of Keynesian, Monetarist and New Classical
and New Keynesian Approaches to Analysis of short run fluctuations
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Summary of Four Macro Models in the above Figure
• Government expenditure rises IS1 shifts to IS2.
Impact on output and interest rates differ across
macroeconomic models.
• Models I and II are Keynesian and new Keynesian
models.
• Model IIIA is monetarists includes a price
feedback. AD drops as real balances decline.
• Model IV monetarist proposition in the long run
and New Classical model with rational
expectation.
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Expansionary Policy to Fight Recession: AS-AD Analysis
LAS: Y=Yn
P1
c
a
P0
AS: Y = Yn +v(P-Pe)
AD1
b
P2
AD
Yr
Yn
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How does output responds to positive demand
and supply shocks in the long run?
Dynamic adjustment process of expansionary
monetary and fiscal policy
AD2
LAS
AD1
D
SAS
P
c
b
a
M
Y = F ( , G, T )
P
Yn
Y
Aggregate demand and aggregate supply
Dynamic adjustment process after a positive
supply shocks
P = (1 + μ ) P e N s ( 1 −
Y
; z)
L
a
P
b
C
AS1
AS2
AD
AS3
Yn
Y
Aggregate demand and aggregate supply in the
short and the medium run
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How does output and prices respond to a
negative demand and supply shocks in the
long run?
Dynamic adjustment process of contractionary
monetary and fiscal policy
SAS
AD
a
Dynamic adjustment process after a negative
supply shocks (increase in oil prices)
P
c
b
P
B
a
c
Yn
Y
Aggregate demand and aggregate supply
Yn
Y
Aggregate demand and aggregate supply in th
short and the medium run
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Internal and External Stability in an Open Economy
S
K Inflow
K Inflow
i=i*
K outflow
K outflow
Unemployment
Deflation
0
X-M=0
Inflation
Boom
Yn
output
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Macroeconomic Equilibrium in a Small Open Economy
with Perfect Capital Mobility
S
IS
LM
i>i*
BOP+ K inflow
BOP+
Boom
K-inflow
Deflation
BOP: X-M =-KA
i=i*
BOP- Outflow
Boom/inflation
Over full employment
BOPK-outflow
Deflation
i<i*
Under full employment.
Yf
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A Small Open Economy with Perfect Capital Mobility:
Convergence towards A Macroeconomic Equilibrium
S
IS
LM
EXSG
i>i*
BOP+
BOP+
EXDM
EXSG
EXDG
EXSM
EXDM
BOP: X-M =-KA
i=i*
BOP-
i<i*
EXDG
ESM
EXDG
EXDM
BOPEXSG
EXDM
Yf
Notes: YF full employment output, BOP = Balance of Payment,
K= capital, ESG =Excess supply of goods, EDG =Excess demand for goods,
ESM =excess supply of money, EDM=excess demand for money
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Macroeconomic Equilibrium in a Small Open Economy
with Imperfect Capital Mobility
S
IS
LM
i>i*
BOP+ K inflow
BOP+
K-inflow
Deflation
Boom
BOP: NX(e(r,y))
i=i*
BOP- Outflow
Boom/inflation
Over full employment
BOPK-outflow
Deflation
i<i*
Under full employment.
Yf
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Numerical Exercises
• Fixed Price Model IS-LM model
• Flexible Price IS-LM Model
• Multiplier Analysis in Keynesian Model
• Open Economy Macro Economic Model
– With perfect capital mobility
– Imperfect capital mobility
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References
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