Download The IS – LM / AD – AS Model: A General Framework for

Agenda
• Business Cycle Analysis: A Preview.
• The Problem of Unemployment.
The IS – LM / AD – AS Model:
A General Framework for
Macroeconomic Analysis,
Part 1
• The Problem of Inflation.
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Business Cycle Analysis: A Preview
Business Cycle Analysis: A Preview
• What explains business cycle fluctuations?
• What explains business cycle fluctuations?
¾ 2 major components of business cycle theories:
¾ Both theories can be studied in an aggregate
demand-aggregate supply (AD-AS) framework.
• A description of the shocks.
• A model of how the economy responds to shocks.
¾ The AD-AS model has 3 main components:
¾ 2 major business cycle theories:
• An aggregate demand (AD) curve,
• A short-run aggregate supply (SRAS) curve, and
• A long-run aggregate supply (LRAS) curve.
• Classical theory.
• Keynesian theory.
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Business Cycle Analysis: A Preview
The Aggregate Demand Curve
• AD and AS—A brief introduction:
¾ The aggregate demand (AD) curve:
• Shows quantity of goods and services demanded (Y)
for any price level (P).
• A higher P means less aggregate demand (lower Y),
– The aggregate demand curve slopes downward.
• An increase in aggregate demand for a given P shifts
the aggregate demand curve to the right.
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Business Cycle Analysis: A Preview
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The Short-run Aggregate Supply Curve
• AD and AS—A brief introduction:
¾ The short-run aggregate supply (SRAS) curve:
• The short-run aggregate supply curve shows how much
output (Y) producers are willing to supply in the shortrun at any given price level (P).
• The short-run aggregate supply curve is horizontal.
– We assume the prices are fixed in the short run.
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Business Cycle Analysis: A Preview
The Long-run Aggregate Supply Curve
• AD and AS—A brief introduction:
¾ The long-run aggregate supply (LRAS) curve:
• The long-run aggregate supply curve shows how much
output (Y) producers are willing to supply in the longrun at any given price level (P).
• The long-run aggregate supply curve is vertical at the
full-employment level of output.
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Business Cycle Analysis: A Preview
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The AD-AS Model
• AD and AS—A brief introduction:
¾ Equilibrium in the AD—AS model:
• Short-run equilibrium: At the Y and P where the
aggregate demand (AD) curve intersects the short-run
aggregate supply (SRAS) curve.
• Long-run equilibrium: At the Y and P level where the
aggregate demand (AD) curve intersects the long-run
aggregate supply (LRAS) curve.
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Business Cycle Analysis: A Preview
Business Cycle Analysis: A Preview
• Business cycles occur because of:
• Example: A negative AD shock:
¾ Aggregate demand shocks:
¾ The aggregate demand curve shifts to the left:
• A positive AD shock shifts the AD curve to the right.
• A negative AD shock shifts the AD curve to the left.
• Short-run equilibrium occurs where the AD curve
intersects the SRAS curve; Y falls, P is unchanged.
¾ (Permanent) Aggregate supply shocks:
• A positive (permanent) AS shock shifts the LRAS curve
to the right.
• A negative (permanent) AS shock shifts the LRAS curve
to the left.
• Long-run equilibrium occurs where the AD curve
intersects the LRAS curve; Y is unchanged, P falls.
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A Negative AD Shock
P
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Business Cycle Analysis: A Preview
• Example: A negative AD shock:
LRAS
¾ How long does it take to get to the long run?
• Classical theory: prices adjust rapidly.
P0
– So recessions are short-lived and
– There is no need for government intervention.
SRAS
• Keynesian theory: prices and wages adjust slowly.
– Adjustment may take several years and
– The government can fight recessions by taking action to shift
the AD curve .
AD
Y0
Y
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Business Cycle Analysis: A Preview
Business Cycle Analysis: A Preview
• Example: A negative (permanent) AS shock :
• Example: A negative (permanent) AS shock :
¾ Permanent aggregate supply shocks shift the
LRAS curve.
¾ A permanent, negative aggregate supply shock
reduces full-employment output and shifts the
LRAS curve to the left.
• Permanent changes in productivity or labor supply can
cause supply shocks.
• The new long-term equilibrium is lower output and a
higher price level.
¾ Classicals view LRAS shocks as the main cause
of fluctuations in output.
– A recession is accompanied by higher price level.
• Keynesians also recognize the importance of supply
shocks.
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A Negative Permanent AS Shock
P
Business Cycle Analysis: A Preview
• Business cycles are caused by both aggregate
demand and aggregate supply shocks hitting
the economy.
LRAS
P0
¾ Depending on the type(s) of shock(s), there are a
variety of possible outcomes for Y and P.
SRAS
•
•
•
•
AD
Y0
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Higher Y, higher P.
Higher Y, lower P.
Lower Y, lower P.
Lower Y, higher P.
Y
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The Problem of Unemployment
The Problem of Unemployment
• The costs of unemployment:
• The costs of unemployment:
¾ Loss in output from idle resources:
¾ Loss in output from idle resources:
• If full-employment output is $15 trillion, each
percentage point of unemployment sustained for one
year costs $300 billion according to Okun’s Law.
• Workers lose income.
• Business firms lose profits.
• Government loses tax revenues.
»
– Each percentage point of cyclical unemployment is associated
with a loss equal to 2% of full-employment output.
– And increases spending for unemployment benefits and other
transfer payments.
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The Problem of Unemployment
The Problem of Unemployment
• The costs of unemployment:
• The benefits of unemployment:
¾ Personal or psychological cost to workers and
their families.
¾ There are some offsetting factors:
• Unemployment leads to increased job search and
acquiring new skills, which may lead to increased
future output.
• Especially important for those with long spells of
unemployment.
• Unemployed workers have increased leisure time,
though most wouldn’t feel that the increased leisure
compensated them for being unemployed.
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The Problem of Inflation
The Problem of Inflation
• The costs of inflation:
• The costs of inflation:
¾ Perfectly anticipated inflation:
¾ Perfectly anticipated inflation:
• No effect if all prices and wages keep up with
inflation.
• Shoe-leather costs: People spend resources to
economize on currency holdings.
– The estimated cost of 10% inflation is 0.3% of GNP.
• Even returns on assets may rise exactly with inflation.
• Menu costs: the costs of changing prices.
– May be mitigated somewhat by technology.
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The Problem of Inflation
The Problem of Inflation
• The costs of inflation:
• The costs of inflation:
¾ Unanticipated inflation, when π – πe = 0:
¾ Unanticipated inflation, when π – πe = 0:
• Realized real returns differ from expected real returns:
• Result: unanticipated transfer of wealth.
– From lenders to borrowers when π > πe.
– From borrowers to lenders when π < πe.
– Expected r: re = i – πe.
– Actual r: r = i – π.
– Actual r differs from expected r by πe – π.
• People want to avoid the risk of unanticipated
inflation.
• Similar effect on wages and salaries.
– They spend resources to forecast inflation.
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The Problem of Inflation
The Problem of Inflation
• The costs of inflation:
• The costs of inflation:
¾ Unanticipated inflation, when π – πe = 0:
¾ The costs of hyperinflation:
• Loss of valuable signals provided by prices:
• Hyperinflation is a very high, sustained inflation
– Confusion over changes in aggregate prices vs. changes in
relative prices.
– Generally, 50% or more per month.
– Hungary in August 1945 had inflation of 19,800% per
month.
– People expend resources to extract correct signals from
prices.
– Bolivia had annual rates of inflation of 1281% in 1984,
11,750% in 1985, 276% in 1986.
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The Problem of Inflation
The Problem of Inflation
• The costs of inflation:
• The costs of inflation:
¾ The costs of hyperinflation:
¾ The costs of hyperinflation:
• There are large shoe-leather costs because people
minimize cash balances.
• Real tax collections fall because people pay taxes with
money whose value has declined sharply.
• People spend many resources getting rid of money as
fast as possible.
• Prices become worthless as signals, so markets become
extremely inefficient.
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The Problem of Inflation
The Problem of Inflation
• Fighting inflation:
• Fighting inflation:
¾ The role of inflationary expectations:
¾ The role of inflationary expectations:
• If rapid money growth causes inflation, why do central
banks allow the money supply to grow rapidly?
• Disinflation is a reduction in the rate of inflation.
– But disinflations may lead to recessions.
– Developing or war-torn countries may not be able to raise
taxes or borrow, so they print money to finance spending.
– An unexpected reduction in actual inflation leads to a rise in
unemployment along the Phillips curve.
– Industrialized countries may try to use expansionary
monetary policy to fight recessions, then not tighten monetary
policy enough later.
• The costs of disinflation could be reduced if expected
inflation fell at the same time actual inflation fell.
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The Problem of Inflation
The Problem of Inflation
• Fighting inflation:
• Fighting inflation:
¾The role of inflationary expectations:
¾ The role of inflationary expectations:
• Keynesians disagree with rapid disinflation:
• Rapid versus gradual disinflation:
– Price stickiness due to menu costs and wage stickiness due to
labor contracts make adjustment slow.
– The classical prescription for disinflation is cold turkey—a
rapid and decisive reduction in money growth.
– Cold turkey disinflation would cause a major recession.
» Proponents argue that the economy will adjust fairly quickly,
with low costs of adjustment, if a credible policy is announced
well in advance.
– The strategy might fail to alter inflation expectations.
» If the costs of the policy are high, the government might
reverse the policy.
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The Problem of Inflation
• Fighting inflation:
¾ The role of inflationary expectations:
• The Keynesian prescription for disinflation is
gradualism:
– A gradual approach gives prices and wages time to adjust to
the disinflation.
– Such a strategy will be politically sustainable because the
costs are lower than going cold turkey.
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