Download Labor Market Equilibrium and the FE curve

Putting it all Together
IS-LM-FE
The Macroeconomy
The Macroeconomy
• Labor Markets
The Macroeconomy
• Labor Markets
– Labor supply is determined by household
preferences
– Labor demand is determined by productivity
(w/p = MPL)
– In equilibrium, Labor Supply = Labor Demand
– The real wage (w/p) is determined
The Macroeconomy
• Capital Markets
The Macroeconomy
• Capital Markets
– Savings is determined by household behavior
– Investment is determined by productivity
Pk*(r+d) = P*MPK
– In Equilibrium, Savings = Investment
– The real interest rate is determined
The Macroeconomy
• Money Markets
The Macroeconomy
• Money Markets
– Money Demand is determined by households
– Money Supply is chosen by the central bank
– In equilibrium, Money Demand = Money
Supply
– The Aggregate price level is determined
IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply
a more compact representation of
labor/capital/money markets
IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply
a more compact representation of
labor/capital/money markets
– FE (Full employment) represents the labor
market equilibrium
IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply
a more compact representation of
labor/capital/money markets
– FE (Full employment) represents the labor
market equilibrium
– LM (Liquidity/Money): Represents the Money
Market equilibrium
IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply
a more compact representation of
labor/capital/money markets
– FE (Full employment) represents the labor
market equilibrium
– LM (Liquidity/Money) represents the money
market equilibrium
– IS (Investment/Savings) represents the capital
market equilibrium
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
– Is labor demand influenced by rising/falling interest rates?
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
– Is labor demand influenced by rising/falling interest rates? NO
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates?
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates? NO
Labor Market Equilibrium and
the FE curve
• Recall that a labor market equilibrium defines a real wage
such that labor demand equals labor supply. Once
employment is determined, output can be found.
• How is this labor market equilibrium effected by interest
rates?
– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates? NO
• If both labor supply and labor demand are independent of
interest rates, then equilibrium employment is independent
of interest rates.
Labor Market Equilibrium and
the FE curve
• Suppose that at an interest rate
of 5%, equilibrium employment
produces $15T of output
6
Interest Rate
5
4
3
2
1
0
0
10
20
Output
30
Labor Market Equilibrium and
the FE curve
6
5
Interest Rate
• Suppose that at an interest rate
of 5%, equilibrium employment
produces $15T of output
• If interest rates fall to 3%,
neither labor supply nor labor
demand are affected and output
is still $15T
4
3
2
1
0
0
10
20
Output
30
Labor Market Equilibrium and
the FE curve
• Suppose that at an interest rate
of 5%, equilibrium employment
produces $15T of output
• If interest rates fall to 3%,
neither labor supply nor labor
demand are affected and output
is still $15T
• The FE curve represents all
possible labor market equilibria
Labor Market Equilibrium and
the FE curve
• How would a positive
technology shock influence the
FE curve?
Labor Market Equilibrium and
the FE curve
• How would a positive
technology shock influence the
FE curve?
• A positive technology shock
would raise employment and
output – regardless of the
interest rate. Therefore, the FE
curve moves to the right
Labor Market Equilibrium and
the FE curve
• How would a positive
technology shock influence the
FE curve?
• A positive technology shock
would raise employment and
output – regardless of the
interest rate. Therefore, the FE
curve moves to the right
• In fact, any shock which
increases (decreases)
employment/output moves the
FE curve to the right (left)
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
• How would the capital market equilibrium be influenced
by a drop in interest rates?
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
• How would the capital market equilibrium be influenced
by a drop in interest rates?
– Is savings affected?
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
• How would the capital market equilibrium be influenced
by a drop in interest rates?
– Is savings affected? Yes, savings falls.
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
• How would the capital market equilibrium be influenced
by a drop in interest rates?
– Is savings affected? Yes, savings falls.
– Is investment affected?
Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest
rate such that savings equals investment
• How would the capital market equilibrium be influenced
by a drop in interest rates?
– Is savings affected? Yes, savings falls.
– Is investment affected? Yes, investment rises.
Capital markets and the IS Curve
• That is, a drop in interest
rates would create excess
demand for investment.
How would income have
to adjust to return to an
equilibrium?
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4
0
0
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200
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500
Capital markets and the IS Curve
• That is, a drop in interest
rates would create excess
demand for investment.
How would income have
top adjust to return to an
equilibrium?
• A rise in income would
increase savings and
eliminate the excess
demand
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8
4
0
0
100
200
300
400
500
Capital markets and the IS Curve
6
5
Interest Rate
• Suppose that with output
of $10T, an interest rate of
5% clears the capital
market
4
3
2
1
0
$0
$10
Output
$20
Capital markets and the IS Curve
6
5
Interest Rate
• Suppose that with output
of $10T, an interest rate of
5% clears the capital
market
• A capital market
equilibrium with an
interest rate of 3% would
necessarily be associated
with a higher level of
output (say, $15T)
4
3
2
1
0
$0
$10
Output
$20
Capital markets and the IS Curve
• The IS curve represents all
possible capital market
equilibria
Capital markets and the IS Curve
• The IS curve represents all
possible capital market
equilibria
• Suppose that a negative
technology shock lowers
the demand for
investment. How would
the IS curve be affected?
Capital Markets and the IS Curve
• Lower investment demand
would result in lower
interest rates. Note that
total output doesn’t
change – only the
composition of demand
(investment falls,
consumption rises)
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4
2
0
0
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200
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400
500
Capital markets and the IS curve
• A negative technology shock
results in an equilibrium with
the same total output, but a
lower interest rate. Hence, the
IS curve shifts down
Capital markets and the IS curve
• A negative technology shock
results in an equilibrium with
the same total output, but a
lower interest rate. Hence, the
IS curve shifts down
• In fact, any shock that causes
interest rates in the capital
market to fall (rise) causes the
IS curve to shift down (up)
Money Markets and the LM
Curve
• Recall our money market equilibrium
M = k*PY
Where M is nominal money supply, PY is nominal
income and k is a constant that is negatively related to
the interest rate
Money Markets and the LM
Curve
• Recall our money market equilibrium
M = k*PY
Where M is nominal money supply, PY is nominal
income and k is a constant that is negatively related to
the interest rate
• We considered two possible types of equilibrium
– Classical: Prices adjust to clear the money market
– Keynesian: Prices are fixed, output and interest rates adjust to clear
the market
Money Markets and the LM
Curve
• Given a fixed supply of real balances (M/P) each interest rate will have
a corresponding level of output so that money demand equals money
supply ( M/P = k*Y)
Money Markets and the LM
Curve
• Given a fixed supply of real balances (M/P) each interest rate will have
a corresponding level of output so that money demand equals money
supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
Money Markets and the LM
Curve
• Given a fixed supply of real balances (M/P) each interest rate will have
a corresponding level of output so that money demand equals money
supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed
– Money demand will, however, rise, due to the lower opportunity
cost of holding dollars (velocity falls)
Money Markets and the LM
Curve
• Given a fixed supply of real balances (M/P) each interest rate will have
a corresponding level of output so that money demand equals money
supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed.
– Money demand will, however, rise, due to the lower opportunity
cost of holding dollars (velocity falls)
• Therefore, with fixed prices, lower interest rates result in excess
demand for dollars. How do we get back to an equilibrium?
Money Markets and the LM
Curve
• Given a fixed supply of real balances (M/P) each interest rate will have
a corresponding level of output so that money demand equals money
supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed
– Money demand will, however, rise, due to the lower opportunity
cost of holding dollars (velocity falls)
• Therefore, with fixed prices, lower interest rates result in excess
demand for dollars. How do we get back to an equilibrium?
• Income will have to fall to lower money demand.
Money Markets and the LM
Curve
• The LM curve represents the
combination of output and
interest rates that clear the
money market given a level of
real money balances (M/P)
• The upward slope reflects that
as interest rates rise (thus
lowering money demand),
output must rise to compensate
Money Markets and the LM
Curve
• What shifts the LM curve?
Money Markets and the LM
Curve
• What shifts the LM curve? If
prices are fixed, the LM curve
is controlled by the central
bank.
Money Markets and the LM
Curve
• What shifts the LM curve? If
prices are fixed, the LM curve
is controlled by the central
bank.
• An increase in the money
supply must be matched by an
equal rise in money demand
(through lower interest rates
and higher income) – LM
moves right.
The LM curve and classical
economics
• Note that LM curve is drawn for a fixed supply of real
balances (M/P). If prices are fixed, an increase (decrease)
in the money supply shifts the LM curve right (left)
The LM curve and classical
economics
• Note that LM curve is drawn for a fixed supply of real
balances (M/P). If prices are fixed, an increase (decrease)
in the money supply shifts the LM curve right (left)
• However, in classical economics, prices are flexible.
Therefore any increase in money supply is matched by an
equal increase in prices – (M/P) is constant. Therefore, the
central bank has no control over the LM curve.
Putting it all together: IS-LM-FE
Putting it all together: IS-LM-FE
• FE: Labor market
equilibrium
Putting it all together: IS-LM-FE
• FE: Labor market
equilibrium
• IS: Capital market
equilibrium
Putting it all together: IS-LM-FE
• FE: Labor market
equilibrium
• IS: Capital market
equilibrium
• LM: Money market
equilibrium
IS-LM-FE and Classical
Economics
• Recall that classical economics emphasizes
flexible prices.
IS-LM-FE and Classical
Economics
• Recall that classical economics emphasizes
flexible prices.
• Flexible prices eliminates the need for the
LM curve (the price level will always adjust
to insure that the money market clears)
Classical Economics and
Technology Shocks
• Suppose that the economy hit
by a temporary negative
productivity shock
Classical Economics and
Technology Shocks
• Suppose that the economy hit
by a temporary negative
productivity shock
• The FE curve shifts to the left.
The shock is temporary, so IS is
unaffected. The result is lower
output and higher interest rates.
What happens to prices?
Classical Economics and
Technology Shocks
• Suppose that the economy hit
by a temporary negative
productivity shock
• The FE curve shifts to the left.
The shock is temporary, so IS is
unaffected. The result is lower
output and higher interest rates.
What happens to prices?
• Higher interest rates as well as
lower output lower money
demand – this causes prices to
rise.
Classical Economics and
Technology Shocks
• Suppose that the economy hit
by a temporary negative
productivity shock
• The FE curve shifts to the left.
The shock is temporary, so IS is
unaffected. The result is lower
output and higher interest rates.
What happens to prices?
• Higher interest al well as lower
output lower money demand –
this causes prices to rise.
• Higher prices lowers real
balances – LM shifts left.
Classical Economics and
Monetary Policy
• The LM curve is irrelevant
in classical economics
because the Fed can’t
influence real balances.
• For example, a decrease in
money supply will result in a
proportional decrease in
prices – the LM curve
doesn’t move.
IS-LM-FE and Keynesian
Economics
• Keynesian economics stresses fixed prices – this
gives the central bank control over the LM curve
(i.e., the ability to influence output)
IS-LM-FE and Keynesian
Economics
• Keynesian economics stresses fixed prices – this
gives the central bank control over the LM curve
(i.e., the ability to influence output)
• Once the level of output has been determined, the
labor market provides the appropriate level of
production. Therefore, in Keynesian economics,
it’s the FE curve that’s irrelevant
Keynesian Economics and
Monetary Shocks
• Suppose that the federal reserve
decreases the money supply
(prices are fixed)
Keynesian Economics and
Monetary Shocks
• Suppose that the federal reserve
increases the money supply
(prices are fixed)
• The decrease in real balances
shifts the LM curve to the left.
Output (and employment) falls
and interest rates rise.
Keynesian Economics and
Monetary Shocks
• Suppose that the federal reserve
increases the money supply
(prices are fixed)
• The decrease in real balances
shifts the LM curve to the left.
Output (and employment) falls
and interest rates rise.
• Lower output and employment
is represented by the FE curve
shifting left.
Keynesian Economics and
Monetary Shocks
• Suppose that the federal reserve
decreases the money supply
(prices are fixed)
• The increase in real balances
shifts the LM curve to the left.
Output (and employment) falls
and interest rates rise.
• However, once prices are
allowed to adjust, prices drop –
this shifts the LM curve back to
the right. (Money is neutral in
the long run)
Keynesian Economics and
Technology Shocks
• With a temporary
decrease in
technology, the FE
curve shifts left, but
the equilibrium
remains at the
intersection of Is and
LM – the economy is
at “above capacity”
employment.