Download Long Run

Professor McElroy
TA: Mannig Simidian
Review Session for Exam 1
Mechanics: AD/AS
FP & MP
Review of Basics:
Chapter 1-2
(PPF & Classical Mechanics)
1) Most exam questions will revolve around the impact of either a Policy Change
(g0, t0 or M0) or an Outside Event (c0, i0, x0 or j0 or k, inst).
2) Read the question carefully to figure out which of these variables change,
hence which of the underlying curves will shift.
a) c0, i0, and x0 all shift IS & AD (via the z0 term).
b) g0 and t0 also shift IS & AD (but in opposite directions).
c) j0 shifts LM & AD (with +j0 shifting LM to the left).
d) M0 also shifts LM & AD.
e) k, inst shift AS*
3) Make the appropriate shifts in the diagram to either IS & AD, LM & AD, or AS*.
4) Now you can read the short and long run effects on y, r, and P directly from the
diagram.
5) Once you determine how y, r, and P are affected, you can plug in those effects
into equations 1-10 to determine how the rest of the economy is affected.
Suppose there is a +x0.
Look at the appropriate equation
that captures the x0 term:
y   z 0  g 0  c1t 0)   (i 2  x 2)r
  1 / (1  c1  c1t 1  x1)
z 0  c0  i 0  x 0
Notice that z0 was increased, thus increasing the value of the horizontal intercept
which translates into a rightward shift of the IS and AD curves. LM´
r
In the short-run, we move along ASSR from
point A to point B.
But as the output market clears, in the long-run,
the price level will increase from P0 to P2.
This +P decreases the value of the
P
LM equation’s horizontal intercept which
P2
translates into a leftward shift of the LM
p0
curve.
( M 0/ P 0)  j 0
j2
 j1 r
j1
y
Finally, this leaves us at point C in both diagrams.
P2
IS IS´
C
LMP0
B
A
ASLR
C
A
B
y
ASSR
ADAD´
y
Now it’s time to determine the effects on the variables in the economy.
For the variables y, p, and r, you can read the effects right off the diagrams.
The other variables c, i, x, and b require you to plug in the effects of
y and r to determine what happens.
Remember that SR is the
movement from A to B.
y +, because y moved from y* to y´
LM´P2
IS IS´
r
LMP0
p 0, because prices are sticky in the SR.
C
r +, because r rises as IS slides up along
the LM curve.
c +, because a +y increases the level of
consumption (c=c0+c1(y-t)).
i – , since r increased, the level of
investment decreased (i=i0-i2r).
x ?, +r and +y both decrease net exports
(?x=x0-x1y-x2r),but since our initial
step was a +x, we can’t tell from this
information which will dominate.
b –, since y rose, tax revenues rise and
decrease the deficit (b= g-t).
B
A
p
p2
p0
ASLR
y
C
B
A
y* y´
ASSR
AD´
AD
y
For the variables y, p, and r, you can read the effects right off the diagrams.
The other variables c, i, x, and b require you to
plug in the effects of y and r to determine what
happens.
Remember that LR is the
movement from A to C.
y 0, because rising P shifts LM to left, returning
r
y to y*as required by long run AS*.
P +, in order to eliminate the excess demand at P0.
r +, reflecting the leftward shift in LM due
to +P.
c 0, since both y and t are back to their initial
levels.(c=c0+c1(y-t)).
i – –, since r has risen even more due to the
p
+ P (i=i0-i2r).
x ?, since +r decreases net exports
p2
(?x=x0-x1y-x2r),but since our initial p
0
step was a +x0, we can’t tell from this
information which will dominate.
b 0, because neither FP nor the tax base
change (b= g0-t0-t1y).
LM´P2
IS IS´
C
LMP0
B
A
ASLR
y
C
B
A
y* y´
ASSR
AD´
AD
y
If...
1) y= c + i + x + g
2) c= co + ci (y-t)
3) t= to + ti y
4) i= io - i2 r
5) x = xo - xiy -x2 r
6) g = go
7) L/P=M/P
8) L/P=j0+j1y-j2r
9) M=M0
10SR) P=P0
10LR) y*=F(n*,K0,I0nst)
IS
Aggregate
Demand
(Equ. 1-9)
LM
Aggregate
Supply
What
happens if
there is a
+c0,
+i0
or a +x0?
What is the impact on y,p,r,c,i,x,b?
r
IS
IS’
LMp2
LMp0
C

B
A
p
p2
p0
y
ASLR
C 
A
ASSR
 B 
AD
AD’
y
1) Either +c0,+i0or
a +x0causes the IS
curve to shift right
to IS’.
2) This leads to a
rightward shift in AD to AD’.
Short Run:
Move from A to B.
Long Run:
Market clears at p0 to p2
from B to C.
3) +P causes LMp0
to shift leftward to
LMp2.
r
IS
IS’
LMp2
LMp0
C

B
Short
Run:
A
p
p2
p0
y
ASLR
C 
A
ASSR
 B 
AD
AD’
y
y
p
r
c
i
x
b
+
0
+
+
?
?
-
Long
Run:
0
+
++
?
?
?
0
What is the impact of a +g on the
macroeconomy?
• “It depends” on how the government finances its spending.
• It has three options:
(+g= +t0) Theft (taxes: coercion now), (+g= +b)
Borrowing (bonds: coersion later), (+g= +M0)
Counterfeiting (Printing money).
Tax-Financed Increase in
Government Spending
(+g0=+t0)
Bond-Financed Increase in
Government Spending
(+g0=+b)
Money-Financed Increase in
Government Spending
(+g0 =+M0)
+g=+t
r
P
P2
P0
+g=+b
IS IS LM
LM
r
IS
AS*
y
P
P2
ASSR
AD
AD
y
IS IS
AS*
+g=+M
LM
LM r
y
P
P2
ASSR
AD
AD
LM
IS
IS
AS*
LM LM
y
ASSR
AD
ADAD
y
y
SR: small impact on AD. SR:stronger impact on AD SR:strongest impact on AD.
LR: small impact on P, r. LR:stronger impact on r,P. LR: Stongest impact on y,r.
Tax-Financed
Increase in
Government
Spending
(+g0=+t0)
r
IS
IS’’
Result:
LMp2
IS’
LMp0
A small rightward
shift in both IS (IS to
IS’’) and AD (AD to
AD’’) and a movement
along ASSR to point B.
E 
B 
A
Given our IS equation:
y=(z0+g0-c1t0)-(i2+x2)r
+g shifts IS to IS’.
But, +t shifts IS back to the left
(to IS ’’). Note: the shift leftward
from IS’ to IS ’’ is less than the pE
original rightward shift because
the tax-multiplier (-c1t0) is less
than the expenditure multiplier 0
().
p
p
y
ASLR
E
A

ASSR
 B 
AD AD’’
y
As the market
clears, the rising
price level
contracts LM
and the
economy
moves to
point E.
End of Mechanics
Fiscal Policy
What is Fiscal Policy?
• Choices about public spending and how to finance that spending.
• It is a system for transfering reserces from the private to public
sector.
“Private vs. Public Choice”
“It Depends” Questions
• What is the impact of a +g on the
macroeconomy?
• What is the size of the national debt and the
deficit?
• What is the impact of continued b>0 on
y,p,r,c,i,x etc..?
• Are continued gov’t defecits sistainable?
?
What is the size of the national
debt and the deficit?
Annual Deficit (1997)
Annual Deficit (1996)
Annual Deficit (1995)
…….
…...
National
Debt
A meaningful deficit...
• Exclude funds borrowed from federal agencies.
• Include the deficits of local and stage governments.
• Modify the real value of outstanding public debt. to reflect current
inflation.
• Include hidden liabilities that currently escape detection in
accounting system.
The Cyclical Deficit
• Changes in the cash flow deficit arise purely
from fluctuations of real output (y) around its
full employment level.
• For example: A recession causes a lower tax
base and therefore decreases the government
collections.
t=t0+t1y
b=g-t
Structural Deficit
• Reflects one or more changes in the fiscal policy instruments g0
or t0 and results in a shift in the IS and AD curves.
g0, t0, or t1
Monetary Policy
Money
Commodity
Symbol
Invention
Without Money
Self-suffiency
Barter
Functions of Money
•
•
•
•
Make Transactions
Store Purchasing Power
Measure Economic Performance
Measure fullfillment of contracts
Here’s what Money Does...
Monetization brings efficiency...
PPF1
PPF2
nst
i )
The better the money, the farther out the PPF.
How does money do this?
Fiat money:
A declaration of legal tender.
Back to Classical Model: Quantity Theory of
Money
• MV=Py
• Take the logs:
ln M + ln V = ln P + ln y
• Next solve for ln P:
ln M +ln V - ln y = ln P
• Then, take the derivative of
the logs to get the percent
changes:
d ln M
dt
+
d ln V d ln y d ln P
=
dt
dt
dt
%M + %V - %y* = %P = P
Growth of Money Supply + Growth of Money Demand - Growth of
output = Inflation (P )
%M = %y* - %V
Non-inflationary condition
for Monetary Policy.
How does the Fed Control the Money
Supply?
• To expand the Money Supply:
They buy ___________ and pay for it with new money.
• To reduce the Money Supply:
They sell ___________ and receive the existing dollars and then
destroy it.
But this is difficult to do…
The criteria for choosing__________.
1. Storage Cost
2. Equity
U.S. Treasury Bonds
•To expand the Money Supply:
They buy U.S. Treasury Bonds and pay for it with new money.
•To reduce the Money Supply:
They sell U.S. Treasury Bonds and receive the existing dollars
and then destroy it.
The Fed Controls the Money Supply
through...
1) Open Market Operations (buying and
selling U.S. Treasury bonds).
2)  Reserve Requirements (never really
used).
3)  Discount rate which member banks
can borrow from the Fed (not meeting
the reserave requirements).
What impact does M have on y, p, r….?
• Whether y=y*, or y<y*.
• Whether SR or LR.
• Continued +M or one shot
+M.
• Depends on Interest Rates
(nominal or real).
Fisher Equation: R = r + Pe
Actual (Market)
Nominal rate of
interest
Real rate
of interest
Inflation
One shot +M
+M
SR -r +y -R
r
IS
+LM, +AD
.
A
In the short-run, prices are stickey, so inflation is zero. (Point
A to B.)
Plug in the latter effects of the AD/AS diagram into the fisher
equation to see the effect on the Nomonal interest rate (R).
e
0
R=
r+
P
 
In the long-run, prices will adjust so quickly
to point c, that the market will not incur any
inflation, despite the new price level P1.
LR r =R =y=0
LM
P
P1
P0
LM’
.
B
.
. .
y
C
A
B
AD
y
AD’
Continuous +M (Increasing rate of gr wth of the
money suppy)
SR: The AD/AS diagram
+M
tells us....-r +y
LR: Prices adjust, shifting LM back leftward, r =0, but
with +P. The fisher equation tells us +Pe
+R (R=0r+Pe)
In the LR, prices will adjust and the Nominal Interest Rate (R) will rise. Any
attempts to -r, at y* will only increase the price level and R.
Money Neutrality: “You can’t print your way
to prosperity.”
Changes in Monetary Policies
have no lasting effect on r, but
changes in Fiscal Policies do.
Distinction between Short-term and Long-term
Interest Rates on Bonds
(3 mos.) RST= r + Pe
(10 yr.) RLT= r + Pe
How will the bond market react to a sudden
+M, what happens to R?
+M
SR -r  RST
LR r =0 + DPe
You would be quite rich if you predict interest
rates.