Download Microfounded Macro:Graphical Illustrations

Macroeconomic Analysis 2003
Micro-Founded Macro: Graphical
Illustrations
Lecture 23
1
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
Labour supply, L
Households
Max U(C,L)
Firms
Max π(LS)
Economy
Payments for goods
Max U  c  l 1
l  h 1
s
pc  wh s  
c  0; l  0; h s  0
Supply of Goods
Lecture 23
Max   py  wh d
y  h
y  0; h  0
d

d 
2
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
Lecture 23
3
Classical economy:
How perfectly flexible prices guarantee macroeconomic
equilibrium in IS-LM Framework
AS
LD
IS
W
M(D)
i=i*
LS
i
LM
L
Labor market
IS-LM: goods and money
Money market
(M/P)
F(Y)
Y
P
Y
Output
L
Output to output , Y
Lecture 23
Price level and money supply
4
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
Domestic bonds
BS
BD
i
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
Lecture 23
Portfolio allocation
e
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.
Lecture 23
6
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.
Lecture 23
7
Keynesian economy: flexed prices and possibility of
underemployment equilibrium
LD
IS
W
S
LM
i=i*
LS
M(D)
i
LM
L
Labor market
IS-LM: goods and money
Money market
(M/P)
F(Y)
Y
P
Y
Output
L
Output to output , Y
Lecture 23
Price level and money supply
8
IS-LM and Aggregate Demand and Aggregate Supply
Analysis
LM3
IS2
LM2
LM1
IS1
Models I, II, IIIA IIIB
Interest
rate, i
Y0
y3
y1 y2
LAS
SAS
Price level
Y0
y1
y2
Lecture 23
9
Exercises
• Show how the flexible prices guarantee full
employment equilibrium in the classical
model.
• How under-full employment may persist in
the Keynesian model?
• Explain Keynesian, New Keynesian and
Classical Model using ISLM and AS-AD
diagrams.
Lecture 23
10