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Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Big Concepts in this lecture… lecture Business B i C Cycles l Econ 402 Professor Yamin Ahmad The Economyy at Full Employment p y the IS curve, and its relation to the Keynesian y cross the loanable funds model the LM curve,, and its relation to the theory of liquidity preference how o tthe e IS-LM S model ode dete determines es income co e a and d tthe e Lecture 3: The IS/LM Model Goods Market Equilibrium (IS Curve) Money Market/Asset interest rate in the short run when P is fixed Market Equilibrium (LM Curve)) Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The Big Picture Keynesian Cross Theory y of Liquidity Preference Context Recall that in Macro, we break up our economy into the IS curve LM curve 1 short run and the long run IS-LM model Agg Agg. demand curve Agg. supply curve Note: These lecture notes are incomplete without having attended lectures Business Cycle fluctuations Model of Agg. gg Demand and Agg. pp y Supply Long run prices flexible output determined by factors of production & technology unemployment l t equals l it its natural t l rate t Short run prices fixed output determined by aggregate demand unemployment negatively related to output 2 Note: These lecture notes are incomplete without having attended lectures 3 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Aggregate Supply in the long run Economy at Full Employment In the long run, output is determined by factor supplies In the long run, output is determined by the and technology supply side: supplies pp of capital, p , labor technology. Y = F (K , L , Z ) Y Changes in demand for goods & services (C, I, G ) only affect prices prices, not quantities quantities. “Full employment” means that unemployment equals its natural rate (not zero). 4 Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 Note: These lecture notes are incomplete without having attended lectures 5 Professor Yamin Ahmad, Business Cycles – ECON 402 The long long-run run aggregate supply curve P Y does not depend on P or r, so LRAS is vertical in both (P,Y) and (r,Y) spaces is the full-employment or natural level of output, the p at which the economy’s y resources are level of output fully employed. LRAS Factors that Shift the LRAS/FE curve Since the full employment level of output is determined by resources in the economy, g in those resources will shift the FE line, changes i.e.: r Y = F (K , L , Z ) Changes in capital Changes in full employment Note: The LRAS is what Abel & Bernanke call the FE line! Changes in technology Y = F (K , L , Z ) Note: These lecture notes are incomplete without having attended lectures Y = F (K , L , Z ) Y Y 6 Note: These lecture notes are incomplete without having attended lectures 7 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Recall: The Keynesian Cross Elements of the Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) C = C (Y − T ) Govt policy variables: G = G , T =T for now now, planned Investment is exogenous: Notation: I = planned investment AE = C + I + G = planned expenditure Y = real GDP = actual expenditure planned expenditure: Difference between actual & planned expenditure p inventory y investment = unplanned 8 Note: These lecture notes are incomplete without having attended lectures Consumption function: Professor Yamin Ahmad, Business Cycles – ECON 402 I =I AE = C (Y − T ) + I + G Y = AE equilibrium condition: actual expenditure = planned expenditure 9 Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 Graphing planned expenditure Graphing the equilibrium condition AE AE p planned expenditure planned p expenditure AE =Y AE =C +I +G MPC 1 45º income, output, Y Note: These lecture notes are incomplete without having attended lectures income, output, Y 10 Note: These lecture notes are incomplete without having attended lectures 11 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The equilibrium value of income An increase in government purchases AE AE AE =Y p planned expenditure AE =C +I +G At Y1, there is now an unplanned drop i iinventory… in t AE =C +I +G2 AE =C +I +G1 ΔG …so firms increase output, and d iincome rises toward a new equilibrium. income, output, Y Equilibrium income Note: These lecture notes are incomplete without having attended lectures 12 Professor Yamin Ahmad, Business Cycles – ECON 402 Y = C + I + G equilibrium condition ΔY = ΔC + ΔI + ΔG in changes ΔC + ΔG = MPC × ΔY + ΔG Collect terms with ΔY on the left side of the equals sign: (1 − MPC) × ΔY = ΔG AE1 = Y1 ΔY AE2 = Y2 Note: These lecture notes are incomplete without having attended lectures 13 Professor Yamin Ahmad, Business Cycles – ECON 402 Solving for ΔY = Y The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. G because I exogenous In this model, the govt purchases h multiplier lti li equals l because ΔC = MPC ΔY Example: Iff MPC C = 0.8, then Solve for ΔY : ⎛ ⎞ 1 ΔY = ⎜ ⎟ × ΔG 1 − MPC ⎝ ⎠ Note: These lecture notes are incomplete without having attended lectures ΔY 1 = ΔG 1 − MPC 14 ΔY 1 = = 5 ΔG 1 − 0.8 An increase in G causes income i tto increase 5 times as much! Note: These lecture notes are incomplete without having attended lectures 15 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 An increase in taxes Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: ΔY = ΔG. But ↑Y ⇒ ↑C ⇒ further ↑Y AE =C2 +I +G At Y1, there is now an unplanned inventory buildup… …so firms educe output, reduce and income falls toward a new equilibrium ⇒ further ↑Y So the final impact on income is much bigger than the initial ΔG. Note: These lecture notes are incomplete without having attended lectures 16 Professor Yamin Ahmad, Business Cycles – ECON 402 Y AE2 = Y2 ΔY AE1 = Y1 Note: These lecture notes are incomplete without having attended lectures 17 Professor Yamin Ahmad, Business Cycles – ECON 402 Solving for ΔY The tax multiplier eq’m condition in changes g ΔY = ΔC + ΔI + ΔG Def: the change in income resulting from a $1 increase in T : I and G exogenous = ΔC = MPC × ( ΔY − ΔT Final result: AE =C1 +I +G ΔC = −MPC ΔT ⇒ further ↑C ↑ S l i ffor ΔY : Solving AE Initially, y the tax increase reduces consumption, and therefore E: ΔY ΔT ) (1 − MPC) × ΔY = − MPC × ΔT Note: These lecture notes are incomplete without having attended lectures 18 − MPC 1 − MPC If MPC = 0.8, then the tax multiplier equals ΔY ΔT ⎛ − MPC ⎞ ΔY = ⎜ ⎟ × ΔT ⎝ 1 − MPC ⎠ = = − 0.8 − 0.8 = = −4 1 − 0.8 0.2 Note: These lecture notes are incomplete without having attended lectures 19 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The tax multiplier Walkthrough Example I: …is negative: A tax t increase i reduces d C C, which reduces income. Economic Scenario: In the Keynesian Cross, assume that the consumption function is given by: C = 475 + 0 0.75(Y 75(Y-T) T) Planned Investment, I = 150, G = 250, T = 100. …is is greater than one (in absolute value): g in taxes has a A change multiplier effect on income. a. Graph planned expenditure as a function of income b. What is the equilibrium level of income …is smaller than the g govt spending p g multiplier: p Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller ll th than ffrom an equall iincrease iin G. G Note: These lecture notes are incomplete without having attended lectures c. If government purchases increase by 125, what is the new equilibrium income? d What level of government purchases is needed to achieve an d. income of 2600? 20 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The IS curve Deriving the IS curve AE =Y AE =C +I (r )+G 2 AE Def: a graph of all combinations of r and Y that result in goods market equilibrium ↓r ⇒ ↑Y The equation for the IS curve is: AE =C +I (r1 )+ ) G ⇒ ↑I ⇒ ↑AE i.e. actual expenditure (output) = planned expenditure ΔI r Y1 Y Y2 r1 Y = C (Y − T ) + I (r ) + G r2 IS Y1 Note: These lecture notes are incomplete without having attended lectures 21 Note: These lecture notes are incomplete without having attended lectures 22 Y2 Note: These lecture notes are incomplete without having attended lectures Y 23 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Why the IS curve is negatively sloped A fall in the interest rate motivates firms to Market For Loanable Funds – Closed Economy Define Sp≡Y Y-T-C(Y-T, T C(Y T, r) increase investment spending, which drives up planned spending p g ((AE )). total p and Sg ≡T T-G G (+) (-) ⇒S ≡ Sp + Sg = Y – C(Y-T) C(Y T) – G = S(Y; G G, T T, r) (+) (-) (+) (+) To T restore t equilibrium ilib i iin th the goods d market, k t Capital Markets Equilibrium: S(Y;G,T) = I(r) ((-)) (Loanable Funds) Or Equivalently: Y = Yd ≡ C(Y-T) + I(r) + G output (a.k.a. actual expenditure, Y ) must increase. increase 24 Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 (a) The L.F. model S2 (b) The IS curve S1 r2 r1 r1 S, I Note: These lecture notes are incomplete without having attended lectures Algebra Of The IS Curve Suppose pp C = c0 + c1((Y-T)) and I = I0 – br r r2 I (r ) 25 Professor Yamin Ahmad, Business Cycles – ECON 402 The IS curve and the loanable funds model r Note: These lecture notes are incomplete without having attended lectures (Note: We could also consider the effect of sales or the business cycle on Investment by incorporating Y, i.e. I=b0+b1Y-b2r) Then Y= C + I + G = c0 + I0 + G + c1(Y-T) – br If we collect like terms: IS Y2 Y1 Y 26 Y= c0 + I 0 + G − c1T b − r 1 − c1 1 − c1 Note: These lecture notes are incomplete without having attended lectures 27 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Fiscal Policy and the IS curve Slope of the IS curve Y= c0 + I 0 + G − c1T b − r 1 − c1 1 − c1 We can use the IS IS-LM LM model to see how fiscal policy (G and T ) affects gg g demand and output. p aggregate Hold everything except Y and r fixed: ΔY = −b Δr 1 − c1 ⇒ Δr c1 − 1 = <0 ΔY b Let’s L t’ start t t by b using i th the K Keynesian i cross Thus IS is relatively flat if either: to see how fiscal policy shifts the IS curve… (i) b is very large; or (ii) c close to unity. 28 Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 29 Professor Yamin Ahmad, Business Cycles – ECON 402 Shifting the IS curve: ΔG At any value of r, Note: These lecture notes are incomplete without having attended lectures AE =Y AE =C +I (r )+G 1 2 AE Factors That Shift the IS Curve AE =C +I (r1 )+ ) G1 ↑ ⇒ ↑AE ↑G ↑ ⇒ ↑Y ↑ …so the IS curve shifts to the right. right The horizontal distance of the IS shift equals ΔY = r Y1 Y Y2 r1 ΔY 1 ΔG 1−MPC Y1 IS1 Y2 Note: These lecture notes are incomplete without having attended lectures IS2 Y 30 Note: These lecture notes are incomplete without having attended lectures 31 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The Theory of Liquidity Preference Money supply r Due to John Maynard Keynes. A simple theory in which the interest rate is determined b money supply by l and d money d demand. d The supply of real money balances is fixed: (M Money M supply l iis exogenous – determined d t i db by F Fed! d! interest rate s 32 r interest rate (M Equilibrium P) s The interest rate adjusts to equate the supply and demand for money: Demand for real money balances: P) d 33 Professor Yamin Ahmad, Business Cycles – ECON 402 Moneyy Bonds (M M/P real money balances Note: These lecture notes are incomplete without having attended lectures Money demand either hold: s M P Professor Yamin Ahmad, Business Cycles – ECON 402 People P) P) =M P People hold wealth in the form of either: Money Demand for money and demand for bonds! Bonds Note: These lecture notes are incomplete without having attended lectures (M L (r ) = L (r ) Note: These lecture notes are incomplete without having attended lectures M P r interest rate P) s r1 L (r ) M P = L (r ) M/P M P real money balances 34 (M Note: These lecture notes are incomplete without having attended lectures M/P real money balances 35 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 The LM curve How the Fed raises the interest rate r To increase r, Fed reduces M Now let’s p put Y back into the moneyy demand function: interest rate (M r2 r1 L (r ) M2 P M1 P Note: These lecture notes are incomplete without having attended lectures M P = L (r ,Y ) 37 Note: These lecture notes are incomplete without having attended lectures Professor Yamin Ahmad, Business Cycles – ECON 402 Deriving the LM curve Nominal or Real Rates in Money Demand? (a) The market for ⎞d ⎛ Money Market Equilibrium: M = ⎜⎜⎜ M ⎟⎟⎟ = L(i,Y ) (-)(+) P ⎝P⎠ What is real return to saving $1? 1+ i 1+ r = 1+ π = L (r ,Y ) The equation for the LM curve is: M/P Professor Yamin Ahmad, Business Cycles – ECON 402 d The LM curve is a graph of all combinations of r and Y that equate q the supply pp y and demand for real money y balances. real money balances 36 P) ⇒ r (b) The LM curve r LM r +π ≈ i r2 This is known as the Fisher Equation. r2 L (r , Y2 ) r1 r1 L (r , Y1 ) M So: = L(r + π , Y ) P M1 P Treat Ms as exogenous; for present set π = 0. Note: These lecture notes are incomplete without having attended lectures real money balances 38 M/P Note: These lecture notes are incomplete without having attended lectures Y1 Y2 Y 39 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Equilibrium in the Bond Market? Why the LM curve is upward sloping An increase in income raises moneyy demand. Since the supply of real balances is fixed fixed, there is now There are two assets ((money y and bonds), ), but onlyy one equilibrium condition. Do we need to worry about bond market equilibrium as well? Answer: No! d Ms + Bs = A = ⎛⎜ M ⎞⎟ + Bd ⎜ ⎟ ⎜ P ⎟ P ⎝ ⎠ excess demand in the money market at the initial interest rate. with A = real wealth. The interest rate must rise to restore equilibrium in the So : money market. d Ms = ⎛⎜ M ⎞⎟ ⇔ Bs = Bd ⎜ ⎟ P ⎜⎝ P ⎟⎠ Thi is This i an example l off Walras W l Law. L Note: These lecture notes are incomplete without having attended lectures 40 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 How ΔM shifts the LM curve Algebra of the LM Curve Write: ⎛ ⎜ ⎜ ⎜ ⎝ ⎞d (a) The market for M ⎟ = m + kY − hr ⎟ 0 P ⎟⎠ r With M and P fixed: 0 = kΔY - h Δr Slope of LM Curve : real money balances (b) The LM curve r LM2 LM1 Δr k = >0 ΔY h r2 r2 r1 LM curve relativelyy flat if either: (i) k small; or (ii) h large ( “ Liquidity Trap”) Trap ) Note: These lecture notes are incomplete without having attended lectures 41 Note: These lecture notes are incomplete without having attended lectures L (r , Y1 ) M2 P 42 M1 P r1 M/P Note: These lecture notes are incomplete without having attended lectures Y1 Y 43 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Walkthrough Example II: Shift iin LM curve ((r fi Shifts fixed) d) Economic Scenario: ΔM = kΔY ⇒ ΔY = 1 ΔM P ΔM Pk Suppose that the money demand function is: (M/P)d = 1000 – 100r where r is the interest rate (in percent). The money supply M is 1000, and the price level is 2. What happens if k = 0? Hold Y fixed: a. Graph the supply and demand for real money balances a balances. b. What is the equilibrium interest rate? c. Assume that the pprice level is fixed. What happens pp to the ΔM = −hΔr ⇒ Δr = − 1 P ΔM Ph equilibrium interest rate if the supply of money is raised from 1000 to 1200? So vertical shift is independent of k d. If the Fed wishes to raise the interest rate to 7 percent, what money supply should it set? Note: These lecture notes are incomplete without having attended lectures 44 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Factors that Shift the LM Curve Macroeconomic equilibrium The long run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium q conditions in the goods & money markets, consistent with the full employment level of output: r Y = C (Y − T ) + I (r ) + G M P = L (r ,Y ) Y = F (K , L , Z ) Note: These lecture notes are incomplete without having attended lectures 45 Note: These lecture notes are incomplete without having attended lectures 46 Equilibrium interest rate Note: These lecture notes are incomplete without having attended lectures LM IS Y = F (K , L , Z ) Equilibrium q level of income Y 47 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Equilibrium With Fixed Prices Equilibrium in the IS IS-LM LM Model r IS Curve LM ⎛ ⎜ ⎜ ⎜ ⎜ ⎜ ⎜ ⎝ c + I + G − c T br 1 − S (Y ;G,T ) = I (r) or Y = 0 0 ((+)(-)(+) )( )( ) 1− c 1− c 1 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Equilibrium interest rate LM Curve M = L(r,Y ) P (-)(+) (or M = m + kY − hr) 0 P IS Equilibrium level of income Solve for Y and r in terms of G,T, M and P. Y Income and Output Note: These lecture notes are incomplete without having attended lectures 48 Professor Yamin Ahmad, Business Cycles – ECON 402 Note: These lecture notes are incomplete without having attended lectures 49 Professor Yamin Ahmad, Business Cycles – ECON 402 Convergence to Equilibrium Practice Question Is there any reason to expect it to converge to this equilibrium from arbitrary r and Y? If there is an excess demand for moneyy ((excess supply pp y of Consider the following IS-LM model: C=200+0.25YD I = 150 +0.25Y – 1000i G = 250; T = 200 ⎛⎜⎝ MP ⎞⎟⎠ = 2Y − 8000i M = 1600 P a Derive the IS equation a. b. Derive the LM equation d bonds) this should drive the return on bonds up, and vice versa. If savings exceeds planned investment, then consumers must be spending less and producers will be accumulating unwanted inventories. So they will cut back production, and vice versa versa. c. Solve for equilibrium output d. Solve for the equilibrium value of the real interest rate e. Solve for the equilibrium values of C and I and verify the value that you Hence the system should converge. Note: These lecture notes are incomplete without having attended lectures obtained for Y by adding up C C, I and G 50 Note: These lecture notes are incomplete without having attended lectures 51 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 General Equilibrium General Equilibrium Applying pp y g the IS-LM framework: A temporary p y adverse supply shock Suppose the productivity parameter in the production f function falls f temporarily The supply shock reduces the marginal productivity of Since the FE, IS, and LM curves don’t intersect intersect, the price level adjusts, shifting the LM curve until a general equilibrium g q is reached labor, hence labor demand With lower labor demand, the equilibrium q real wage g and employment fall Lower employment and lower productivity both reduce the equilibrium level of output, thus shifting the FE line to the left Note: These lecture notes are incomplete without having attended lectures Applying pp y g the IS-LM framework: A temporary p y adverse supply shock There’s no effect of a temporary supply shock on the IS S or LM curves 52 Professor Yamin Ahmad, Business Cycles – ECON 402 In this case the price level rises to shift the LM curve up and to the left to restore equilibrium Note: These lecture notes are incomplete without having attended lectures 53 Professor Yamin Ahmad, Business Cycles – ECON 402 Effects of a temporary adverse supply shock General Equilibrium Applying pp y g the IS-LM framework: A temporary p y adverse supply shock The inflation rate rises temporarily, not permanently Summary: The real wage, employment, and output decline, while the real interest rate and price level are higher There is a temporary burst of inflation as the price level moves to a higher level Since the real interest rate is higher and output is lower, consumption and investment must be lower Note: These lecture notes are incomplete without having attended lectures 54 Note: These lecture notes are incomplete without having attended lectures 55 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 General Equilibrium General Equilibrium Application: pp Oil p price shocks revisited Does the IS-LM model correctly predict the results of an adverse supply shock? The data from the 1973–1974 and 1979–1980 oil price shocks shows the following Output, Output employment employment, and the real wage declined It could be that people expected the 1973–1974 oil price p shock to be permanent In that case the real interest rate would not necessarily rise Consumption fell slightly and investment fell substantially If so, people’s expectations were correct, since the 1973– 1974 shock seems to have been permanent, while the 1979– 1980 shock h k was reversed d quickly i kl Inflation surged temporarily All the above results are consistent with the theory Note: These lecture notes are incomplete without having attended lectures Application: pp Oil p price shocks revisited The real interest rate did not rise during the 1973– 1974 oil price shock (though it did during the 1979– 1980 shock)) 56 Professor Yamin Ahmad, Business Cycles – ECON 402 Note: These lecture notes are incomplete without having attended lectures 57 Professor Yamin Ahmad, Business Cycles – ECON 402 General Equilibrium General Equilibrium Econometric models and macroeconomic forecasts The Federal Reserve Board’s FRB/US model, introduced in Econometric models and macroeconomic forecasts Many models that are used for macroeconomic research and 1996, improves on the old model by better handling of expectations, improved modeling of reactions to shocks, and use off newer statistical t ti ti l techniques t h i analysis are based on the IS-LM model There are three major steps in using an economic model for forecasting An econometric model estimates the parameters of the model d l ((slopes, l iintercepts, t t elasticities) l ti iti ) through th h statistical t ti ti l analysis of the data The FRB/US model is the workhorse for policy analysis by the Projections are made of exogenous variables (variables outside id the h model), d l) lik like oilil prices i and d changes h iin productivity d i i Board of Governor’s staff adjust the FRB/US forecasts with their Fed’s staff economists The model is solved for the values of endogenous variables, such as output, employment, and interest rates Note: These lecture notes are incomplete without having attended lectures 58 judgment; the subsequent forecasts reported in the Greenbook have been found to be superior to private-sector forecasts Note: These lecture notes are incomplete without having attended lectures 59 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Price Adjustment and the Attainment of General Equilibrium The effects of a monetary y expansion p An increase in money supply shifts the LM curve down and to the right Because financial markets respond most quickly to changes in economic conditions, the asset market responds to the disequilibrium The decline in the real interest rate causes consumption and p y investment to increase temporarily Th The FE line li iis slow l tto respond, d b because jjob b matching t hi and d wage renegotiation take time Output is assumed to increase temporarily to meet the extra demand The IS curve responds somewhat slowly We assume that the labor market is temporarily out of equilibrium, so there’s a short-run equilibrium at the intersection of the IS and LM curves Note: These lecture notes are incomplete without having attended lectures The effects of a monetary y expansion p The increase in the money supply causes people to try to get rid of excess money balances by buying assets, driving the real interest rate down 60 Professor Yamin Ahmad, Business Cycles – ECON 402 Note: These lecture notes are incomplete without having attended lectures 61 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Effects of a monetary expansion The effects of a monetary y expansion p The adjustment of the price level Since the demand for goods exceeds firms’ desired supply of goods, d fi firms raise i prices i The rise in the p price level causes the LM curve to shift up p The price level continues to rise until the LM curve intersects with the FE line and the IS curve at general Note: These lecture notes are incomplete without having attended lectures 62 Note: These lecture notes are incomplete without having attended lectures 63 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Price Adjustment and the Attainment of General Equilibrium The effects of a monetary y expansion p The result is no change in employment, output, or the real interest rate Trend money growth and inflation This analysis also handles the case in which the money supply is growing continuously The price level is higher by the same proportion as the increase in the money supply If both the money supply and price level rise by the same proportion, there is no change in the real money supply, and the LM curve doesn’t doesn t shift So all real variables (including the real wage) are unchanged, while nominal values (including the nominal wage) have risen proportionately with the change in the money supply Note: These lecture notes are incomplete without having attended lectures The effects of a monetary y expansion p If the money supply grew faster than the price level, the LM curve would ld shift hift d down and d tto th the right i ht 64 Note: These lecture notes are incomplete without having attended lectures 65 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Price Adjustment and the Attainment of General Equilibrium The effects of a monetary y expansion p Classical versus Keynesian y versions of the IS-LM model Trend money growth and inflation There are two key questions in the debate between classical and Keynesian approaches: Often, then, we’ll discuss things in relative terms – The examples can often be thought of as a change in M or P relative to the expected or trend growth of money and inflation – Thus when we talk about “an increase in the money supply,” we have in mind an increase in the growth rate supply, relative to the trend – Similarly, a result that the price level declines can be interpreted as the price level declining relative to a trend; for example, inflation may fall from 7% to 4% Note: These lecture notes are incomplete without having attended lectures 66 How rapidly does the economy reach general equilibrium? What are the effects of monetary policy on the y economy? 67 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Price Adjustment and the Attainment of General Equilibrium Classical versus Keynesian y versions of the IS-LM model Classical versus Keynesian y versions of the IS-LM model Price adjustment and the self-correcting economy Classical economists see rapid adjustment of the The economy is brought into general equilibrium by adjustment of the price level The Th speed d att which hi h thi this adjustment dj t t occurs iis much h debated price level So the economy returns quickly to full employment after a shock If firms change prices instead of output in response to a change in demand, the adjustment process is almost immediate 68 69 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Price Adjustment and the Attainment of General Equilibrium Classical versus Keynesian y versions of the IS-LM model Classical versus Keynesian y versions of the IS-LM model Keynesian economists see slow adjustment of the Monetary neutrality price level It may be several years before prices and wages adjust fully When not in general equilibrium, output is determined by aggregate demand at the intersection of the IS and LM curves, and the labor market is not in equilibrium 70 Money is neutral if a change in the nominal money supply changes the price level proportionately but has no effect on real variables The classical view is that a monetary expansion affects prices quickly with at most a transitory effect on real variables 71 Professor Yamin Ahmad, Business Cycles – ECON 402 Professor Yamin Ahmad, Business Cycles – ECON 402 Price Adjustment and the Attainment of General Equilibrium Back to The Big Picture Keynesian Cross Classical versus Keynesian y versions of the IS-LM model Monetary neutrality Keynesians think the economy may spend a long time in disequilibrium, so a monetary expansion increases output and employment and causes the real interest rate to fall Keynesians believe in monetary neutrality in the long run but not the short run, while classicals believe it holds even in the relatively short run 72 Theoryy of Liquidity Preference IS curve LM curve IS-LM model Agg Agg. demand curve Agg. supply curve Business Cycle fluctuations Model of Agg. gg Demand and Agg. Supply pp y Note: These lecture notes are incomplete without having attended lectures Summary 73 Summary 1. Keynesian cross 3. Theory of Liquidity Preference basic model of income determination basic model of interest rate determination takes fiscal policy & investment as exogenous takes money supply & price level as exogenous fiscal policy has a multiplier effect on income. an increase in the money supply lowers the interest rate 2. IS curve 4. LM curve comes from Keynesian cross when planned comes from liquidity preference theory when investment depends negatively on interest rate shows h allll combinations bi ti off r and dY that equate planned expenditure with actual expenditure on goods & services money demand depends positively on income shows all combinations of r and Y that equate demand for real money balances with supply slide 74 slide 75 Summary 5. IS-LM model Intersection of IS and LM curves shows the unique point (Y, r ) that satisfies equilibrium in both the goods and money markets. slide 76
