The fundamental questions of macroeconomics The data of macroeconomics: production and income Macroeconomics 12 September 2018 Required readings Topics for today • Which are the main questions of macroeconomics? What makes macroeconomics different form microeconomics? What types of questions are macroeconomic questions? • One of the main aggregates: GDP Microeconomics versus Macroeconomics • The prefix micro is derived from the Greek word mikros, which means ―small.‖ Microeconomics therefore studies the economic behaviour of individual economic decision makers, such as a consumer, a worker, a firm, or a manager. It also analyses the behaviour of individual households, industries, markets, labour unions, or trade associations. • The prefix macro comes from the Greek word makros, which means ―large.‖ Macroeconomics thus analyses how an entire national economy performs. A course in macroeconomics examines aggregate levels of income and employment, the levels of interest rates and prices, the rate of inflation, and the nature of business cycles in a national economy. Macroeconomics is built on microeconomics but new concepts and models will have to be introduced. Macro vs micro Macroeconomics is the study of the economy as a whole it models the behaviour of aggregates that describe the economy. • What causes recessions? What is ―government stimulus‖ and why might it help? • How can problems in the housing market spread to the rest of the economy? • What is the government budget deficit? How does it affect workers, consumers, businesses, and taxpayers? • Why does the cost of living keep rising? • Why are so many countries poor? What policies might help them grow out of poverty? • What is the trade deficit? How does it affect a country‘s well-being? The US real GDP (billions of 2012 chain-linked dollars) The US real GDP (percent change from quarter one year ago) US real GDP per capita Inflation in the US Unemployment in the US Economic models In macroeconomics, too, we used models, which …are simplified versions of a more complex reality. • irrelevant details are stripped away …are used to: • show relationships between variables • explain the economy‘s behaviour • devise policies to improve economic performance Endogenous vs. exogenous variables • The values of endogenous variables are determined in the model. • The values of exogenous variables are determined outside the model: The model takes their values and behaviour as given. • In the model of supply & demand for cars, • endogenous: P, Qd, Qs • exogenous: income, price of materials There are various models So we will learn different models for studying different issues (e.g., unemployment, inflation, longrun growth). For each new model, you should keep track of: • its assumptions; • which variables are endogenous; • which are exogenous; • the questions it can help us understand, and those it cannot. Fundamental aggregates Three fundamental aggregates • GDP; • measures of inflation; • Unemployment (and other measures about the labour market) Measuring GDP and inflation are strongly connected, and will be discussed at the beginning of the course. The discussion of the measures of unemployment is left to the class in which the causes of unemployment will be dealt with. 0 Source: Penn World Table 9.1 2016 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 1958 1956 1954 1952 1950 GDP per capita in the US and Hungary (in 2011 US dollars) 60000 50000 40000 30000 20000 10000 0 Source: KSH 2016 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 The quantity index of Hungarian GDP (1960=100) 500 [ÉRTÉK] 450 400 350 300 250 200 150 100 50 GDP • What is GDP and how to calculate it? • What does it mean that „in 2011 US dollars‖? Why isn‘t it enough to compare them just in dollars? • What does it mean that „1960=100‖? GDP The total market value of all final goods and services produced within a country in a given period of time. (1) ―GDP is the Market Value . . .‖: Output is valued at market prices. (2) ―. . . Of All Final . . .‖: It records only the value of final goods, not intermediate goods (the value is counted only once). (3) ―. . . Goods and Services . . . ―: It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). (4) ―. . . Produced . . .‖: It includes goods and services currently produced, not transactions involving goods produced in the past. (5) ― . . . Within a Country . . .‖: It measures the value of production within the geographic confines of a country. (6) ―. . . In a Given Period of Time.‖: It measures the value of production that takes place within a specific interval of time, usually a year or a quarter (three months). The circular flow diagram MARKETS FOR GOODS AND SERVICES •Firms sell Goods •Households buy and services sold Revenue Wages, rent, and profit Goods and services bought HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production Spending MARKETS FOR FACTORS OF PRODUCTION •Households sell •Firms buy Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Copyright © 2004 South-Western Three approaches of GDP accounting Expenditure equals income because every dollar a buyer spends becomes income to the seller • Total expenditure on domestically produced final goods and services. • Total income earned by domestically located factors of production. • Total value added: the sum of all the valuesadded in producing those goods and services. • Value added: The value of output minus the value of the Value added Crude oil is tapped from a well and sold to a refiner for $1.00, who converts it into plastic stock. The plastic stock is sold to a toy manufacturer for $2.00, who makes a Frisbee and sells it at wholesale to a toy store for $7.15. The toy store sells it at retail to the public for $9.99. The value of the final good=9.99 Total values-added=(1.00-0.00)+(2.00-1.00)+(7.15-2.00)+(9.99-7.15)=9.99 Total income is not explicit in this example, but because of the simplicity of the example the calculation must formally be the same as the calculation of total income. GDP accounting Agriculture Revenue: 25 000 Interest: 10 000 Wage 10 000 Industry Revenue: 20 000 Intermediate product: 10 000 Wage: 8000 • GDP = total market value of final goods= =20 000 + (25 000-10 000)=35 000 • GDP = total value added=25000+(20 000 -10 000)=35 000 • GDP= Total income=Interest+wage+profit= 10 000 +(10 000+8000)+(5 000+2000)=35 000 The expenditure components of GDP • consumption, C • investment, I • government spending, G • net exports, NX The national income identity: value Y of= total C + I + G + NX output aggregate expenditure Consumption (C) Consumption is the value of all goods and services bought by households. It includes: • durable goods : last a long time, e.g., cars, home appliances • nondurable goods: last a short time, e.g., food, clothing • services: work done for consumers, e.g., dry cleaning, air travel Investment (I) • This is spending on goods bought for future use (i.e., capital goods) • It includes: • Business fixed investment Spending on plant and equipment and intellectual property products • Residential fixed investment Spending by consumers and landlords on housing units • Inventory investment The change in the value of all firms‘ inventories Investment vs. Capital Note: Investment is spending on new capital. Example: – 1/1/2009: economy has $500b worth of capital – during 2009: investment = $60b – 1/1/2010: economy will have $560b worth of capital • assumes no depreciation Stocks vs. Flows Flow A stock is a quantity measured at a point in time. E.g., ―The U.S. capital stock was $26 trillion on January 1, 2009.‖ A flow is a quantity measured per unit of time. E.g., ―U.S. investment was $2.5 trillion during 2009.‖ Stock Stocks vs. Flows - examples stock flow a person‘s wealth a person‘s annual saving # of people with college degrees # of new college graduates this year the gov‘t debt the gov‘t budget deficit NOW YOU TRY: Stock or Flow? • • • • • the balance on your credit card statement how much you study economics outside of class the size of your compact disc collection the inflation rate the unemployment rate Government spending (G) • G includes all government spending on goods and services. • It excludes transfer payments (e.g., unemployment insurance payments), because they do not represent spending on goods and services. Net Exports: NX = EX – IM It is the value of total exports (EX) minus the value of total imports (IM) NOW YOU TRY: An expenditure-output puzzle? Suppose a firm: • produces $10 million worth of final goods • sells only $9 million worth Does this violate the expenditure = output identity? Why output = expenditure • Unsold output goes into inventory, and is counted as ―inventory investment‖… …whether or not the inventory buildup was intentional. • In effect, we are assuming that firms purchase their unsold output. GDP: An important and versatile concept We have now seen that GDP measures: • total income • total output • total expenditure • the sum of value-added at all stages in the production of final goods Some multiple choice questions about GDP If the price of a hot dog is $2 and the price of a hamburger is $4, then 30 hot dogs contribute as much to GDP as _________ hamburgers. a) 5 b) 15 c) 30 d) 60 Answer: b Some multiple choice questions about GDP Angus the sheep farmer sells wool to Barnaby the knitter for $20. Barnaby makes two sweaters, each of which has a market price of $40. Collette buys one of them, while the other remains on the shelf of Barnaby‘s store to be sold later. What is GDP here? a) $40 b) $60 c) $80 d) $100 Answer: c) Some multiple choice questions about GDP Which of the following does NOT add to U.S. GDP? a) Air France buys a plane from Boeing, the U.S. aircraft manufacturer. b) General Motors builds a new auto factory in North Carolina. c) The city of New York pays a salary to a policeman. d) The federal government sends a Social Security check to your grandmother. Answer: d) Some multiple choice questions about GDP An American buys a pair of shoes manufactured in Italy. How do the U.S. national income accounts treat the transaction? a) Net exports and GDP both rise. b) Net exports and GDP both fall. c) Net exports fall, while GDP is unchanged. d) Net exports are unchanged, while GDP rises. Answer: c) Some multiple choice questions about GDP Which is the largest component of GDP? a) consumption b) investment c) government purchases d) net exports Answer: a) GNI vs. GDP • Gross National Income (GNI): Total income earned by the nation‘s factors of production, regardless of where located • Gross Domestic Product (GDP): Total income earned by domestically-located factors of production, regardless of nationality • GNI – GDP = factor payments from abroad minus factor payments to abroad • Examples of factor payments: wages, profits, NOW YOU TRY: Discussion Question In your country, which would you want to be bigger, GDP or GNI? Why? Real and Nominal GDP • GDP is the market value of all final goods and services produced. • nominal GDP measures these values using current prices. • Current prices are the prices that prevailed at the time of production • real GDP measure these values using constant prices (the prices during the base year). Nominal versus real GDP (Supposing that there are two goods for final use, A and B) NGDPt P Q P Q A t A t B t RGDPt P Q P Q A b A t B b B t B t NOW YOU TRY: Real and Nominal GDP 2016 2017 2018 P Q P Q P Q good A $30 900 $31 1,000 $36 1,050 good B $100 192 $102 200 $100 205 Nominal GDP Real GDP Compute nominal GDP in each year. Compute real GDP in each year using 2016 as the base year. NOW YOU TRY: Real and Nominal GDP 2016 2017 2018 P Q P Q P Q good A $30 900 $31 1,000 $36 1,050 good B $100 192 $102 200 $100 205 Nominal GDP (30×900) + (100×192) = $46,200 (31×1000) + (102×200) = $51,400 (36×1,050) + (100×205) = $58,300 Real GDP (30×900) + (100×192) = $46,200 (30×1000) + (100×200) = $50,000 (30×1,050) + (100×205) = $52,000 Growth Rate: computation Value for the year value for previous year Growth Rate 100 value for previous year Nomina l GDP 2016 2017 2018 $46,200 $51,400 $58,300 $46,200 $50,000 $52,000 NOW YOU TRY: Real and Nominal GDP Growth Rate % Real GDP Growth Rate % Value for the year value for previous year Growth Rate 100 value for previous year Nominal GDP 2016 2017 2018 $46,200 $51,400 $58,300 11.26 13.42 $50,000 $52,000 8.23 4.00 Growth Rate % Real GDP Growth Rate % $46,200 NOW YOU TRY: Real and Nominal GDP [(51,400 – 46,200) / 46,200] ✕ 100 = 11.26 Value for the year value for previous year Growth Rate 100 value for previous year Chain-Weighted Real GDP • Over time, relative prices change, so the base year should be updated periodically. • In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. • Your textbook uses constant-price real GDP, because: • the two measures are highly correlated • constant-price real GDP is easier to compute. Chain-Weighted Real GDP RGDP3 RGDP1 RGDP2 RGDP3 RGDP0 RGDP0 RGDP1 RGDP2 at prices of year 0 and 1 at prices year 1 and 2 at prices year 2 and 3 A multiple choice question about GDP If all quantities produced rise by 10 percent and all prices fall by 10 percent, which of the following occurs? a) Real GDP rises by 10 percent, while nominal GDP falls by 10 percent. b) Real GDP rises by 10 percent, while nominal GDP is unchanged. c) Real GDP is unchanged, while nominal GDP rises by 10 percent. d) Real GDP is unchanged, while nominal GDP falls by 10 percent. Answer: b) Hungarian GDP at current prices (million HUF) 45.000.000 42.072.786 40.000.000 35.000.000 30.000.000 27.193.630 25.000.000 20.000.000 15.000.000 5.835.633 10.000.000 5.000.000 Source: KSH 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 0 Hungarian GDP at current prices and at average 2005 prices (million HUF) 45.000.000 42.072.786 40.000.000 35.000.000 30.000.000 22.559.880 25.000.000 20.000.000 27.468.843 15.000.000 10.000.000 5.000.000 RGDP NGDP Forrás: KSH 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 0 „Economic growth”=growth of real GDP quantity index of GDP Seasonally adjusted (same quarter of the previous year=100,0) 106 104 102 100 98 96 94 92 I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. III. I. 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: KSH Values added by sector in Hungary, 2018 (taxes on production excluded) Mezőgazdaság, erdőgazdálkodás, halászat 4,39% Feldolgozóipar 23,72% Szolgáltatások összesen 66,40% Építőipar 5,48% Sources: KSH The expenditure side of GDP in Hungary, 2018 (million HUF) 25.000.000 20.000.000 15.000.000 10.000.000 5.000.000 0 Fogyasztás (49,07%) Beruházás (27,06%) Sources: KSH Kormányzati vásárlás (19,09%) Nettó export (4,78%) Something we will not consider (export + import as percentage of GDP in Hungary and the US) 180 160 140 120 100 80 60 40 20 Source: WDI 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 0 GDP and GNI in Hungary (current prices, million HUF) 45.000.000 38.355.115 40.000.000 36.823.641 35.000.000 30.000.000 25.000.000 20.000.000 15.000.000 10.000.000 5.000.000 GNI Source: KSH GDP 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 0 GDP and „happiness” GDP and „human development” Source: Kulhamn et al. (2011, p. 10) Problems (at the end of chapter 2 of your textbook) A farmer grows a bushel of wheat and sells it to a miller for $1. The miller turns the wheat into flour and then sells the flour to a baker for $3. The baker uses the flour to make bread and sells the bread to an engineer for $6. The engineer eats the bread. What is the value added by each person? What is the bread‘s contribution to GDP? Problems (at the end of chapter 2 of your textbook) Suppose a woman marries her butler. After they are married, her husband continues to wait on her as before, and she continues to support him as before (but as a husband rather than as an employee). How does the marriage affect GDP? How do you think it should affect GDP? Problems (end of chapter 2 of your textbook) Place each of the following transactions in one of the four components of expenditure: consumption, investment, government purchases, and net exports. a. Boeing sells an airplane to the U.S. Air Force. b. Boeing sells an airplane to American Airlines. c. Boeing sells an airplane to Air France. d. Boeing sells an airplane to Amelia Earhart. e. Boeing builds an airplane to be sold next year. The data of macroeconomics: inflation Macroeconomics 19 September 2019 Real GDP is inflation-adjusted • Changes in nominal GDP can be due to: – changes in prices, and – changes in quantities of output produced. • Changes in real GDP can only be due to changes in quantities, – because real GDP is computed using constant base-year prices. GDP Deflator • Inflation rate: the percentage increase in the overall level of prices • One measure of the price level: GDP deflator Definition: Nominal GDP GDP deflator = 100 Real GDP NOW YOU TRY: GDP deflator and inflation rate NGDP GDP deflator Inflation RGDP (2016=10 rate (%) 0) 2016 $46,200 $46,200 2017 51,400 n.a. 50,000 2018 58,300 52,000 • Use your previous answers to compute the GDP deflator in each year. • Use GDP deflator to compute the inflation rate from 2016 to 2017, and from 2017 to 2018. NOW YOU TRY: Answers NGDP GDP deflator Inflation RGDP (2016=10 rate (%) 0) 2006 $46,200 $46,200 100.0 n.a. 2007 51,400 50,000 102.8 2.8 2008 58,300 52,000 112.1 9.1 GDP Deflator: overall price level 2016 2017 2018 GDP Deflat good or A P 100×Q P 100×Q 51,400/50,0 58,300/52,0 100 $30 900 $31 1,000 00 $36= 112.1 1,050 00 = 102.8 good B 12.1% Same192 $102 2.8% higher $100 200 $100 205 higher Average prices compared to base year P Q Nomin (30×900) + (31×1000) + (36×1,500) al (100×192) (102×200) = + (100×205) GDP = $46,200 $51,400 = $58,300 Real GDP (30×900) + (30×1000) + (30×1,500) (100×192) (100×200) = + (100×205) = $46,200 $50,000 = $52,000 2016 2017 2018 NOW YOU TRY: Real and Nominal Nomin GDP $46,20 $51,40 $58,30 al 0 0 0 GDP Growt h Rate % 11.26 13.42 GDP Deflator = Nominal GDP / Real GDP It is a measure of the overall price Real $46,20 $50,00 $52,00 level Its growth rate is a GDP 0 0 0 measure of the rate of inflation Growt h Rate % GDP Deflat or 8.23 1.00 4.00 1.028 1.121 As an approximation, the GDP Deflator’s growth rate = growth rate of Nominal GDP – Understanding the GDP deflator Example with 3 goods For good i = 1, 2, 3 Pit = the market price of good i in month t Qit = the quantity of good i produced in month t NGDPt = Nominal GDP in month t RGDPt = Real GDP in month t Understanding the GDP deflator NGDPt P1tQ1t P2tQ2t P3tQ3t GDP deflatort RGDPt RGDPt Q1t P1t RGDPt Q2t P2t RGDPt Q3t P3t RGDPt The GDP deflator is a weighted average of prices. The weight on each price reflects that good‘s relative importance in GDP. Note that the weights change over time. International Comparisons • When the GDP numbers for various countries‘ are being compared, the same currency units must be used • There are two ways of converting from national countries to a common currency, such as the US dollar – Use market exchange rates – Use a common set of prices (PPP) GDP per capita, in US dollars Source: World Development Indicators, Country Name Singapore Switzerland United States Netherlands Austria Germany United Kingdom Japan Italy Hungary Russian Federation Iran, Islamic Rep. Botswana China Jordan Jamaica India Nigeria Cameroon GDP2017 at PPP exhange rates 93 905.42 65 006.53 59 531.66 52 941.12 52 557.48 50 715.55 43 876.60 43 875.75 39 817.15 28 375.37 25 533.00 20 949.94 17 354.20 16 806.74 9 153.35 8 995.35 7 055.55 5 860.85 3 694.20 GDP2017 at market exchange rates 57 714.30 80 189.70 59 531.66 48 223.16 47 290.91 44 469.91 39 720.44 38 428.10 31 952.98 14 224.85 10 743.10 5 415.21 7 595.60 8 826.99 4 129.75 5 109.55 1 939.61 1 968.56 1 446.70 Chain-Weighted Real GDP • Over time, relative prices change, so the base year should be updated periodically. • In essence, chain-weighted real GDP updates the base year every year, so it is more accurate than constant-price GDP. • Your textbook uses constant-price real GDP, because: – the two measures are highly correlated – constant-price real GDP is easier to compute. CONSUMER PRICE INDEX (CPI) Consumer Price Index (CPI) • It is a measure of the overall level of prices • It is published by national and international statistical offices. • The CPI is used to: – track changes in the typical household‘s cost of living – adjust many contracts for inflation (COLA, cost of living adjustment) – allow comparisons of dollar amounts over time How CPI is constructed 1. Survey consumers to determine composition of the typical consumer‘s ―basket‖ of goods 2. Every month, collect data on prices of all items in the basket; compute cost of basket 3. CPI in any month equals Cost of basket in that month 100 Cost of basket in base period The composition of the CPI’s “basket” in the US Other goods and services; 3,179 Transportation; 17,107 Housing; 41,649 Medical care; 8,631 Apparel; 3,069 Food and beverages; 14,159 Recreation(5); 5,651 Education and communication(5); 6,556 NOW YOU TRY: Compute the CPI Typical consumer‘s basket: 20 pizzas, 10 compact discs prices: For each year, compute pizza CDs the cost of the basket 2012 $10 $15 the CPI (use 2002 as 2013 $11 the base year) $15 the inflation rate 2014 $12 from the preceding $16 year 2015 $13 NOW YOU TRY: Compute the CPI and Inflation Rate Typical consumer’s basket: 20 pizzas, 10 compact discs pizza CDs cost CPI inflation 201 $10 $15 2 201 $11 $15 3 201 $12 $16 4 Cost of typical consumer' s basket in current period CPI 100 201 Cost of typical consumer' s basket in base period $13 $15 5 NOW YOU TRY: Compute the CPI and Inflation Rate Typical consumer‘s basket: 20 pizzas, 10 compact discs pizza CDs cost CPI inflation 201 $10 $15 2 $350 201 $11 $15 3 $370 201 $12 $16 s basket in current period 4 Cost of typical consumer'$400 CPI 100 201 Cost of typical consumer' s basket in base period $13 $15 5 $410 NOW YOU TRY: Compute the CPI and Inflation Rate Typical consumer‘s basket: 20 pizzas, 10 compact discs pizza CDs cost CPI inflation 201 $10 $15 2 $350 100 201 $11 $15 3 $370 105.71 201 $12 $16 s basket in114.29 current period 4 Cost of typical consumer'$400 CPI 100 201 Cost of typical consumer' s basket in base period $13 $15 5 $410 117.14 NOW YOU TRY: Compute the CPI and Inflation Rate Typical consumer‘s basket: 20 pizzas, 10 compact discs pizza CDs cost CPI inflation 201 $10 $15 2 $350 100 201 $11 $15 3 $370 105.71 5.71 201 $12 $16 s basket in114.29 current period8.11 4 Cost of typical consumer'$400 CPI 100 201 Cost of typical consumer' s basket in base period $13 $15 5 $410 117.14 2.50 CPI in current period CPI in preceding period Inflation 100 CPI in preceding period US inflation -1 01/01/1999 01/07/1999 01/01/2000 01/07/2000 01/01/2001 01/07/2001 01/01/2002 01/07/2002 01/01/2003 01/07/2003 01/01/2004 01/07/2004 01/01/2005 01/07/2005 01/01/2006 01/07/2006 01/01/2007 01/07/2007 01/01/2008 01/07/2008 01/01/2009 01/07/2009 01/01/2010 01/07/2010 01/01/2011 01/07/2011 01/01/2012 01/07/2012 01/01/2013 01/07/2013 01/01/2014 01/07/2014 01/01/2015 01/07/2015 01/01/2016 01/07/2016 01/01/2017 01/07/2017 01/01/2018 01/07/2018 01/01/2019 01/07/2019 Eurozone inflation 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0 -0,5 Source: Eurostat 0 -5 1993/ Jan/ 1993/ Sep/ 1994/ May/ 1995/ Jan/ 1995/ Sep/ 1996/ May/ 1997/ Jan/ 1997/ Sep/ 1998/ May/ 1999/ Jan/ 1999/ Sep/ 2000/ May/ 2001/ Jan/ 2001/ Sep/ 2002/ May/ 2003/ Jan/ 2003/ Sep/ 2004/ May/ 2005/ Jan/ 2005/ Sep/ 2006/ May/ 2007/ Jan/ 2007/ Sep/ 2008/ May/ 2009/ Jan/ 2009/ Sep/ 2010/ May/ 2011/ Jan/ 2011/ Sep/ 2012/ May/ 2013/ Jan/ 2013/ Sep/ 2014/ May/ 2015/ Jan/ 2015/ Sep/ 2016/ May/ 2017/ Jan/ 2017/ Sep/ 2018/ May/ 2019/ Jan/ Hungarian inflation (12 months) 35 30 25 20 15 10 5 Source: MNB Understanding the CPI Example with 3 goods For good i = 1, 2, 3 Ci = the amount of good i in the CPI‘s basket Pit = the price of good i in month t Et = the cost of the CPI basket in month t Eb = the cost of the basket in the base period Understanding the CPI Et P1tC1 + P2tC2 + P3tC3 CPI in month t Eb Eb C1 C2 C3 P1t P2t P3t Eb Eb Eb The CPI is a weighted average of prices. The weight on each price reflects that good’s relative importance in the CPI’s basket. Note that the weights remain fixed over time. Why the CPI may overstate inflation • Substitution bias: The CPI uses fixed weights, so it cannot reflect consumers‘ ability to substitute toward goods whose relative prices have fallen. • Introduction of new goods: The introduction of new goods makes consumers better off and, in effect, increases the real value of the dollar. But it does not reduce the CPI, because the CPI uses fixed weights. • Unmeasured changes in quality: Quality improvements increase the value of the dollar, but are often not fully measured. The size of the CPI’s bias • In 1995, a Senate-appointed panel of experts estimated that the CPI overstates inflation by about 1.1% per year. • So the BLS made adjustments to reduce the bias. • Now, the CPI‘s bias is probably under 1% per year. NOW YOU TRY: Discussion Questions 1. If your grandmother receives Social Security, how is she affected by the CPI‘s bias? 2. Where does the government get the money to pay COLAs to Social Security recipients? 3. If you pay income and Social Security taxes, how does the CPI‘s bias affect you? 4. Is the government giving your grandmother too much of a COLA? 5. How does your grandmother‘s ―basket‖ differ from the CPI‘s? Does this affect your answer to Q4? CPI vs. GDP Deflator • Prices of non-consumer goods: – included in GDP deflator (if produced domestically) – excluded from CPI • Prices of imported consumer goods: – included in CPI – excluded from GDP deflator • The basket of goods: – CPI: fixed – GDP deflator: changes every year Two measures of inflation in the U.S. Percentage change from 12 months earlier 15% C PI 10% 5% GDP deflator 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Problems (end of chapter 2 of your textbook) Consider an economy that produces and consumes hot dogs and hamburgers. In the following table are data for two different years. • • • Using 2010 as the base year, compute the following statistics for each year: nominal GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as the CPI. By what percentage did prices rise between 2010 and 2015? Give the answer for each good and also for the two measures of the overall price level. Compare the answers given by the Laspeyres and Paasche price indexes. Explain the difference. End-of-chapter problems End-of-chapter problems GROWTH RATE MATH Two arithmetic tricks for working with percentage changes 1. For any variables X and Y, percentage change in (X Y ) percentage change in X + percentage change in Y Example: If your hourly wage rises 5% and you work 7% more hours, then your wage income rises approximately 12%. Two arithmetic tricks for working with percentage changes 2. percentage change in (X/Y ) percentage change in X percentage change in Y Example: GDP deflator = 100 NGDP/RGDP. If NGDP rises 9% and RGDP rises 4%, then the inflation rate is approximately 5%. • The growth rate of the ratio of two variables equals the difference of their growth rates. • The growth rate of the product of two variables equals the sum of their growth rates. • The growth rate of a variable raised to an exponent, is the growth rate of the variable times the exponent. If Z = X × Y then gz = gx + g y znew zold znew gz 1 zold zold znew xnew ynew 1 gz zold xold yold 1 g z (1 g x )(1 g y ) 1 gz 1 gx g y gx g y gz gx g y gx g y gz gx g y The growth rates here are in decimal form: for example, if X grows at the rate of 5%, then gx = 0.05. The product of two decimals is small enough to be ignored: for example, 0.05 × 0.04 = 0.0020. If Z = X ÷ Y then gz = gx – g y x z y z y x gz g y gx gz gx g y If Z = a X then gz = a × gx zx x x x a a times gz gx gx gx a gx a times The economy in the long run: production and the division of income Macroeconomics 26 September 2019 The Long Run ‖This great increase of the quantity of work which, in consequence of the division of labour, the same number of people are capable of performing, is owing to three different circumstances; first to the increase of dexterity in every particular workman; secondly, to the saving of the time which is commonly lost in passing from one species of work to another; and lastly, to the invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.‖ (Adam Smith: An Inquiry into the Nature and Causes of the Wealth pf Nations, Book I, Chapter I) Introduction • In the last lecture we defined and measured some key macroeconomic variables. • Now we start building theories about what determines these key variables. • In the next couple lectures we will build up theories that we think hold in the long run, when prices are flexible and markets clear. • Called Classical theory or Neoclassical. The Neoclassical model Is a general equilibrium model: • involves multiple markets; • each with own supply and demand; • price in each market adjusts to make quantity demanded equal quantity supplied. Neoclassical model The macroeconomy involves three types of markets: 1. Goods (and services) Market 2. Factors Market or Labor market , needed to produce goods and services 3. Financial market (the market for loanable funds) Three types of agents in an economy: 1. Households 2. Firms 3. Government The circular flow -- extended Neoclassical model Agents interact in markets, where they may be demander in one market and supplier in another 1) Goods market: Supply: firms produce the goods Demand: by households for consumption, government spending, and other firms demand them for investment Neoclassical model 2) Labor and capital market (factors of production) Supply: Households sell their labor services. Demand: Firms need to hire labor and capital to produce the goods. 3) Financial market Supply: households supply private savings: income less consumption Demand: firms borrow funds for investment; government borrows funds to finance expenditures. Neoclassical model • We will develop a set of equations to characterize supply and demand in these markets • Then use algebra to solve these equations together, and see how they interact to establish a general equilibrium. • Start with production… Supply in goods market: Production Supply in the goods market depends on a production function: denoted Y = F (K, L) Where K = capital (tools, machines, and structures used in production) L = labor (the physical and mental efforts of workers) The production function • shows how much output (Y ) the economy can produce from K units of capital and L units of labor. • reflects the economy‘s level of technology. • Generally, we will assume it exhibits constant returns to scale. Returns to scale Initially Y1 = F (K1 , L1 ) Scale all inputs by the same factor z: K2 = zK1 and L2 = zL1 for z>1 (If z = 1.25, then all inputs increase by 25%) What happens to output, Y2 = F (K2 , L2 ) ? • If constant returns to scale, Y2 = zY1 • If increasing returns to scale, Y2 > zY1 • If decreasing returns to scale, Y2 < zY1 Exercise: determine returns to scale Determine whether each of the following production functions has constant, increasing, or decreasing returns to scale: a) F (K , L ) 2K 15L b) F (K , L ) 2 K 15 L Exercise: determine returns to scale Does F (zK , zL ) zF (K , L )? a) Suppose F (K , L ) 2K 15L F (zK , zL ) 2 zK 15 zL z (2K 15L ) zF (K , L ) Yes, constant returns to scale slide 120 Exercise: determine returns to scale b) Suppose F (K , L ) 2 K 15 L F (zK , zL ) 2 zK 15 zL 2 z K 15 z L z 2 K 15 L z F (K , L ) zF (K , L ) No, decreasing returns to scale slide 121 Assumptions of the model 1. Technology is fixed. 2. The economy‘s supplies of capital and labor are fixed at K K and L L Determining GDP Output is determined by the fixed factor supplies and the fixed state of technology: So we have a simple initial theory of supply in the goods market: Y F (K , L ) Equilibrium in the factors market • Equilibrium is where factor supply equals factor demand. • Recall: Supply of factors is fixed. • Demand for factors comes from firms. Demand in factors market Analyze the decision of a typical firm. • It buys labor in the labor market, where price is wage, W. • It rents capital in the factors market, at rate R. • It uses labor and capital to produce the good, which it sells in the goods market, at price P. Demand in factors market Assume the market is competitive: Each firm is small relative to the market, so its actions do not affect the market prices. It takes prices in markets as given - W,R, P. Demand in factors market It then chooses the optimal quantity of Labor and capital to maximize its profit. Profit = revenue -labor costs -capital costs = PY - WL - RK = P F(K,L) - WL - RK Demand in the factors market • Increasing hiring of L will have two effects: 1) Benefit: raise output by some amount 2) Cost: raise labor costs at rate W • To see how much output rises, we need the marginal product of labor (MPL) Marginal product of labor (MPL) An approximate definition (used in text) : The extra output the firm can produce using one additional labor (holding other inputs fixed): MPL = F (K, L +1) – F (K, L) Exercise: compute & graph MPL a. Determine MPL at each value of L b. Graph the production function c. Graph the MPL curve with MPL on the vertical axis and L on the horizontal axis L L 0 1 2 3 ?4 5 6 7 8 9 10 Y MP 0 10 19 27 34 40 45 49 52 54 55 ? ? 8 ? ? ? ? ? ? ? The MPL and the production function Y outp ut F (K , L ) MP 1 L 1 MP L 1 slide 131 As more labor is added, MPL MP L Slope of the production function equals MPL: rise over run lab or L Diminishing marginal returns • As a factor input is increased, its marginal product falls (other things equal). • Intuition: L while holding K fixed fewer machines per worker lower productivity MPL as a derivative As we take the limit for small change in L: F (K , L L ) F (K , L ) MPL lim L 0 L FL (K , L ) Which is the definition of the (partial) derivative of the production function with respect to L, treating K as a constant. This shows the slope of the production function at any particular point, which is what we want. slide 133 The MPL and the production function Y outp ut MPL is slope of the production function (rise over run) F (K , L ) F (K, L +L) – F (K, L)) L L lab or A brief calculus review: Derivatives 1) Y F (L ) 2L 3 Y FL 2 L Y 3 Slope = 2 Intercept at 3 L Firm problem: hiring L Firm chooses L to maximize its profit. How will increasing L change profit? Δ profit = Δ revenue - Δ cost = P * MPL - W If this is: > 0 should hire more < 0 should hire less = 0 hiring right amount Firm problem continued So the firm‘s demand for labor is determined by the condition: P ×MPL = W Hires more and more L, until MPL falls enough to satisfy the condition. Also may be written: MPL = W/P, where W/P is the ‗real wage‘ Real wage Think about units: • W = $/hour • P = $/good • W/P = ($/hour) / ($/good) = goods/hour The amount of purchasing power, measured in units of goods, that firms pay per unit of work Example: deriving labor demand • Suppose a production function for all firms in the economy: Y K 0.5L0.5 MPL 0.5K 0.5L0.5 Labor demand is where this equals real wage: 0.5 0.5 W 0.5K L P Labor demand or rewrite with L as a function of real wage W 0.5K L P 2 2 W 0.5 0.5 0.5K L P 2 1 1 P K L 0.25 W 2 P demand L 0.25K W So a rise in wage want to hire less labor; rise in capital stock want to hire more labor 0.5 0.5 Labor market equilibrium Take this firm as representative, and sum over all firms to derive aggregate labor demand. Combine with labor supply to find equilibrium wage: demand: 0.5K 0.5 L demand 0.5 W P supply: Lsupply L 0.5 W 0.5 equilibrium: 0.5K L P So rise in labor supply fall in equlibrium real wage MPL and the demand for labor Units of output labor supply Real wag e Each firm hires labor up to the point where MPL = W/P MPL, Labor demand L Units of labor, L Determining the rental rate We have just seen that MPL = W/P The same logic shows that MPK = R/P : • diminishing returns to capital: MPK as K • The MPK curve is the firm‘s demand curve for renting capital. • Firms maximize profits by choosing K such that MPK = R/P . How income is distributed We found that if markets are competitive, then factors of production will be paid their marginal contribution to the production process. W total labor income = L MPL L P total capital income R K MPK K = P Euler’s theorem: Under our assumptions (constant returns to scale, profit maximization, and competitive markets)… total output is divided between the payments to capital and labor, depending on their marginal products, with no extra profit left over. Y MPL L MPK K nation al incom e labor incom e capital incom e slide 145 Mathematical example Consider a production function with Cobb-Douglas form: Y = AKL1- where A is a constant, representing technology Show this has constant returns to scale: multiply factors by Z: F(ZK,ZY) = A (ZK) (ZL)1- = A Z K Z1- L1- = A Z Z1- K L1- = Z x A K L1- = Z x F(K,L) slide 146 Mathematical example • Compute marginal products: MPL = (1-) A K L- MPK = A K-1L1- • Compute total factor payments: MPL x L + MPK x K = (1-) A K L- x L + A K-1L1- x K = (1-) A K L1- + A K L1- = A K L1- =Y So total factor payments equals total production. End-of-chapter problems Use the neoclassical theory of distribution to predict the impact on the real wage and the real rental price of capital of each of the following events: a) A wave of immigration increases the labor force. b) An earthquake destroys some of the capital stock. c) A technological advance improves the production function. d) High inflation doubles the prices of all factors and outputs in the economy. End-of-chapter problems Suppose the production function in medieval Europe is Y=K 0.5L0.5, where K is the amount of land and L is the amount of labor. The economy begins with 100 units of land and 100 units of labor. Use a calculator and equations in the chapter to find a numerical answer to each of the following questions. a) How much output does the economy produce? b) What are the wage and the rental price of land? c) What share of output does labor receive? d) If a plague kills half the population, what is the new level of output? e) What is the new wage and rental price of land? f) What share of output does labor receive now? End-of-chapter problems According to the neoclassical theory of distribution, a worker‘s real wage reflects her productivity. Let‘s use this insight to examine the incomes of two groups of workers: farmers and barbers. Let Wf and Wb be the nominal wages of farmers and barbers, Pf and Pb be the prices of food and haircuts, and Af and Ab be the marginal productivity of farmers and barbers. a) For each of the six variables defined above, state as precisely as you can the units in which they are measured. (Hint: Each answer takes the form ―X per unit of Y.‖) b) Over the past century, the productivity of farmers Af has risen substantially because of technological progress. According to the neoclassical theory, what should have happened to farmers‘ real wage, Wf/Pf ? In what units is this End-of-chapter problems c) Over the same period, the productivity of barbers Ab has remained constant. What should have happened to barbers‘ real wage, Wb/Pb? In what units is this real wage measured? d) Suppose that, in the long run, workers can move freely between being farmers and being barbers. What does this mobility imply for the nominal wages of farmers and barbers, Wf and Wb? e) What do your previous answers imply for the price of haircuts relative to the price of food, Pb/Pf ? f) Suppose that barbers and farmers consume the same basket of goods and services. Who benefits more from technological progress in farming—farmers or barbers? Explain how your answer is consistent with the results on End-of-chapter problems (This problem requires the use of calculus.) Consider a Cobb– Douglas production function with three inputs. K is capital (the number of machines), L is labor (the number of workers), and H is human capital (the number of college degrees among the workers). The production function is Y =K1/3L1/3H1/3. a) Derive an expression for the marginal product of labor. How does an increase in the amount of human capital affect the marginal product of labor? b) Derive an expression for the marginal product of human capital. How does an increase in the amount of human capital affect the marginal product of human capital? End-of-chapter problems c) What is the income share paid to labor? What is the income share paid to human capital? In the national income accounts of this economy, what share of total income do you think workers would appear to receive? (Hint: Consider where the return to human capital shows up.) d) An unskilled worker earns the marginal product of labor, whereas a skilled worker earns the marginal product of labor plus the marginal product of human capital. Using your answers to parts (a) and (b), find the ratio of the skilled wage to the unskilled wage. How does an increase in the amount of human capital affect this ratio? Explain. e) Some people advocate government funding of college scholarships as a way of creating. a more egalitarian society. Others argue that scholarships help only those who are able to go to college. Do your answers to the preceding questions shed light on this debate? The economy in the long run: demand and equilibrium on market for goods and services Macroeconomics 3 October 2018 Questions for this lecture • What determines the demand for goods and services? • How is equilibrium in the goods market achieved? • What determines the real interest rate? Two productive resources and one produced good • There are two productive resources: • Capital, K • Labor, L • These two productive resources are used to produce one • final good, Y (GDP) Consumption Expenditure • Now that we know what determines total output (Y), the next question is: • What happens to that output? • In particular, what determines how much of that output is consumed? • What determines C? Consumption, C • Net Taxes = Tax Revenue – Transfer Payments • Denoted T and always assumed exogenous • Disposable income (or, after-tax income) is total income minus net taxes: Y – T. • Assumption: Consumption expenditure is directly related to disposable income Predictions Y C Capital, K + + Labor, L + + Technolo gy + + The Consumption Function C C (Y – T) 1 MP C The slope of the consumption function is the MPC. Marginal propensity to consume (MPC) is the increase in consumption (C) when disposable income (Y – T) increases by one Y– T The MPC is usually a positive fraction: 0 < MPC < 1. Consumption, C • Assumption: Consumption expenditure is directly related to disposable income • Consumption function: C = C (Y – T ) • Specifically, C = Co + Cy × (Y – T) • Co represents all other exogenous variables that affect consumption, such as asset prices, consumer optimism, etc. • Cy is the marginal propensity to consume (MPC), the fraction of every additional dollar of income that is consumed Predictions Y C Capital, K + + Labor, L + + Technolo gy + + Taxes, T − Co + The Consumption Function C = Co2 + Cy∙(Y – T) C C = Co1 + Cy∙(Y – T) Predictions Grid 𝐾 , 𝐿, Technology F(K, L) – T1 T1 > T2 F(K, L) – T2 Consumption shift factor: greater consumer optimism, higher asset prices Y C + + Taxes, T − Co + Y– T Consumption: example • Suppose F(K, L) = 5K0.3L0.7 and K = 2 and L = 10. Then Y = 30.85. • Suppose T = 0.85. Therefore, disposable income is Y – T = 30. • Now, suppose C = 2 + 0.8×(Y – T). Private Saving is defined as • Then, C = 2 + 0.8 ×30 = 26 disposable income minus consumption, which is Y – T – C = 30 – 26 = 4. K, L, F(K, L) Y C C(Y – T), T Marginal Propensity to Consume • The marginal propensity to consume is a positive fraction (1 > MPC > 0) • That is, when income (Y) increases, consumption (C) also increases, but by only a fraction of the increase in income. • Therefore, Y↑⇒ C↑ and Y – C↑ • Similarly, Y↓⇒ C↓ and Y – C↓ Predictions Y C Y– C K, L, Technology Taxes, T + + + − + Government Spending • Assumption: government spending (G) is exogenous • Public Saving is defined as the net tax revenue of the government minus government spending, which is T – G National Saving and Investment • • • • • • In chapter 2, we saw that Y = C + I + G + NX In this chapter, we study a closed economy: NX = 0 Therefore, Y = C + I + G Y−C−G=I Y − C − G is defined as national saving (S) Therefore, S = I K, L, F(K, L) Y G C C(Y – T), S=I=Y– C–G Investment: example • Suppose F(K, L) = 5K0.3L0.7 and K = 2 and L = 10. Then Y = 30.85. • Suppose T = 0.85. Therefore, disposable income is Y – T = 30. • Now, suppose C = 2 + 0.8×(Y – T). Public Saving = T – • Then, C = 2 + 0.8 ×30 = 26 G = 0.85 – 3 = – 2.15 • Suppose G = 3 • Then, I = S = Y – C – G = 30.85 – 26 – 3 = 1.85 The Real Interest Rate • Imagine that lending and borrowing take place in the economy, but in commodities, not cash • That is, you may borrow some amount of the final good, as long as you pay back the quantity you borrowed plus a little bit extra as interest • The real interest rate (r) is the fraction of every unit of the final good borrowed that the borrower will have to pay to the lender as interest The nominal interest rate • The interest rate that a bank charges you for a cash loan is called the nominal interest rate (i) • It is the fraction of every dollar borrowed that the lender must pay in interest • The nominal interest rate is not adjusted for inflation Investment and the real interest rate • Assumption: investment spending is inversely related to the real interest rate • I = I(r), such that r↑⇒ I↓ r I (r )I Investment and the real interest rate • Specifically, I = Io − Irr • Here Ir is the effect of r on I and • Io represents all other factors that also affect business investment spending • such as business optimism, technological progress, etc. r Io2 − I rr Io1 − I rr I The Real Interest Rate: example • Suppose F(K, L) = 5K0.3L0.7 and K = 2 and L = 10. Then Y = 30.85. Suppose T = 0.85. Therefore, disposable income is Y – T = 30. • Now, suppose C = 2 + 0.8✕(Y – T). Then, C = 2 + 0.8 ×30 = 26 • Suppose G = 3. Then, I = S = Y – C – G = 30.85 – 26 – 3 = 1.85 • Suppose I = 11.85 – 2r is the investment function • Then, 11.85 – 2r = 1.85. Therefore, r = 5 percent Whole chapter in one slide! • 𝑌 = 𝐴 ∙ 𝐾 0.3 𝐿0.7 • 𝐶 = 𝐶0 + 𝐶𝑦 ∙ (𝑌 − 𝑇) • 𝐼 =𝑆 =𝑌−𝐶−𝐺 • 𝐼 = 𝐼0 − 𝐼𝑟 ∙ 𝑟 which gives 𝑟 = Predictions Y C S, I r K, L, A (Technology) + + + − Net Taxes, T − + − Co + − + − + Govt Spending, G 𝐼0 −𝐼 𝐼𝑟 The Real Interest Rate • Recall that the amount of investment has already been determined • The investment function can therefore be used to determine the real interest rate K, L, F(K, L) Y G C C(Y – T), I(r ) S=I=Y– C–G r The Real Interest Rate r I = Y – C(Y-T) – G Predictions I = F(K, L) – C(F(K, L) – T) – G Y C S, I r + + + − Taxes, T − + − Co + − + − + K, L, Technology I(r) = Io − I rr Govt, G Io I K, L, F(K, L) Y G C C(Y – T), + I(r ) S=I=Y– C–G r The Real Interest Rate: predictions As investment and the real interest rate are inversely related, any exogenous variable that affects investment one way will affect the real interest rate the other way. Predictions Grid Y C S, I r + + + − Taxes, T − + − Co + − + − + K, L, Technology Govt, G Io + Q: Why is it that business optimism or technological progress shifts the investment curve upwards, but does not affect the amount of investment in the long run? The Real Interest Rate: predictions Predictions Grid • The amount of business investment has already been determined • So, any increase in business optimism must be cancelled out by an increase in the real interest rate • The result that an increase in businesses‘ desire to invest may not lead to more investment shows the benefit of the macroeconomic approach Y C S, I r + + + − Taxes, T − + − Co + − + − + K, L, Technology Govt, G Io r + I = F(K, L) – C(F(K, L) – T) – G Io2 − I rr Io1 − I rr I Budget surpluses and deficits • If T > G, budget surplus = (T – G ) = public saving. • If T < G, budget deficit and public saving is negative. = (G – T ) • If T = G , ―balanced budget,‖ public saving = 0. • The U.S. government finances its deficit by issuing Treasury bonds – i.e., borrowing. CASE STUDY: The Reagan deficits • Reagan policies during early 1980s: • increases in defense spending: G > 0 • big tax cuts: T < 0 • Both policies reduce national saving: S Y C (Y T ) G G S T C S CASE STUDY: The Reagan deficits 1. The increase in the deficit reduces saving… 2. …which causes the real interest rate to rise… 3. …which reduces the level of investment. r S2 S1 r 2 r 1 I I 2 1 I (r ) S, I Are the data consistent with these results? 3.9 .4 3 .4 variable 1980s T–G 1970s –2.2 – S 19.6 17 r 1.1 6. I 19.9 19 T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. NOW YOU TRY: The effects of saving incentives • Draw the diagram for the loanable funds model. • Suppose the tax laws are altered to provide more incentives for private saving. (Assume that total tax revenue T does not change) • What happens to the interest rate and investment? End-of-chapter problems The government raises taxes by $100 billion. If the marginal propensity to consume is 0.6, what happens to the following? Do they rise or fall? By what amounts? a) Public saving b) Private saving c) National saving d) Investment End-of-chapter problems Suppose that an increase in consumer confidence raises consumers‘ expectations about their future income and thus increases the amount they want to consume today. This might be interpreted as an upward shift in the consumption function. How does this shift affect investment and the interest rate? End-of-chapter problems Consider an economy described as follows: Y = C+ I + G. Y = 8,000. G = 2,500. T =2,000. C =1000+(2/3)(Y-T ). I =1,200 -100r. a) In this economy, compute private saving, public saving, and national saving. b) Find the equilibrium interest rate. c) Now suppose that G is reduced by 500. Compute private saving, public saving, and national saving. d) Find the new equilibrium interest rate. End-of-chapter problems Suppose that the government increases taxes and government purchases by equal amounts. What happens to the interest rate and investment in response to this balanced-budget change? Explain how your answer depends on the marginal propensity to consume. Money supply Macroeconomics 10 October 2019 Three Main Questions 1) What is money? 2) What is the role of a nation‘s banking system in determining the quantity of money in the economy? 3) How does a nation‘s central bank influence the banking system and the quantity of money? What is money? Money is the stock of assets that can be readily used to make transactions. • Functions of money – Medium of exchange: we use it to buy stuff – Store of value: transfers purchasing power from the present to the future – Unit of account: the common unit by which everyone measures prices and values Two Types of Money • Fiat money People accept fiat money either because a government decree (or, fiat) requires them to do so or simply because others would also accept it as payment • Commodity money This money is valuable in itself (e.g., gold coins) or can by law be converted into something valuable (as in a gold standard system) The Quantity of Money The quantity of money, amount of money, and supply of money all refer to the same thing: • The total value of all assets in the economy that can be used as money • It is denoted M The Quantity of Money There are several prominent measures of the quantity of money (M) What counts as money? • The dollar value of the currency we carry, C, should clearly be counted as money • Moreover, when we do our shopping, we use checks and debit cards exactly the way we use currency. Therefore, the dollars that we can spend this way should also be counted as money. The Measures of Money Simplified version: Money Supply (M) = Currency (C) + Demand Deposits (D) C, M1, M2 in the United States Banks’ role in the monetary system • The money supply equals currency plus demand (checking account) deposits: M=C+D • Since the money supply includes demand deposits, the banking system plays an important role. A few preliminaries • Reserves (R): the portion of deposits that banks have not lent. • A bank‘s liabilities include deposits; assets include reserves and outstanding loans. • 100-percent-reserve banking: a system in which banks hold all deposits as reserves. • Fractional-reserve banking: a system in which banks hold a fraction of their deposits as reserves. Banks’ role in the monetary system To understand the role of banks, we will consider three scenarios: 1) No banks 2) 100-percent-reserve banking (banks hold all deposits as reserves) 3) Fractional-reserve banking (banks hold a fraction of deposits as reserves, use the rest to make loans) In each scenario, we assume C = $1,000. SCENARIO 1: No banks With no banks, D = 0 and M = C = $1,000. SCENARIO 2: 100-percent-reserve banking • Initially C = $1000, D = $0, M = $1,000. • Now suppose households deposit the $1,000 at ―Firstbank.‖ • After the deposit: C = $0, D = $1,000, M = $1,000 LESSON: 100%-reserve banking has no impact on size of money supply. SCENARIO 3: Fractional-reserve banking • Suppose banks hold 20% of deposits in reserve, making loans with the rest. • Firstbank will make $800 in loans. • The money supply now equals $1,800: – Depositor has $1,000 in demand deposits. – Borrower holds $800 in currency. SCENARIO 3: Fractional-reserve banking • Suppose the borrower deposits the $800 in Secondbank. • Initially, Secondbank‘s balance sheet is: • Secondbank will loan 80% of this deposit. SCENARIO 3: Fractional-reserve banking • If this $640 is eventually deposited in Thirdbank, • Then Thirdbank will keep 20% of it in reserve and loan the rest out: Finding the total amount of money: Original deposit = $1000 + Firstbank lending = $ 800 + Secondbank lending = $ 640 + Thirdbank lending = $ 512 + other lending… • Total money supply = (1/rr ) × $1,000 where rr = ratio of reserves to deposits • In our example, rr = 0.2, so M = $5,000 The Role of banks in the Monetary System Banks’ Liabilities: how do banks get money? Banks take deposits (D) from depositors • • Banks also borrow money (by selling bonds). This is called their debt • The owners of a bank must also invest their own money in their bank. This is called the bank‘s capital (or, equity) • Total bank liabilities = deposits + debt • Total bank funds = liabilities + capital Banks’ Assets: what do banks do with their money? • Some of the banks‘ funds are kept in the banks‘ vaults as reserves (R) • Banks‘ funds are also used to make loans • The interest charged is a source of income • … and also to make securities purchases • This too is a source of income • Total bank assets = reserves + loans + securities purchases The Role of Banks in the Monetary System: Bank’s Balance Sheet • The bank‘s funds – its liabilities plus capital – are used to buy assets • Assets = liabilities + capital Liabilities and Owners’ Equity Assets Reserves Loans Securities $200 Deposits 500 Debt 300 Capital (owners’ equity) $750 200 50 The Role of Banks in the Monetary System: Leverage • Leverage is the use of borrowed money (deposits + debt) to supplement owners‘ funds for purposes of investment • Leverage ratio = assets/capital = $(200 + 500 + 300)/$50 = 20 Liabilities and Assets Owners’ Equity Reserves Loans Securities $200 Deposits 500 Debt 300 Capital (owners’ equity) $750 200 50 The Role of Banks in the Monetary System: Leverage • Being highly leveraged makes banks vulnerable. • Example: Suppose the value of our bank‘s assets falls by 5%, to $950. • Then, capital = assets – liabilities = 950 – 950 =0 Liabilities and Owners’ Equity Assets Reserves Loans Securities $200 Deposits 500 Debt 300 Capital (owners’ $750 200 50 The Central Bank’s Influence • We will now build an algebraic model of the central bank‘s influence on the monetary system of a country. • Our first equation is one we have seen already: M = C + D • All three variables—money supply, currency held by the public, and demand deposits—will be considered endogenous Monetary Base • The monetary base (B) is the total number of dollars held • by the public as currency (C) or • by banks as reserves (R) • So, our second equation is B = C + R • A country‘s monetary base is directly determined by its central bank • B is exogenous; C and R are endogenous The Money Multiplier • cd = C/D is the currency-deposit ratio, and • rd = R/D is the reserve-deposit ratio Note that 0 < rd < 1 • Although C and R are endogenous, cd and rd will be considered exogenous • This is a huge simplification of reality Demand Deposits • B = C + R = cd ∙ D + rd ∙ D = (cd + rd) ∙ D • Therefore, D = 1 ∙ cd+rd B • We have expressed an endogenous variable, D, entirely in terms of our exogenous variables (cd, rd, and B) Currency held by the public • 𝐶 = 𝑐𝑑 × 𝐷 = 𝑐𝑑 𝑐𝑑+𝑟𝑑 ∙𝐵 • Again, we have expressed an endogenous variable, C, entirely in terms of our exogenous variables (cd, rd, and B) Reserves held by banks • 𝑅 = 𝑟𝑑 × 𝐷 = 𝑟𝑑 𝑐𝑑+𝑟𝑑 ∙𝐵 • Again, we have expressed an endogenous variable, R, entirely in terms of our exogenous variables (cd, rd, and B) Money Supply • We know that M = C + D. Therefore, • 𝑀= 𝑐𝑑 𝑐𝑑+𝑟𝑑 ∙𝐵+ 1 𝑐𝑑+𝑟𝑑 ∙𝐵 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙𝐵 • Again, we have expressed an endogenous variable, M, entirely in terms of our exogenous variables (cd, rd, and B) The Money Multiplier • 𝑀= 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙𝐵 • The factor of proportionality is called the money multiplier: • 𝑚= 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 • Therefore, 𝑀 = 𝑚 × 𝐵 • Note that, as 0 < rd < 1, it must be that m > 1 • That is, for every dollar of monetary base created by the central bank, the money supply increases by more than a dollar Numerical Example • Q: Suppose the monetary base is B = $800 billion, the reservedeposit ratio is rd = 0.1, and the currency-deposit ratio is cd = 0.8. Calculate C, R, M, D, and m. • A: R = $88.89 billion; C = $711.11 billion; D = $888.89 billion; M = $1,600 billion, and m = 2. The Central Bank 𝑐𝑑 + 1 𝑀= ∙𝐵 𝑐𝑑 + 𝑟𝑑 • When the central bank increases the monetary base, the money supply increases • When the reserve-deposit ratio decreases, the money supply increases • When the currency-deposit ratio decreases, the money supply increases (Why?) The Central Bank • 𝑀= 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙𝐵 • A country‘s central bank • directly controls the monetary base, B, and • indirectly controls the reserve-deposit ratio, rd. • Therefore, the central bank can change a country‘s monetary supply How does the Fed change the monetary base? • Open-market operations: • The Fed could print dollars and use them to buy securities (usually short-term Treasury bonds) from banks or from the public. • This reduces ―securities‖ and increases ―reserves‖ (R↑) in the assets column of the banks‘ balance sheets, and • Increases cash held by the public (C↑) • Therefore, the monetary base increases (B = C + R↑) How does the Fed change the monetary base? • Making loans to banks and thereby increasing banks‘ reserves (R↑) • This typically happens when banks have lost the trust of private lenders and are unable to borrow from them. • The Fed is the ―lender of last resort‖ • The Fed‘s lending can take two forms: • Discount Window • Term Auction Facility How does the Fed change the monetary base? Discount Window • The Fed lends to banks directly and charges them an interest rate called the discount rate • When the Fed reduces the discount rate, banks borrow more, their reserves rise by a bigger amount, and so the monetary base rises by a bigger amount How does the Fed change the monetary base? Term Auction Facility • The TAF was a response to the financial crisis of 2008-9 • The Fed decides how much it wants to lend to banks. Eligible banks then bid to borrow those funds, with the loans going to the banks that offer to pay the highest interest • In this way, both banks‘ reserves and the monetary base increase. How does the Fed indirectly control the reserve-deposit ratio? • We have seen that a decrease in the reserve-deposit ratio (rd↓) causes the money multiplier and the money supply to increase • The Fed drives the rd in two ways: • reserve requirements for banks, and • interest on banks‘ reserves How does the Fed indirectly control rd? Reserve Requirements • Reserve requirements are Fed regulations that impose a minimum reserve-deposit ratio on banks This is to ensure that there will always be enough money in banks for depositors who may need to withdraw cash • The required minimum rd is only a minimum • Still, when reserve requirements decrease, rd tends to fall. • This causes m, M and B to increase How does the Fed indirectly control rd? Interest on Reserves • This was a response to the financial crisis of 2008-9 • US banks keep their reserves with the Fed • The Fed now pays banks interest on the reserves they keep at the Fed • A reduction in this interest, induces banks to keep fewer reserves • This reduces rd, and increases m, M, and B Case Study: Quantitative Easing • Prior to the financial crisis of 2008, the US monetary base rose gradually • Between 2007 and 2011, it tripled, mainly through openmarket operations • The Fed printed money and used it to buy riskier securities than the Treasury bonds it buys during normal times Case Study: Quantitative Easing • Although the monetary base tripled during 2007-11, the money supply rose a lot less: M1 increased 40% and M2 increased 25% • Why? • Recall that 𝑀 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙ 𝐵 and 𝑚 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 • Banks had suffered huge losses on their loans. As a result, they stopped lending. • The reserve-deposit ratio rose, thereby reducing m • This is why M did not rise as fast as B Case Study: Quantitative Easing • But what if the rd returns to the pre-crisis level? • Then the huge increase in B would translate into an equally huge increase in M • This, as we shall see in Chapter 5, could cause massive inflation • Should we be worried? Case Study: Quantitative Easing • No, there‘s nothing to worry, says the Fed • They could simply sell the securities that they had earlier bought, thereby reducing the monetary base to pre-crisis levels • Moreover, if there are signs that banks are beginning to lend the reserves they have accumulated, the Fed could raise the interest it pays on reserves, thereby reversing any decline in rd Monetary base in the US Total reserves in the US Money multiplier in the US The Fed’s Monetary Control is Imperfect • Recall that 𝑀 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙ 𝐵 and 𝑚 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 • The Fed can control the required minimum rd but not the actual rd. Banks may decide to keep reserves in excess of what is required. • The currency-deposit ratio is not under the Fed‘s control. For example, when people are scared of keeping money in banks, cd increases. Case Study: The 1930s • During the Great Depression of the 1930s, the monetary base increased but the money supply didn‘t • Why? • Recall that 𝑀 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 ∙ 𝐵 and 𝑚 = 𝑐𝑑+1 𝑐𝑑+𝑟𝑑 • Both cd and rd increased, which reduced m, making M grow slower than B Case Study: The 1930s • Businesses were losing money and defaulting on their loans • This caused lots of bank failures • Ordinary depositors lost faith in banks and chose to keep their savings in cash • As a result, the cash-deposit ratio increased • This reduced the money multiplier • So, M rose slower than B The Money Supply and Its Determinants: 1929 and 1933 End-of-chapter problems End-of-chapter problems End-of-chapter problems End-of-chapter problems End-of-chapter problems Money and inflation The quantity theory of money, and the Fisher effect The demand for money, the costs of inflation Macroeconomics 17, 24 October 2019 Topics • The classical theory of inflation – causes – effects – social costs • ―Classical‖: assumes prices are flexible & markets clear and applies to the long run US inflation -1 01/01/1999 01/06/1999 01/11/1999 01/04/2000 01/09/2000 01/02/2001 01/07/2001 01/12/2001 01/05/2002 01/10/2002 01/03/2003 01/08/2003 01/01/2004 01/06/2004 01/11/2004 01/04/2005 01/09/2005 01/02/2006 01/07/2006 01/12/2006 01/05/2007 01/10/2007 01/03/2008 01/08/2008 01/01/2009 01/06/2009 01/11/2009 01/04/2010 01/09/2010 01/02/2011 01/07/2011 01/12/2011 01/05/2012 01/10/2012 01/03/2013 01/08/2013 01/01/2014 01/06/2014 01/11/2014 01/04/2015 01/09/2015 01/02/2016 01/07/2016 01/12/2016 01/05/2017 01/10/2017 01/03/2018 01/08/2018 01/01/2019 01/06/2019 Eurozone inflation 4,5 4 3,5 3 2,5 2 1,5 1 0,5 0 -0,5 Source: Eurostat 0 -5 1993/ Jan/ 1993/ Aug/ 1994/ Mar/ 1994/ Oct/ 1995/ May/ 1995/ Dec/ 1996/ Jul/ 1997/ Feb/ 1997/ Sep/ 1998/ Apr/ 1998/ Nov/ 1999/ Jun/ 2000/ Jan/ 2000/ Aug/ 2001/ Mar/ 2001/ Oct/ 2002/ May/ 2002/ Dec/ 2003/ Jul/ 2004/ Feb/ 2004/ Sep/ 2005/ Apr/ 2005/ Nov/ 2006/ Jun/ 2007/ Jan/ 2007/ Aug/ 2008/ Mar/ 2008/ Oct/ 2009/ May/ 2009/ Dec/ 2010/ Jul/ 2011/ Feb/ 2011/ Sep/ 2012/ Apr/ 2012/ Nov/ 2013/ Jun/ 2014/ Jan/ 2014/ Aug/ 2015/ Mar/ 2015/ Oct/ 2016/ May/ 2016/ Dec/ 2017/ Jul/ 2018/ Feb/ 2018/ Sep/ 2019/ Apr/ Hungarian inflation 35 30 25 20 15 10 5 Forrás: MNB The quantity theory of money • A simple theory linking the inflation rate to the growth rate of the money supply. • Begins with the concept of velocity… Velocity: • Basic concept: the rate at which money circulates • Definition: the number of times the average dollar bill changes hands in a given time period Velocity Example: In 2015, $500 billion in transactions money supply = $100 billion The average dollar is used in five transactions in 2015 So, velocity = 5 Velocity This suggests the following definition: M×V=P×T or V=P×T/M where V: transactions velocity of money T : number of transactions M: money supply P: value of one typical transaction The quantity theory of money Money×Velocity=Price×Output M×V=P×Y M: quantity of money V: income velocity of money (the number of times a dollar bill enters someone‘s income in a given period of time) P: price level Y: income (real GDP) Money demand and the quantity equation M/P: real money balances, the purchasing power of the money supply. A simple money demand function: (M/P)d = kY where k: how much money people wish to hold for each dollar of income (k is exogenous) Money demand and the quantity equation Money demand: (M/P)d = kY Quantity equation: M × V = P × Y The connection between them: k = 1/V When people hold lots of money relative to their incomes (k is large), money changes hands infrequently (V is small). The quantity theory of money with constant velocity • Start with quantity equation • Assumes V is constant and𝐕exogenous: =𝐕 • Then, quantity equation becomes: 𝐌×𝐕=𝐏×𝐘 The quantity theory of money with constant velocity 𝐌×𝐕=𝐏×𝐘 • With V constant, the money supply determines nominal GDP (P × Y ). • Real GDP is determined by the economy‘s supplies of K and L and the production function. • The price level is P = (nominal GDP)/(real GDP). The quantity theory of money with constant velocity • The growth rate of a product equals the sum of the growth rates. • The quantity equation in growth rates: 𝚫𝐌 𝚫𝐕 𝚫𝐏 𝚫𝐘 + = + 𝐌 𝐕 𝐏 𝐘 • The quantity theory of money assumes • V is constant, so ΔV = 0. The quantity theory of money π (Greek letter pi) denotes the inflation rate: ΔP π P and ΔM ΔP ΔY M P Y Solve this result for π: ΔM ΔY π M Y The quantity theory of money • Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. • Money growth in excess of this amount leads to inflation. • ΔY/Y depends on growth in the factors of production and on technological progress (all of which we take as given, for now). • Hence, the quantity theory predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. The origins of the Quantity Theory of Money goes back to old times ‖Money is not, properly speaking, one of the subjects of commerce; but only the instrument which men have agreed upon to facilitate the exchange of one commodity for another. It is none of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy. If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money…. It is only the public which draws any advantage from the greater plenty of money; and that only in its wars and negociations with foreign states.‖ (David Hume (1752): Of Money) Confronting the quantity theory with data The quantity theory of money implies: 1. Countries with higher money growth rates should have higher inflation rates. 2. The long-run trend in a country‘s inflation rate should be similar to the long-run trend in the country‘s money growth rate. Are the data consistent with these implications? The quantity theory of money (103 countries) GDPD growth rate=-0.055+0,97×(M3 growth) Source: WDI The quantity theory of money (98 countries) GDPD growth=-0.042+0,88×(M3 growth) Source: WDI Source: WDI United States Hungary Argentina Japan 2018 2016 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 1960 V=PY/M3 10 9 8 7 6 5 4 3 2 1 0 Inflation and interest rate • Nominal interest rate, i not adjusted for inflation • Real interest rate, r adjusted for inflation: r=i−π The Fisher effect • • • • The Fisher equation: i = r + π S = I determines r. Hence, an increase in π causes an equal increase in i. This one-for-one relationship is called the Fisher effect. Interest rate vs inflation rate Two real interest rate Notation: π: actual inflation rate (not known until after it has occurred) Eπ: expected inflation rate Two real interest rates: i – Eπ ex ante real interest rate: the real interest rate people expect at the time they buy a bond or take out a loan i – π: ex post real interest rate: the real interest rate actually realized Money demand and the nominal interest • In the quantity theory of money, the demand for real money balances depends only on real income Y. • Another determinant of money demand: the nominal interest rate, i, the opportunity cost of holding money (instead of bonds or other interest-earning assets). • So, money demand depends negatively on i. The money demand function 𝐌 𝐏 𝐝 = 𝐋 𝐢, 𝐘 (M/P)d = real money demand, depends • negatively on i • i is the opportunity cost of holding money • positively on Y • higher Y increases spending on goods and services, so increases need for money • (―L‖ is used for the money demand function because money is the most liquid asset.) The money demand function 𝐌 𝐏 𝐝 = 𝐋 𝐢, 𝐘 = 𝐋 𝐫 + 𝐄𝛑, 𝐘 • When people are deciding whether to hold money or bonds, they don‘t know what inflation will turn out to be. • Hence, the nominal interest rate relevant for money demand is r + Eπ. Equilibrium 𝐌 = 𝐋 𝐫 + 𝐄𝛑, 𝐘 𝐏 The supply of real money balances =real money demand What determines what? Variabl How is it determined in the long run? e M exogenous (central bank) r adjusts to ensure S = I Y Y =F (K ,L) P Adjusts to ensure 𝐌 𝐏 = 𝐋 𝐢, 𝐘 How P responds to ΔM? 𝐌 = 𝐋 𝐫 + 𝐄𝛑, 𝐘 𝐏 For given values of r, Y, and Eπ, a change in M causes P to change by the same percentage—just like in the quantity theory of money. The role of expectations • Over the long run, people don‘t consistently over- or under-forecast inflation, so Eπ = π on average. • In the short run, Eπ may change when people get new information. • E.g.: The Fed announces it will increase M next year. People will expect next year‘s P to be higher, so Eπ rises. • This affects P now, even though M hasn‘t changed yet... The role of expectations 𝐌 = 𝐋 𝐫 + 𝐄𝛑, 𝐘 𝐏 For given values of r, Y, and M E increases i increases (Fisher effect) (M/P)d decreases M/P decreases by an increase in P. Why is inflation bad? • Common misperception: inflation reduces real wages • This is true only in the short run, when nominal wages are fixed by contracts. • In the long run, the real wage is determined by labour supply and the marginal product of labour, not the price level or inflation rate. • Consider the data . . . The social costs of inflation The classical view: A change in the price level is merely a change in the units of measurement. The social costs of inflation fall into two categories: 1. costs when inflation is expected 2. costs when inflation is different than people had expected The costs of expected inflation 1. Shoeleather cost Definition: the costs and inconveniences of reducing money balances to avoid the inflation tax. • If π increases, i increases (why?), so people reduce their real money balances. • Remember: In long run, inflation does not affect real income or real spending. • So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash. The costs of expected inflation 2. Menu Costs Definition: The costs of changing prices. Examples: • cost of printing new menus • cost of printing & mailing new catalogues The higher is inflation, the more frequently firms must change their prices and incur these costs. The costs of expected inflation 3. Relative Price Distortions Firms facing menu costs change prices infrequently. Example: • A firm issues new catalogue each January. • As the general price level rises throughout the year, the firm‘s relative price will fall. Different firms change their prices at different times, leading to relative price distortions causing microeconomic inefficiencies in the allocation of resources. The costs of expected inflation 4. General Inconvenience • Inflation makes it harder to compare nominal values from different time periods. • This complicates long-range financial planning. Additional cost of unexpected inflation: Arbitrary redistribution of purchasing power • Many long-term contracts not indexed, but based on Eπ. • If π turns out different from Eπ, then some gain at others‘ expense. Example: borrowers & lenders • If π > Eπ, then (i − π) < (i − Eπ) and purchasing power is transferred from lenders to borrowers. • If π < Eπ, then purchasing power is transferred from borrowers to lenders. Additional cost of unexpected inflation • When inflation is high, it‘s more variable and unpredictable: π turns out different from Eπ more often, and the differences tend to be larger, though not systematically positive or negative. • So, arbitrary redistributions of wealth more likely. • This increases uncertainty, making risk-averse people worse off. Seigniorage • To spend more without raising taxes or selling bonds, the government can print money. • The ―revenue‖ raised from printing money is called seigniorage. • The inflation tax: • Printing money to raise revenue causes inflation. • Inflation is like a tax on people who hold money. Hyperinflation • Common definition: π ≥ 50% per month • All the costs of moderate inflation described above become huge under hyperinflation. • Money ceases to function as a store of value, and may not serve its other functions (unit of account, medium of exchange). • People may conduct transactions with barter or a stable foreign currency. What causes hyperinflation? • Hyperinflation is caused by excessive money supply growth. • When the central bank prints money, the price level rises. • If it prints money rapidly enough, the result is hyperinflation. • When a government cannot raise taxes or sell bonds, it must finance spending increases by printing money. • In theory, the solution to hyperinflation is simple: stop printing money. • In the real world, this requires drastic and painful fiscal restraint. Hungarian hyperinflation, 1921-25 2 500 000 5 000 000 4 500 000 2 000 000 4 000 000 3 500 000 1 500 000 3 000 000 2 500 000 1 000 000 2 000 000 1 500 000 500 000 1 000 000 500 000 CPI (1914=100) (left-hand scale) Source: Sargent (2005:7585) money supply (million crown) (right-hand scale) 30 April 1925 31 January 1925 31 October 1924 31 July 1924 30 April 1924 31 January 1924 31 October 1923 31 July 1923 30 April 1923 31 January 1923 31 October 1922 31 July 1922 30 April 1922 31 January 1922 31 October 1921 31 July 1921 30 April 1921 0 31 January 1921 0 Hungarian hyperinflation, 1945-46 CPI on 31 July 1946 =399 623×1024 (26 aug. 1939=100) (Siklos 1989:141) The classical dichotomy • Recall: Real variables were explained in Chapter 3, nominal ones in Chapter 5. • Classical dichotomy: the theoretical separation of real and nominal variables in the classical model, which implies nominal variables do not affect real variables. • Neutrality of money: Changes in the money supply do not affect real variables. • In the real world, money is approximately neutral in the long run. End-of-chapter problems In the country of Wiknam, the velocity of money is constant. Real GDP grows by 3 percent per year, the money stock grows by 8 percent per year, and the nominal interest rate is 9 percent. What is a) the growth rate of nominal GDP? b) the inflation rate? c) the real interest rate? End-of-chapter problems Suppose a country has a money demand function (M/P )d = kY, where k is a constant parameter. The money supply grows by 12 percent per year, and real income grows by 4 percent per year. a) What is the average inflation rate? b) How would inflation be different if real income growth were higher? Explain. c) How do you interpret the parameter k? What is its relationship to the velocity of money? d) Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain. End-of-chapter problems An economy has the following money demand function: (M/P )d=0.2Y/i 1/2. a) Derive an expression for the velocity of money. What does velocity depend on? Explain why this dependency may occur. b) Calculate velocity if the nominal interest rate i is 4 percent. c) If output Y is 1,000 units and the money supply M is $1,200, what is the price level P ? d) Suppose the announcement of a new head of the central bank, with a reputation of being soft on inflation, increases expected inflation by 5 percentage points. According to the Fisher effect, what is the new nominal interest rate? End-of-chapter problems e) Calculate the new velocity of money. f) If, in the aftermath of the announcement, both the economy’s output and the current money supply are unchanged, what happens to the price level? Explain why this occurs. g) If the new central banker wants to keep the price level the same after the announcement, at what level should she set the money supply? End-of-chapter problems Suppose that the money demand function takes the form (M/P )d =L (i, Y ) =Y/(5i ) a) If output grows at rate g and the nominal interest rate is constant, at what rate will the demand for real balances grow? b) What is the velocity of money in this economy? c) If inflation and nominal interest rates are constant, at what rate, if any, will velocity grow? d) How will a permanent (once-and-for-all) increase in the level of interest rates affect the level of velocity? How will it affect the subsequent growth rate of velocity? e) If the central bank wants to achieve a long run target inflation rate of p, at what rate should the money supply grow? End-of-chapter problems In each of the following scenarios, explain and categorize the cost of inflation. a) Because inflation has risen, the J. Crew clothing company decides to issue a new catalog monthly rather than quarterly. b) Grandpa buys an annuity for $100,000 from an insurance company, which promises to pay him $10,000 a year for the rest of his life. After buying it, he is surprised that high inflation triples the price level over the next few years. c) Maria lives in an economy with hyperinflation. Each day after being paid, she runs to the store as quickly as possible so she can spend her money before it loses value. End-of-chapter problems d) Gita lives in an economy with an inflation rate of 10 percent. Over the past year, she earned a return of $50,000 on her million-dollar portfolio of stocks and bonds. Because her tax rate is 20 percent, she paid $10,000 to the government. e) Your father tells you that when he was your age, he worked for only $4 an hour. He suggests that you are lucky to have a job that pays $9 an hour. The natural rate of unemployment: job search and real-wage rigidity Macroeconomics 24 October, 7 November 2019 Chapter objectives The natural rate of unemployment: • what it means • what causes it • understanding its behavior in the real world Labor Force Statistics • We can devide the population into 3 groups: • Employed: paid employees, self-employed, and unpaid workers in a family business • Unemployed: people not working who have looked for work during previous 4 weeks • Not in the labor force: everyone else • The labor force is the total # of workers, including the employed and unemployed. Labor Force Statistics Unemployment rate (―u-rate‖): % of the labor force that is unemployed u-rate # of = 100 unemployed x labor force Labor force participation rate: % of the adult population that is in the labor force labor force = 100 labor force participation x adult rate population Example Compute the labor force, u-rate, adult population, and labor force participation rate using this data: Adult population of the U.S. by group, June 2008 # of employed 145.9 million # of unemployed 8.5 million not in labor force 79.2 million Example Labor force = employed + unemployed = 145.9 + 8.5 = 154.4 million U-rate = 100 x (unemployed)/(labor force) = 100 x 8.5/154.4 = 5.5% Example Population = labor force + not in labor force = 154.4 + 79.2 = 233.6 LF partic. rate = 100 x (labor force)/(population) = 100 x 154.4/233.6 = 66.1% Natural Rate of Unemployment • Natural rate of unemployment: the average rate of unemployment around which the economy fluctuates. • In a recession, the actual unemployment rate rises above the natural rate. • In a boom, the actual unemployment rate falls below the natural rate. U.S. Unemployment, 1958-2019 A first model of the natural rate Notation: L = # of workers in labor force E = # of employed workers U = # of unemployed U/L = unemployment rate Assumptions 1) L is exogenously fixed. 2) During any given month, s = fraction of employed workers that become separated from their jobs, f = fraction of unemployed workers that find jobs. s = rate of job separations f = rate of job finding (both exogenous) The transitions between employment and unemployment s E Employe d Unemploy ed f U The steady state condition • Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant. • The steady-state condition is: # of employed people who lose or leave their jobs s E = f U # of unemployed people who find jobs Solving for the “equilibrium” U rate f U = s E = s (L –U ) = s L – s U Solve for U/L: (f + s)U = s L so, U s L s f Example • Each month, 1% of employed workers lose their jobs (s = 0.01) • Each month, 19% of unemployed workers find jobs (f = 0.19) • Find the natural rate of unemployment: U s 0.01 0.05, or 5% L s f 0.01 0.19 Policy implication A policy that aims to reduce the natural rate of unemployment will succeed only if it lowers s or increases f. Why is there unemployment? • If job finding were instantaneous (f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero. • There are two reasons why f < 1: – job search – wage rigidity Job Search & Frictional Unemployment • Frictional unemployment: caused by the time it takes workers to search for a job • It occurs even when wages are flexible and there are enough jobs to go around • It occurs because – – – – workers have different abilities, preferences jobs have different skill requirements geographic mobility of workers not instantaneous flow of information about vacancies and job candidates is imperfect Sectoral shifts • Changes in the composition of demand among industries or regions • example: Technological change increases demand for computer repair persons, decreases demand for typewriter repair persons • example: A new international trade agreement causes greater demand for workers in the export sectors and less demand for workers in importcompeting sectors. • It takes time for workers to change sectors, so sectoral shifts cause frictional unemployment. Sectoral shifts abound • Examples: – Late 1800s: decline of agriculture, increase in manufacturing – Late 1900s: relative decline of manufacturing, increase in service sector – 1970s energy crisis caused a shift in demand away from huge gas guzzlers toward smaller cars. • In our dynamic economy, smaller (though still significant) sectoral shifts occur frequently, contributing to frictional unemployment. Public Policy and Job Search Goverment programs affecting unemployment – Goverment employment agencies: disseminate info about job openings to better match workers & jobs – Public job training programs: help workers displaced from declining industries get skills needed for jobs in growing industries Unemployment insurance (UI) • UI pays part of a worker‘s former wages for a limited time after losing his/her job. • UI increases search unemployment, because it: – reduces the opportunity cost of being unemployed – reduces the urgency of finding work – hence, reduces f • Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment. Benefits of UI By allowing workers more time to search, UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes. Unemployment from real wage rigidity If the real wage is stuck above the equilibrium level, then there aren‘t enough jobs to go around. Then, firms must ration the scarce jobs among workers. Structural unemployment: the unemployment resulting from real wage rigidity and job rationing. Real wag e Rigi d real wa ge Supp ly Unemploy ment Deman d Amount of labor hired Labo r Amount of labor willing to work Reasons for wage rigidity • Minimum wage laws • Labor unions • Efficiency wages (employers offer high wage as incentive for worker productivity and loyalty) The minimum wage • The minimum wage is well below the equilibrium wage for most workers, so it cannot explain the majority of natural rate unemployment. • However, the minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers. • If so, then we would expect that increases in the minimum wage would increase unemployment among these groups. Source: Eurostat Slovenia Luxembourg Lithuania Bulgaria Poland Portugal Romania Ireland Malta Hungary United Kingdom Serbia Latvia Croatia Germany Estonia Spain Slovakia Czech Republic Monthly minimum wage as a proportion of the mean value of average monthly earnings 60 50 40 30 20 10 0 Labor unions • Unions exercise monopoly power to secure higher wages for their members. • When the union wage exceeds the equilibrium wage, unemployment results. • Employed union workers are insiders whose interest is to keep wages high. • Unemployed non-union workers are outsiders and would prefer wages to be lower (so that labor demand would be high enough for them to get jobs). Efficiency Wage Theory • Theories in which high wages increase worker productivity: – attract higher quality job applicants – increase worker effort and reduce ―shirking‖ – reduce turnover, which is costly – improve health of workers (in developing countries) • The increased productivity justifies the cost of paying above-equilibrium wages. • The result: unemployment The duration of unemployment • The data: • More spells of unemployment are short-term than medium-term or long-term. • Yet, most of the total time spent unemployed is attributable to the long-term unemployed. • This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries. • Knowing this is important because it can help us craft policies that are more likely to succeed. 5 Czechia Japan Iceland Germany Hungary Malta Netherlands Poland Norway US UK Romania Austria Denmark Slovenia Bulgaria Estonia Luxembourg Ireland Belgium Lithuania Sweden Slovakia Portugal Latvia Finland Croatia Cyprus France Italy Turkey Spain Greece Unemployment rates in Europe, 2018 25 20 19,3 15 15,3 2,2 2,7 2,4 3,7 3,4 3,7 11,0 10,6 10 3,8 3,9 3,9 4,0 3,9 4,9 5,1 5,4 5,1 Forrás: EUROSTAT 5,2 5,8 5,5 6,2 8,4 8,4 6,0 9,1 6,3 6,5 7,0 7,4 7,4 4,2 0 European unemployment rates in the long run 14 12 10 8 6 4 2 0 19681970197219741976197819801982198419861988199019921994199619982000200220042006200820102012201420162018 UK France Germany Source: OECD Annual Labor Force Statistics European unemployment rates in the long run 14 12 10 8 6 4 US Italy Sweden Source: OECD Annual Labor Force Statistics 2018 2016 2014 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 0 1968 2 The rise in European Unemployment Two explanations: 1) Most countries in Europe have generous social insurance programs. 2) Shift in demand from unskilled to skilled workers, due to technological change. This demand shift occurred in the U.S., too. But wage rigidity is less of a problem there, so the shift caused an increase in the skilled-to-unskilled wage gap instead of an increase in unemployment. Chapter summary 1) The natural rate of unemployment – the long-run average or ―steady state‖ rate of unemployment – depends on the rates of job separation and job finding 2) Frictional unemployment – due to the time it takes to match workers with jobs – may be increased by unemployment insurance Chapter summary 3) Structural unemployment – results from wage rigidity - the real wage remains above the equilibrium level – causes: minimum wage, unions, efficiency wages 4) Duration of unemployment – most spells are short term – but most weeks of unemployment are attributable to a small number of long-term unemployed persons 5) European unemployment – has risen sharply since 1980 End-of-chapter problems The residents of a certain dormitory have collected the following data: people who live in the dorm can be classified as either involved in a relationship or uninvolved. Among involved people, 10 percent experience a breakup of their relationship every month. Among uninvolved people, 5 percent enter into a relationship every month. What is the steady-state fraction of residents who are uninvolved? End-of-chapter problems In this chapter we saw that the steady-state rate of unemployment is U/L = s/(s+f ). Suppose that the unemployment rate does not begin at this level. Show that unemployment will evolve over time and reach this steady state. (Hint: Express the change in the number of unemployed as a function of s, f, and U. Then show that if unemployment is above the natural rate, unemployment falls, and if unemployment is below the natural rate, unemployment rises.) End-of-chapter problems Consider an economy with the following Cobb–Douglas production function: Y=K 1/3L 2/3. a) Derive the equation describing labor demand in this economy as a function of the real wage and the capital stock. (Hint: Review Chapter 3.) b) The economy has 27,000 units of capital and a labor force of 1,000 workers. Assuming that factor prices adjust to equilibrate supply and demand, calculate the real wage, total output, and the total amount earned by workers. c) Now suppose that Congress, concerned about the welfare of the working class, passes a law setting a minimum wage that is 10 percent above the equilibrium wage you derived End-of-chapter problems d) Does Congress succeed in its goal of helping the working class? Explain. e) Do you think that this analysis provides a good way of thinking about a minimum wage law? Why or why not? Aggregate demand: the Keynesian Cross and the IS-LM model Macroeconomics 14, 21 November 2019 Facts about the business cycle • GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. • Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. • Unemployment rises during recessions and falls during expansions. • Okun‘s Law: the negative relationship between GDP and unemployment. The US real GDP (percent change from quarter one year ago) US real consumption US real investment Unemployment in the US Okun’s law (Hungary) RGDP growth =1.80-1.85×(change of u-rate) Source: KSH, ILO Short-Run Theory of Output: it’s all about demand • The short-run theory of total real GDP is also called – Keynesian theory, after the economist John Maynard Keynes, or – Aggregate Demand Theory • This theory assumes that, in the short run, output is determined by aggregate demand: the economy will produce as much output as there is demand for • Keynesian cross: The simplest theory of short-run equilibrium in the goods market. Planned Expenditure • Assumption: The economy is a closed economy • Planned Expenditure (E) is the total desired expenditure of the three sectors of the economy: – Households (C) – Businesses (I) and – Government (G) E=C+I+G Consumption, C • Net Taxes = Tax Revenue – Transfer Payments Denoted T and always assumed exogenous: 𝑇 = 𝑇 • Recall that GDP is defined as the market value of all final goods and services produced in an economy during a given period of time • But this is also actual total expenditure, which is also actual total income. Therefore, Y also represents actual total income. • Disposable income (or, after-tax income) is total income minus total net taxes: Y – T. • Assumption: planned consumption expenditure (C) is Consumption, C • Assumption: Planned expenditure by households is directly related to disposable income • Consumption function: C = C (Y – T ) Consumption Function: algebra • Consumption function: C = C (Y – T ) • Specifically, C = Co + MPC✕(Y – T) • Co represents all other exogenous variables that affect consumption, such as asset prices, consumer optimism, etc. • MPC is the marginal propensity to consume, the fraction of every additional dollar of income that is consumed Consumption Function: graph C C (Y –T) = Co + MPC✕(Y – T) 1 MP C The slope of the consumption function is the MPC. CoMPC×T Marginal propensity to consume (MPC) is the increase in consumption (C) when disposable income (Y – T) increases by one dollar. Y Consumption Function: shifts C C = Co2 + MPC✕(Y – T) C = Co1 + MPC✕(Y – T) Consumption shift factor: higher consumer optimism, higher asset prices (Co↑). Y Consumption Function: shifts C C = Co + MPC✕(Y – T2) C = Co + MPC✕(Y – T 1) The same shift can also be caused by lower taxes. (T2 < T1) Y Income and Private Saving • The marginal propensity to consume is a positive fraction (0 < MPC < 1) • That is, when income (Y) increases, consumption (C) also increases, but by only a fraction of the increase in income. • Therefore, Y↑⇒ C↑ and Y – C↑ and Y – T – C↑ • Similarly, Y↓⇒ C↓ and Y – C↓ and Y – T – C↓ Planned Investment E=C+I+G • Assumption: Planned investment spending by businesses (I) is exogenous • This assumption is a big simplification. • (Recall that business investment was assumed to be inversely related to the real interest rate.) Government Spending E=C+I+G • Assumption: government spending (G) is exogenous • Public Saving is defined as the net tax revenue of the government minus government spending, which is T – G – This is also called the budget surplus Planned Expenditure E=C+I+G • Therefore, E = C(Y – T) + I + G • Or, more specifically, E = Co + MPC✕(Y – T) + I+G Equilibrium Assumption: The goods market will be in equilibrium. That is, actual expenditure will be equal to planned expenditure. Actual and planned expenditure • Actual and planned expenditure do not have to be equal in all circumstances • Actual expenditure = planned expenditure + unplanned increase in inventory – When unplanned increase in inventory > 0, more is bought than was intended. – When unplanned increase in inventory < 0, less is bought than was intended. Equilibrium • When unplanned increase in inventory > 0, more is bought than was intended. • So, actual expenditure > planned expenditure • In this case, output will shrink • In other words, the current output level cannot represent equilibrium Equilibrium • When unplanned increase in inventory < 0, less is bought than was intended. • So, actual expenditure < planned expenditure • In this case, output will increase • In other words, the current output level cannot represent equilibrium Equilibrium • For an economy to be in equilibrium, unplanned increase in inventory must be zero • Therefore, actual expenditure = planned expenditure + unplanned increase in inventory = planned expenditure • But recall that actual expenditure is actual GDP or Y, and planned expenditure is C + I + G • Therefore, in equilibrium, Y = C + I + G Graphing planned expenditure E planned expenditure E =C +I +G MP 1 C income, output, Y Graphing the equilibrium condition E E =Y planned expendit ure 45 º income, output, Y The equilibrium value of income E planned expendit ure E =Y E =C +I +G Output gap Y Equilibri um income 𝒀, natural rate of output An increase in government purchases E At Y1, there is now an unplanned drop in inventory G …so firms … increase output, and income E1 = rises toward Y1 a new equilibrium. E =C +I +G 2 E =C +I +G 1 Y Y E2 = Y2 Solving for Y Y C I G Y C I G C G MPC Y G Collect terms with Y on the left side of the equals sign: (1 MPC)Y G equilibrium condition in changes because I exogenous because C = MPC Y Solve for Y : 1 Y G 1 MPC The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt Y 1 purchases multiplier equals G 1 MPC Example: If MPC = 0.8, then An increase in G Y 1 causes income to 5 G 1 0.8 increase 5 times as much! Why the multiplier is greater than 1 • Initially, the increase in G causes an equal increase in Y: Y = G. • But Y C further Y further C further Y • So the final impact on income is much bigger than the initial G. An increase in taxes E Initially, the tax increase reduces consumption, and therefore PE: E =C1 +I +G E =C2 +I +G At Y1, there is now an unplanned inventory buildup… C = MPC T …so firms reduce output, and income falls toward a new equilibrium Y E2 = Y2 Y E1 = Y1 Solving for Y Y C I G C MPC Y T Solving for Y : Final result: equilibrium condition in changes I and G exogenous (1 MPC)Y MPC T MPC Y T 1 MPC The tax multiplier def: the change in income resulting from a $1 increase in T : Y MPC T 1 MPC If MPC = 0.8, then the tax multiplier equals Y 0.8 0.8 4 T 1 0.8 0.2 The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is smaller than the spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G (or Tax Cuts: JFK • Kennedy cut personal and corporate income taxes in 1964 • An economic boom followed. – GDP grew 5.3% in 1964 and 6.0 in 1965. – Unemployment fell from 5.7% in 1963 to 5.2% in 1964 to 4.5% in 1965. • However, it is not easy to prove that the tax cuts caused the boom • Even when they agree that the tax cuts caused the boom, economists can‘t agree on the reason Tax Cuts: JFK • Keynesians argued that the tax cuts boosted demand, which led to higher production and falling unemployment • Supply-siders argued that demand had nothing to do with it. The tax cuts gave people the incentive to work harder. So, L increased. Therefore, Y = F(K, L) also increased. Tax Cuts: GWB • Bush cut taxes in 2001 and 2003 • After the second tax cut, a weak recovery from the 2001 recession turned into a strong recovery – GDP grew 4.4% in 2004 – Unemployment fell from its peak of 6.3% in June 2003 to 5.4% in December 2004 • In justifying his tax cut, Bush used the Keynesian explanation: – ―When people have more money, they can spend it on goods and services. … when they demand an additional good or service, somebody will produce the good or service.‖ Spending Stimulus: Barack Obama • When President Obama took office in January 2009, the economy had suffered the worst collapse since the Great Depression • Obama helped enact an $800 billion (5% of annual GDP) stimulus to be spent over a two-year period • About 40% was tax cuts, and 60% was additional government spending – White House economists had estimated the spending multiplier to be 1.57 and the tax-cut multiplier to be 0.99 Spending Stimulus: Barack Obama • Much of the new spending was on infrastructure projects • These projects were fine for the long run, but took a long time to be implemented, and were therefore not ideal as a short-run boost • Obama publicly justified his stimulus bill using Keynesian demand-side reasoning End-of-chapter problem In the Keynesian cross model, assume that the consumption function is given by C =120+0.8(Y-T ). Planned investment is 200; government purchases and taxes are both 400. Graph planned expenditure as a function of income. a) What is the equilibrium level of income? b) If government purchases increase to 420, what is the new equilibrium income? What is the multiplier for government purchases? c) What level of government purchases is needed to achieve an income of 2,400? (Taxes remain at 400.) End-of-chapter problem Consider the impact of an increase in thriftiness in the Keynesian cross model. Suppose the consumption function is C=C0 +MPC(Y-T ), where C0 is a parameter called autonomous consumption that represents exogenous influences on consumption and MPC is the marginal propensity to consume. a) What happens to equilibrium income when the society becomes more thrifty, as represented by a decline in C0? b) What happens to equilibrium saving? c) Why do you suppose this result is called the paradox of thrift? d) Does this paradox arise in the classical model of Chapter 3? Why or why not? The IS Curve • The Keynesian Cross model assumed that planned expenditure by businesses (I) is exogenous • Recall that, in chapter 3, we had assumed that investment spending is inversely related to the real interest rate • The IS Curve theory of the goods market brings back the investment function I = I(r) The Real Interest Rate • Recall that, the real interest rate is the inflation-adjusted interest rate • To adjust the nominal interest rate for inflation, you simply subtract the inflation rate from the nominal interest rate – If the bank charges you 5% interest rate on a cash loan, that‘s the nominal interest rate (i = 0.05). – If the inflation rate turns out to be 3% during the loan period (π = 0.03), then you paid the real interest rate of just 2% (r = i − π = 0.02) The Real Interest Rate • The problem is that when you are taking out a loan you don‘t quite know what the inflation rate will be over the loan period • So, economists distinguish between – the ex post real interest rate: r = i − π – and the ex ante real interest rate: r = i − Eπ, where Eπ is the expected inflation rate over the loan period – We will use the ex ante interpretation of the real interest rate Investment and the real interest rate • Assumption: investment spending is inversely related to the real interest rate I = I(r), such that r↑⇒ I↓ r I (r )I The IS Curve • Recall that the goods market is in equilibrium when Y = C + I +G • The IS curve is a graph that shows all combinations of r and Y for which the goods market is in equilibrium • Therefore, the basic equation underlying the IS curve is Y = C(Y – T) + I(r) + G Deriving the IS curve: graphs E =Y E r I E Y E = C + I ( r2 )+G E = C + I ( r1 )+G I r Any change in the real r interest rate will cause 1 an opposite change in r real total GDP by a 2 multiple determined by the size of the interest rate effect. Y Y 1 2 Y I Y S 1 2 Y Y Why the IS curve is negatively sloped • A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (E ). • To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase. The IS curve and the loanable funds model (a) The L.F. r (b) The IS model S S 2 1 r r r 2 2 r r 1 I (r ) S, I curve 1 Y I SY Y 2 1 Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. • Let‘s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… Shifting the IS curve: G At any value of r, G E Y …so the IS curve shifts to the right. The horizontal r distance of r the 1 IS shift equals 1 Y 1 MPC E E =Y Y Y 1 2 G Y IS Y Y Y 1 2 E = C + I ( r1 )+G2 E = C + I ( r1 )+G1 1 IS 2Y THE MONEY MARKET IN THE SHORT RUN: THE LM CURVE The Theory of Liquidity Preference (review) • Liquid assets are assumed to earn no interest • Illiquid assets are assumed to earn the nominal interest rate i • Therefore, an increase in i is assumed to reduce the demand for money • That is, money demand (Md) is assumed to be inversely related to the nominal interest rate (i) (M/P)d=L(i) Prices are sticky in the short run • Recall that the long-run analysis assumed that P is endogenous. – Recall also that in the long run P changes proportionately with M. • The short-run analysis in the IS-LM model assumes that P is exogenous: it is what it is, it is historically determined – That is, the overall price level is ―sticky‖: what it was last week, it will be this week too Prices are sticky in the short run • This sticky-prices assumption is the crucial distinction between long-run and short-run macroeconomic analysis • Except this assumption, all assumptions made in short-run analysis are also assumed in long-run analysis • So, the differences between long-run and short-run theories are caused by this sticky-prices assumption The Theory of Liquidity Preference r interest rate M P r s L (r) 1 M P M/P real money balances Reduction in the money supply r interest rate By decreasing the money supply the central bank increases the interest rate. r 2 r L (r ) 1 M2 P M1 P M/P real money blances How the Fed raises the interest rate r To increase r, Fed reduces M intere st rate r 2 r 1 L (r M2 P M1 P ) M/P real money balance s CASE STUDY: Monetary Tightening & Interest Rates • Late 1970s: > 10% • Oct 1979: Fed Chairman Paul Volcker announces that monetary policy would aim to reduce inflation • Aug 1979-April 1980: Fed reduces M/P 8.0% • Jan 1983: = 3.7% How do you think this policy change would affect nominal interest rates? Monetary Tightening & Interest Rates, cont. The effects of a monetary tightening on nominal interest rates short run long run Liquidity preference Quantity theory, Fisher effect (Keynesian) (Classical) prices sticky flexible prediction i > 0 i < 0 actual outcome 8/1979: i = 10.4% 4/1980: i = 15.8% 8/1979: i = 10.4% 1/1983: i = 8.2% model End-of-chapter problem Suppose that the money demand function is (M/P )d=800-50r, where r is the interest rate in percent. The money supply M is 2,000 and the price level P is fixed at 5. a) Graph the supply and demand for real money balances. b) What is the equilibrium interest rate? c) What happens to the equilibrium interest rate if the supply of money is reduced from 2,000 to 1,500? d) If the central bank wants the interest rate to be 4 percent, what money supply should it set? The LM curve Now let‘s put Y back into the money demand function: M P d L (r ,Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P L (r ,Y ) Deriving the LM curve (a) The market for real money r balances (b) The LM r curve L M r r 2 2 r 1 M1 P L (r , Y2 ) L (r , Y1 ) M/ P r 1 Y Y 1 2 Y Why the LM curve is upward sloping • An increase in income raises money demand. • Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate. • The interest rate must rise to restore equilibrium in the money market. How M shifts the LM curve (a) The market for real money r balances (b) The LM r curve r r 2 2 r r 1 M2 P M1 P L (r , Y1 ) M/ P L M 2LM 1 1 Y 1 Y NOW YOU TRY: Shifting the LM curve • Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. • Use the liquidity preference model to show how these events shift the LM curve. SHORT-RUN EQUILIBRIUM IN THE IS-LM MODEL Short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in both the goods and money markets: Y C (Y T ) I (r ) G r L M I S Y M P L (r ,Y ) Equilibriu m interest rate Equilibriu m level of income Short-run equilibrium By insisting that both the r goods market and the money market need to be in equilibrium, we have managed to find a way to pinpoint both r and Y simultaneously! Y C (Y T ) I (r ) G M P L (r ,Y ) Equilibriu m interest rate L M I S Y Equilibriu m level of income Short-run equilibrium Note that the short-run equilibrium GDP does not have to be equal to the longrun equilibrium GDP (𝑌, also called potential GDP and natural GDP) Thus, like the Keynesian Cross the IS-LM model can But,model, the Keynesian Cross Equilibriu explain recessions and booms. model could determine only equilibrium GDP. The IS-LM model determines the m interest rate r L M 𝒀 I S Y Equilibriu m level of income End-of-chapter problem The following equations describe an economy. Y=C +I+G C=50+0.75 (Y-T). I=150-10 r. (M/P)d =Y-50r. G=250. T =200. M=3,000. P =4. a) Identify each of the variables and briefly explain their meaning. b) From the above list, use the relevant set of equations to derive the IS curve. Graph the IS curve on an appropriately labeled graph. c) From the above list, use the relevant set of equations to derive the LM curve. Graph the LM curve on the same graph you used in part (b). d) What are the equilibrium level of income and the equilibrium interest rate? Economic policy in the IS-LM model Macroeconomics 21, 28 November 2019 Context We will use the IS-LM model to – see how policies and shocks affect income and the interest rate in the short run when prices are fixed – derive the aggregate demand curve – explore various explanations for the Great Depression Equilibrium in the IS-LM Model The IS curve represents equilibrium in the goods market. r LM Y C (Y T ) I (r ) G The LM curve represents money market equilibrium. r 1 M P L (r ,Y ) Y The intersection determines 1 the unique combination of Y and r that satisfies equilibrium in both markets. IS Y Policy analysis with the IS-LM Model Y C (Y T ) I (r ) G r LM M P L (r ,Y ) Policymakers can affect macroeconomic variables r with 1 • fiscal policy: G and/or T • monetary policy: M We can use the IS-LM model to analyze the effects of these policies. IS Y 1 Y Fiscal Policy and the IS curve • We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. • Let‘s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… Shifting the IS curve: G At any value of r, G E Y …so the IS curve shifts to the right. The horizontal r distance of r the 1 IS shift equals 1 Y 1 MPC E E =Y Y Y 1 2 G Y IS Y Y Y 1 2 E = C + I ( r1 )+G2 E = C + I ( r1 )+G1 1 IS 2Y An increase in government purchases 1. IS curve shifts right 1 by G 1 MPC r r causing output 2 2 & income to . r rise. raises 1 2. This money demand, causing the interest rate to 3. …which reduces rise… investment, so the 1 Y final increase in is smaller than G 1 MPC LM 1 . Y Y 1 3 . 2 IS2 IS1 Y A tax cut Because consumers save (1MPC) of the tax cut, the initial boost in spending is smaller for T than for an equal G… r LM r 2 2 . r 1 1 IS2 . IS 1 MPC T and1the IS curve 1 MPC . shifts by 2 …so the effects on r . and Y are smaller for a T than for an equal G. Y Y 1 22 . Y How M shifts the LM curve (a) The market for real money r balances (b) The LM r curve r r 2 2 r r 1 M2 P M1 P L (r , Y1 ) M/ P L M 2LM 1 1 Y 1 Y Monetary Policy: an increase in M r 1. M > 0 shifts the LM curve down (or to the right) 2. …causing the interest rate to fall 3. …which increases investment, causing output & income to rise. LM 1 LM 2 r 1 r 2 IS Y Y 1 2 Y Interaction between monetary & fiscal policy • Model: monetary & fiscal policy variables (M, G and T ) are exogenous • Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. • Such interaction may alter the impact of the original policy change. The Fed‘s response to G > 0 • Suppose the government increases G. • Possible Fed responses: 1) hold M constant 2) hold r constant 3) hold Y constant • In each case, the effects of the G are different: Response 1: hold M constant If the government raises G, the IS curve shifts right If Fed holds M constant, then LM curve doesn‘t shift. r LM 1 r r2 1 IS2 IS1 Results: Y Y 2 Y1 r r2 r1 YY 1 2 Y Response 2: hold r constant If the government raises G, the IS curve shifts right To keep r constant, Fed increases M to shift LM curve Results: right. Y Y 3 Y1 r 0 r LM 1 LM 2 r r2 1 IS2 IS1 YYY 1 2 3 Y Response 3: hold Y constant If the government raises G, the IS curve shifts right To keep Y constant, Fed reduces M to shift LM curve Results: left. Y 0 r r3 r1 r LM 2 LM 1 r r3 r2 1 IS2 IS1 YY 1 2 Y Shocks in the IS-LM Model IS shocks: exogenous changes in the demand for goods & services. Examples: • stock market boom or crash change in households‘ wealth C • change in business or consumer confidence or expectations I and/or C Shocks in the IS-LM Model LM shocks: exogenous changes in the demand for money. Examples: • a wave of credit card fraud increases demand for money. • more ATMs or the Internet reduce money demand. EXERCISE: Analyze shocks with the IS-LM model Use the IS-LM model to analyze the effects of 1. A boom in the stock market makes consumers wealthier. 2. After a wave of credit card fraud, consumers use cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r . b. determine what happens to C, I, and the unemployment rate. The Great Depression 220 billions of 1958 dollars 30 Unemploy ment (right scale) 25 200 20 180 15 160 10 140 120 1929 1931 1933 Real GNP (left scale) 1935 1937 5 0 1939 percent of labor force 240 The Spending Hypothesis: Shocks to the IS Curve • asserts that the Depression was largely due to an exogenous fall in the demand for goods & services -- a leftward shift of the IS curve • evidence: output and interest rates both fell, which is what a leftward IS shift would cause The Spending Hypothesis: Reasons for the IS shift 1. Stock market crash exogenous C • Oct-Dec 1929: S&P 500 fell 17% • Oct 1929-Dec 1933: S&P 500 fell 71% 2. Drop in investment • ―correction‖ after overbuilding in the 1920s • widespread bank failures made it harder to obtain financing for investment 3. Contractionary fiscal policy • in the face of falling tax revenues and increasing deficits, politicians raised tax rates and cut spending The Money Hypothesis: A Shock to the LM Curve • asserts that the Depression was largely due to huge fall in the money supply • evidence: M1 fell 25% during 1929-33. But, two problems with this hypothesis: 1) P fell even more, so M/P actually rose slightly during 1929-31. 2) nominal interest rates fell, which is the opposite of what would result from a leftward LM shift. The Money Hypothesis Again: The Effects of Falling Prices • asserts that the severity of the Depression was due to a huge deflation: • P fell 25% during 1929-33. • This deflation was probably caused by the fall in M, so perhaps money played an important role after all. • In what ways does a deflation affect the economy? The Money Hypothesis Again: The Effects of Falling Prices The stabilizing effects of deflation: • P (M/P ) LM shifts right Y • Pigou effect: P (M/P ) consumers‘ wealth C IS shifts right Y The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of unexpected deflation: debt-deflation theory P (if unexpected) transfers purchasing power from borrowers to lenders borrowers spend less, lenders spend more if borrowers‘ propensity to spend is larger than lenders, then aggregate spending falls, the IS curve shifts left, and Y falls The Money Hypothesis Again: The Effects of Falling Prices The destabilizing effects of expected deflation: e r for each value of i I because I = I (r ) planned expenditure & agg. demand income & output Why another Depression is unlikely • Policymakers (or their advisors) now know much more about macroeconomics: • The Fed knows better than to let M fall so much, especially during a contraction. • Fiscal policymakers know better than to raise taxes or cut spending during a contraction. • Federal deposit insurance makes widespread bank failures very unlikely. • Automatic stabilizers make fiscal policy expansionary during an economic downturn. End-of-chapter problem According to the IS–LM model, what happens in the short run to the interest rate, income, consumption, and investment under the following circumstances? Be sure your answer includes an appropriate graph. a) The central bank increases the money supply. b) The government increases government purchases. c) The government increases taxes. d) The government increases government purchases and taxes by equal amounts. End-of-chapter problem Use the IS–LM model to predict the short-run effects of each of the following shocks on income, the interest rate, consumption, and investment. In each case, explain what the Fed should do to keep income at its initial level. Be sure to use a graph in each of your answers. a) After the invention of a new high-speed computer chip, many firms decide to upgrade their computer systems. b) A wave of credit card fraud increases the frequency with which people make transactions in cash. c) A best-seller titled Retire Rich convinces the public to increase the percentage of their income devoted to saving. d) The appointment of a new ―dovish‖ Federal Reserve chair increases expected inflation. End-of-chapter problem An economy is initially described by the following equations: C =500+0.75(Y-T); I =1,000-50r; M/P =Y-200r; G=1000; T=1000; M =6,000; P =2. a) Derive and graph the IS curve and the LM curve. Calculate the equilibrium interest rate and level of income. Label that point A on your graph. b) Suppose that a newly elected president cuts taxes by 20 percent. Assuming the money supply is held constant, what are the new equilibrium interest rate and level of income? What is the tax multiplier? c) Now assume that the central bank adjusts the money supply to hold the interest rate constant. What is the new level of income? What must the new money supply be? What is the tax multiplier? d) Now assume that the central bank adjusts the money supply to hold the level of income constant. What is the new equilibrium interest rate? What must the money supply be? What is the tax multiplier? e) Show the equilibria you calculated in parts ( b), (c), and (d) on the graph you drew in part (a). Label them points B, C, and D. End-of-chapter problem The Fed is considering two alternative monetary policies: • holding the money supply constant and letting the interest rate adjust, or • adjusting the money supply to hold the interest rate constant. In the IS–LM model, which policy will better stabilize output under the following conditions? Explain your answer. • All shocks to the economy arise from exogenous changes in the demand for goods and services. • All shocks to the economy arise from exogenous changes in the demand for money The economic policy message public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money … Thus, as the prime mover in the first stage of the technique of recovery, I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by loans and is not merely a transfer through taxation, from existing incomes. Long-run versus short-run equlibrium: aggregate demand and aggregate supply Macroeconomics 28 November 2019 Topics • how the short run differs from the long run • an introduction to aggregate demand • an introduction to aggregate supply in the short run and long run • how the model of aggregate demand and aggregate supply can be used to analyze the short-run and longrun effects of ―shocks.‖ Facts about the business cycle • GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run. • Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. • Unemployment rises during recessions and falls during expansions. • Okun‘s Law: the negative relationship between GDP and unemployment. Time horizons in macroeconomics • Long run: Prices are flexible, respond to changes in supply or demand. • Short run: Many prices are ―sticky‖ at some predetermined level. The economy behaves much differently when prices are sticky. Short run vs long run …though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. David Hume (1752): Of Money . Price stickiness Forrás: Álvarez et al. (2005:12) Price stickiness Forrás: Álvarez et al. (2005:15) Recap of classical macro theory • Output is determined by the supply side: • supplies of capital, labor • technology. • Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. • Assumes complete price flexibility. • Applies to the long run. When prices are sticky… …output and employment also depend on demand, which is affected by • fiscal policy (G and T ) • monetary policy (M ) • other factors, like exogenous changes in C or I. The model of aggregate demand and supply • the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy • shows how the price level and aggregate output are determined • shows how the economy‘s behavior is different in the short run and long run Aggregate demand • The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. • For this chapter‘s intro to the AD/AS model, we use a simple theory of aggregate demand based on the quantity theory of money. • Later we will develop the theory of aggregate demand in more detail. The Quantity Equation as Aggregate Demand Recall the quantity equation MV = PY For given values of M and V, this equation implies an inverse relationship between P and Y : The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. P A D Y Shifting the AD curve P An increase in the money supply shifts the AD curve to the right. A A D2 D1 Y Aggregate supply in the long run Recall : In the long run, output is determined by factor supplies Y F(K ,and L) technology Y is the full-employment or natural level of output, the level of output at which the economy‘s resources are fully employed. “Full employment” means that unemployment equals its natural rate (not zero). The long-run aggregate supply curve P Y does LRA S not depend on P, so LRAS is vertical. Y F (K , L ) Y Long-run effects of an increase in M P P In the long 2 run, this P raises the 1 price level… …but leaves output the same. LRA S Y An increase in M shifts AD to the right. A A D2 D1 Y Aggregate supply in the short run • Many prices are sticky in the short run. • For now, we assume • all prices are stuck at a predetermined level in the short run. • firms are willing to sell as much at that price level as their customers are willing to buy. • Therefore, the short-run aggregate supply (SRAS) curve is horizontal: The short-run aggregate supply curve The SRAS curve is horizontal: The price level is fixed at a predetermine d level, and firms sell as much as buyers demand. P P SRAS Y Short-run effects of an increase in M In the short run when prices are sticky,… P …an increase in aggregate demand… P …causes output to rise. Y Y 1 2 SRAS A A D2 D1 Y From the short run to the long run Over time, prices gradually become ―unstuck.‖ When they do, will they rise or fall? In the shortthen over run time, equilibrium, if P will… rise Y Y Y Y Y Y fall remain constant The adjustment of prices is what moves the economy to its long-run equilibrium. The SR & LR effects of M > 0 P A = initial equilibrium B = new short-run eq’m after Fed increases M C = longrun equilibrium LRA S C P 2 P B SRAS A Y Y 2 A A D2 D1 Y Shocks • shocks: exogenous changes in agg. supply or demand • Shocks temporarily push the economy away from full employment. • Example: exogenous decrease in velocity • If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services. The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. Over time, prices fall and the economy moves down its demand curve toward full- P LRA S B P P A SRAS C A D1 A D2 2 Y 2 Y Y Supply shocks • A supply shock alters production costs, affects the prices that firms charge. (also called price shocks) • Examples of adverse supply shocks: • Bad weather reduces crop yields, pushing up food prices. • Workers unionize, negotiate wage increases. • New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. CASE STUDY: The 1970s oil shocks • Early 1970s: OPEC coordinates a reduction in the supply of oil. • Oil prices rose 11% in 1973 68% in 1974 16% in 1975 • Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. CASE STUDY: The 1970s oil shocks The oil price P shock shifts SRAS up, causing output and employment P2 to fall. In absence of further price shocks, prices will fall over time and economy moves back toward full LRA S B SRAS 2 A P1 SRAS A D Y 2 Y 1 Y CASE STUDY: The 1970s oil shocks 70% Predicted effects of the oil shock: • inflation • output • unemploymen t …and then a gradual recovery. 12% 60% 50% 10% 40% 8% 30% 20% 6% 10% 0% 1973 1974 1975 1976 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 4% 1977 CASE STUDY: The 1970s oil shocks 60% Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 14% 50% 12% 40% 10% 30% 8% 20% 6% 10% 0% 1977 4% 1978 1979 1980 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 1981 CASE STUDY: The 1980s oil shocks 40% 1980s: A favorable supply shocka significant fall in oil prices. As the model predicts, inflation and unemployme nt fell: 10% 30% 8% 20% 10% 6% 0% -10% 4% -20% -30% 2% -40% -50% 1982 0% 1983 1984 1985 1986 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 1987 Stabilization policy • def: policy actions aimed at reducing the severity of short-run economic fluctuations. • Example: Using monetary policy to combat the effects of adverse supply shocks: Stabilizing output with monetary policy P The adverse supply shock moves the economy to point B. P2 LRA S B SRAS 2 A P1 SRAS 1 A D1 Y 2 Y Y Stabilizing output with monetary policy But the Fed accommodat es the shock by raising agg. demand. results: P is permanently higher, but Y remains at its fullemployment P P2 LRA S B C SRAS 2 A P1 Y 2 Y A A D2 D1 Y Chapter Summary 1) Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. Short run: prices are sticky, shocks can push output and employment away from their natural rates. 2) Aggregate demand and supply: a framework to analyze economic fluctuations Chapter Summary 3) The aggregate demand curve slopes downward. 4) The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. 5) The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels. Chapter Summary 6) Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7) The Fed can attempt to stabilize the economy with monetary policy. End-of-chapter problems An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of currency and demand deposits, including checking accounts, so this regulatory change makes holding money more attractive. a) How does this change affect the demand for money? b) What happens to the velocity of money? If the Fed keeps the money supply constant, what will happen to output and prices in the short run and in the long run? c) If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply constant in response to this regulatory change? If not, what should it do? Why? d) If the goal of the Fed is to stabilize output, how would your End-of-chapter problems Suppose the Fed reduces the money supply by 5 percent. Assume the velocity of money is constant. a) What happens to the aggregate demand curve? b) What happens to the level of output and the price level in the short run and in the long run? Give a precise numerical answer. c) In light of your answer to part (b), what happens to unemployment in the short run and in the long run according to Okun‘s law? Again, give a precise numerical answer. d) What happens to the real interest rate in the short run and in the long run? (Hint: Use the e) model of the real interest rate in Chapter 3 to see what happens when output changes.) Here, your answer should just give the End-of-chapter problems Let‘s examine how the goals of the Fed influence its response to shocks. Suppose that in scenario A the Fed cares only about keeping the price level stable and in scenario B the Fed cares only about keeping output and employment at their natural levels. Explain how in each scenario the Fed would respond to the following. a) An exogenous decrease in the velocity of money. b) An exogenous increase in the price of oil. The theory of Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment Macroeconomics 5 December 2019 Two models of aggregate supply 1) The sticky-wage model 2) The sticky-price model Both models imply: Y Y P EP agg. outp ut natural rate of output a positive parame ter the expected price level the actual price level The sticky-wage model • Assumes that firms and workers negotiate contracts and fix the nominal wage before they know what the price level will turn out to be. • The nominal wage they set is the product of a target real wage and the expected price level: W EP W EP P P Target real wage The sticky-wage model W EP P P If it turns out that P EP P EP P EP then unemployment and output are at their natural rates Real wage is less than its target, so firms hire more workers and output rises above its natural Real wage exceedsrate its target, so firms hire fewer workers and output falls below its natural rate The sticky-wage model • Implies that the real wage should be counter-cyclical , it should move in the opposite direction as output over the course of business cycles: – In booms, when P typically rises, the real wage should fall. – In recessions, when P typically falls, the real wage should rise. • This prediction does not come true in the real world: Percentage change in real wage The cyclical behavior of the real wage 4 1972 3 1998 2 1960 1997 1999 1 1996 1970 0 2000 1984 1993 1992 1982 1991 -1 1965 1990 -2 1975 -3 1979 1974 -4 -5 1980 -3 -2 -1 0 1 2 3 4 5 6 7 8 Percentage change in real GDP Wages, employment, and prices during the Great Depression Bordo, M. D., Erceg, Ch. J., Evans, Ch. L. (2000): Money, Sticky Wages, and the Great Depression. American Economic Review, 90(5), 1447-1463., p. 1448 Problem (not from the book) In an economy where the conditions of the sticky-wage model of AS hold, the production function is given by: Y=K0.5N0.5, and the capital stock is 1600. The target real wage is 2. a) Calculate the natural rate output. b) Derive the short-run aggregate supply curve. The sticky-price model • Reasons for sticky prices: – long-term contracts between firms and customers – menu costs – firms not wishing to annoy customers with frequent price changes • Assumption: – Firms set their own prices (e.g., as in monopolistic competition). The sticky-price model An individual firm‘s desired price is: p P a(Y Y ) where a > 0. Suppose two types of firms: • firms with flexible prices, set prices as above • firms with sticky prices, must set their price before they know how P and Y will turn out: p EP a( EY EY ) The sticky-price model p EP a( EY EY ) • Assume sticky price firms expect that output will equal its natural rate. Then, p EP • To derive the aggregate supply curve, first find an expression for the overall price level. • s = fraction of firms with sticky prices. Then, we can write the overall price level as… The sticky-price model P s[ EP ] (1 s )[ P a(Y Y )] price set by price set by flexible price sticky price firms firms • Subtract (1s)P from both sides: sP s[ EP ] (1 s )[a(Y Y )] • Divide both sides by s : (1 s )a P EP (Y Y ) s The sticky-price model (1 s )a P EP (Y Y ) s • High EP High P If firms expect high prices, then firms that must set prices in advance will set them high. Other firms respond by setting high prices. • High Y High P When income is high, the demand for goods is high. Firms with flexible prices set high prices. • The greater the fraction of flexible price firms, the smaller is s and the bigger is the effect of Y on P. The sticky-price model (1 s )a P EP (Y Y ) s Finally, derive AS equation by solving for Y : Y Y (P EP ), s where 0 (1 s )a Summary & implications P LRA S Y Y (P EP) P EP SRA S P EP P EP Y Y Both models of agg. supply imply the relationship summarized by the SRAS curve & equation. Summary & implications SRAS equation: Y Y (P EP) Suppose a positive AD shock moves SRA output above its P LRA S2 natural rate and S SRA P above the level S1 people had expected. P3 EP3 P2 Over time, EP rises, EP2 P1 EP1 SRAS shifts up, and output returns to its natural rate. AD 2 AD 1 Y3 Y1 Y Y2 Y Inflation, Unemployment, and the Phillips Curve The Phillips curve states that depends on – expected inflation, E. – cyclical unemployment: the deviation of the actual rate of unemployment from the natural rate – supply shocks, (Greek letter ―nu‖). E (u u ) n where > 0 is an exogenous constant. Deriving the Phillips Curve from SRAS (1) Y Y (P EP ) (2) P EP (1 )(Y Y ) (3) P EP (1 )(Y Y ) (4) (P P1 ) ( EP P1 ) (1 )(Y Y ) (5) E (1 )(Y Y ) (6) (1 )(Y Y ) (u un ) (7) E (u un ) Comparing SRAS and the Phillips Curve SRAS: Y Y (P EP ) Phillips curve: E (u un ) • SRAS curve: Output is related to unexpected movements in the price level. • Phillips curve: Unemployment is related to unexpected movements in the inflation rate. Adaptive expectations • Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. • A simple version: Expected inflation = last year‘s actual inflation E 1 Then, P.C. becomes 1 (u un ) Inflation inertia 1 (u un ) In this form, the Phillips curve implies that inflation has inertia: – In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate. – Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. Two causes of rising & falling inflation 1 (u un ) • cost-push inflation: inflation resulting from supply shocks Adverse supply shocks typically raise production costs and induce firms to raise prices, ―pushing‖ inflation up. • demand-pull inflation: inflation resulting from demand shocks Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which ―pulls‖ the inflation rate up. Graphing the Phillips curve In the short run, policymakers face a tradeoff between and u. E (u un ) 1 The shortrun Phillips curve E u n u Shifting the Phillips curve People adjust their expectations over time, E 2 so the tradeoff E1 only holds in the short run. E.g., an increase in E shifts the short-run P.C. upward. E (u un ) u n u The sacrifice ratio • To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate. • The sacrifice ratio measures the percentage of a year‘s real GDP that must be foregone to reduce inflation by 1 percentage point. • A typical estimate of the ratio is 5. The sacrifice ratio • Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year‘s GDP: GDP loss = (inflation reduction) × (sacrifice ratio) = 4 ×5 • This loss could be incurred in one year or spread over several, e.g., 5% loss for each of four years. • The cost of disinflation is lost GDP. One could use Okun‘s law to translate this cost into unemployment. Use the Phillips curve to explain what Milton Friedman is saying ‖Only surprises matter. If everyone anticipated that prices would rise at, say, 20 percent a year, then this anticipation would be embodied in future wage (and other) contracts, real wages would then behave precisely as they would if everyone anticipated no price rise, and there would be no reason for the 20 percent rate of inflation to be associated with a different level of unemployment than a zero rate‖. (Friedman, M. (1976), Inflation and Unemployment, Nobel Memorial Use the Phillips curve to explain what Milton Friedman is saying ‖what matters is not inflation per se, but unanticipated inflation; there is no stable trade-off between inflation and unemployment; there is a ―natural rate of unemployment‖…, which is consistent with the real forces and with accurate perceptions; unemployment can be kept below that level only by an accelerating inflation; or above it, only by accelerating deflation‖. (Friedman, M. (1976), Inflation and Unemployment, Nobel Memorial Problem 2 (Mankiw, p. 432) Suppose that an economy has the Phillips curve =-1 -0.5(u-5) What is the natural rate of unemployment? a) Graph the short-run and long-run relationships between inflation and unemployment. b) How much cyclical unemployment is necessary to reduce inflation by 4 percentage points? c) Inflation is running at 6 percent. The central bank wants to reduce it to 2 percent. Give two scenarios that will achieve that goal. Rational expectations Ways of modeling the formation of expectations: – adaptive expectations: People base their expectations of future inflation on recently observed inflation. – rational expectations: People base their expectations on all available information, including information about current and prospective future policies. Painless disinflation? Proponents of rational expectations believe that the sacrifice ratio may be very small: • Suppose u = un and = E = 6%, and suppose the Fed announces that it will do whatever is necessary to reduce inflation from 6 to 2 percent as soon as possible. • If the announcement is credible, then E will fall, perhaps by the full 4 points. • Then, can fall without an increase in u. Painless disinflation? An alternative "rational expectations" view denies that there is any inherent momentum in the present process of inflation…An implication of this view is that inflation can be stopped much more quickly than advocates of the "momentum" view have indicated…This is not to say that it would be easy to eradicate inflation. On the contrary, it would require far more than a few temporary restrictive fiscal and monetary actions. It would require a change in the policy regime. Sargent, Th. (1982): The Ends of Four Big Inflations, p. 42) Thomas Sargent Calculating the sacrifice ratio for the Volcker disinflation 1981: = 9.7% 1985: = 3.0% Total disinflation = 6.7% year u un uu n 1982 9.5% 6.0% 3.5% 1983 9.5 6.0 3.5 1984 7.4 6.0 1.4 1985 7.1 6.0 1.1 Total 9.5% Calculating the sacrifice ratio for the Volcker disinflation • From previous slide: Inflation fell by 6.7%, total cyclical unemployment was 9.5%. • Okun‘s law: 1% of unemployment = 2% of lost output. • So, 9.5% cyclical unemployment = 19.0% of a year‘s real GDP. • Sacrifice ratio = (lost GDP)/(total disinflation)= 19/6.7 = 2.8 percentage points of GDP were lost for each 1 percentage point reduction in inflation. The natural rate hypothesis Our analysis of the costs of disinflation, and of economic fluctuations in the preceding chapters, is based on the natural rate hypothesis: Changes in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the ‖classical model‖. Problem 5 (Mankiw 2015, p. 433 ) Suppose that the economy is initially at a long-run equilibrium. Then the Fed increases the money supply. a) Assuming any resulting inflation to be unexpected, describe any changes in GDP, unemployment, and inflation that are caused by the monetary expansion. Explain your conclusions using three diagrams: one for the IS– LM model, one for the AD–AS model, and one for the Phillips curve. b) Assuming instead that any resulting inflation is expected, describe any changes in GDP, unemployment, and inflation that are caused by the monetary expansion. Once again, explain your conclusions using three diagrams: one for the IS–LM model, one for the AD–AS model, and one for the Phillips curve. Problem 6 (Mankiw 2015, p. 433 ) Assume that people have rational expectations and that the economy is described by the sticky price model. Explain why each of the following propositions is true. a) Only unanticipated changes in the money supply affect real GDP. Changes in the money supply that were anticipated when prices were set do not have any real effects. b) If the Fed sets the money supply at the same time as people are setting prices, so that everyone has the same information about the state of the economy, then monetary policy cannot be used systematically to stabilize output. Hence, a policy of keeping the money supply constant will have the same real effects as a policy of adjusting the money supply in response to the state of the economy. (This is called the policy irrelevance proposition.) c) If the Fed sets the money supply well after people have set prices, so that the Fed has collected more information about the state of the economy, then monetary policy can be used systematically to stabilize output. The imperfect-information model: a problem (not from the book) Suppose that in an economy in which the imperfect-information model holds, the supply curve of a milk producer can be described by the equation: Q=a×Pmilk/EP, where Q is the quantity produced, a>0 is a constant, Pmilk is the price of milk and EP is the expected price level. Suppose that both the price level and the price of milk increase by 10 percent. a) Since in this economy the aggregate demand fluctuates very frequently, the producer will think that the probability that the increase of the price of milk is caused by an increase in the price level is 80 percent, and the probability of an increase in relative demand is only 20 percent. With what percentage will the producer increase production as a reaction to this 10 percent increase in the price level? b) Suppose, instead, that aggregate demand shocks are not that frequent, and the producer will, therefore, think that there is only a 40 percent probability that an increase in the price level is A review of the course Macroeconomics 12 December 2019 Measuring GDP • Three approaches to GDP: expenditure, income, value added • Real and nominal GDP Inflation • GDP deflator inflation • Consumer Price Index inflation Unemployment • Employed, Unemployed, not in the labour force • Unemployment rate Simple labour market statistics Compute the labor force, u-rate, adult population, and labor force participation rate using this data: Adult population of the U.S. by group, June 2008 # of employed 145.9 million # of unemployed 8.5 million not in labor force 79.2 million Long-run issues Production and the division of income (the classical model) • Model of the market for loanable funds real interest rate • Euler theorem (neoclassical theory of income distribution) Money and inflation • • • • The money supply (money multiplier) Demand for money, the Fisher equation The quantity theory of money Costs of inflation Unemployment (theories of the natural rate of unemployment) • Frictions from job search • Real wage rigidity (stickiness) Euler’s theorem: Under our assumptions (constant returns to scale, profit maximization, and competitive markets)… total output is divided between the payments to capital and labor, depending on their marginal products, with no extra profit left over. Y MPL L MPK K nation al incom e labor incom e capital incom e slide 527 Euler’s theorem: Suppose the production function in Europe is Y=K 1/3L2/3, where K is the amount of capital and L is the amount of labor. The economy begins with 100 units of land and 100 units of labor. Use a calculator and equations in the chapter to find a numerical answer to each of the following questions. a) How much output does the economy produce? b) What are the wage and the rental price of capital? c) What share of output does labor receive? Market for loanable funds Consider an economy described as follows: Y = C+ I + G. Y = 1,200. G = 150. T =100. C =125+0.75(Y-T ). I =200 -10r. a) In this economy, compute private saving, public saving, and national saving. b) Find the equilibrium interest rate. Money supply End-of-chapter problems An economy has the following money demand function: (M/P )d=0.2Y/i 1/2. a) Derive an expression for the velocity of money. What does velocity depend on? Explain why this dependency may occur. b) Calculate velocity if the nominal interest rate i is 4 percent. c) If output Y is 1,000 units and the money supply M is $1,200, what is the price level P ? d) Suppose the announcement of a new head of the central bank, with a reputation of being soft on inflation, increases expected inflation by 5 percentage points. According to the Fisher effect, what is the new nominal interest rate? End-of-chapter problems e) Calculate the new velocity of money. f) If, in the aftermath of the announcement, both the economy’s output and the current money supply are unchanged, what happens to the price level? Explain why this occurs. g) If the new central banker wants to keep the price level the same after the announcement, at what level should she set the money supply? Natural rate of unemployment In this chapter we saw that the steady-state rate of unemployment is U/L = s/(s+f ). Suppose that the unemployment rate does not begin at this level. Show that unemployment will evolve over time and reach this steady state. (Hint: Express the change in the number of unemployed as a function of s, f, and U. Then show that if unemployment is above the natural rate, unemployment falls, and if unemployment is below the natural rate, unemployment rises.) Natural rate of unemployment On a labour market the demand curve can be described as LD(w/p)=32000/(w/p)2, where w/p denotes the real wage. The labour supply is 8000 and independent of the real wage. a) Calculate the equilibrium (market clearing) real wage. Calculate the unemployment rate. b) Suppose that a minimum wage of 2.1 is introduced by the government. Calculate employment and the unemployment rate after the minimum wage is introduced. Short-run issues Keynesian cross: the short-run model of the market for goods and services IS-LM model • Deriving the IS curve form the Keynesian cross, and the LM curve from the money market equilibrium • IS-LM equilibrium: the effect of policy actions and shocks on real GDP and real interest rate Aggregate demand and aggregate supply • • • • AD as derived form the QTM LRAS-SRAS-AD model Positively sloped AS as derived form the sticky wage/sticky price model Phillips curve Keynesian cross C(Y-T)=125+0.75(Y-T) I=100 G=150 T=100 Equilibrium income The effect of a fiscal policy change or of some other shock. IS-LM model SRAS-LRAS-AD Let‘s examine how the goals of the Fed influence its response to shocks. Suppose that in scenario A the Fed cares only about keeping the price level stable and in scenario B the Fed cares only about keeping output and employment at their natural levels. Explain how in each scenario the Fed would respond to the following. a) An exogenous decrease in the velocity of money. b) An exogenous increase in the price of oil. Sticky wage model -- problem (not from the book) In an economy where the conditions of the sticky-wage model of AS hold, the production function is given by: Y=K0.5N0.5, and the capital stock is 1600. The target real wage is 2. a) Calculate the natural rate output. b) Derive the short-run aggregate supply curve. Phillips curve Suppose that an economy has the Phillips curve π= π-1-0.5(u-5) a) What is the natural rate of unemployment? b) Graph the short-run and long-run relationships between inflation and unemployment. c) How much cyclical unemployment is necessary to reduce inflation by 4 percentage points? d) Inflation is running at 6 percent. The central bank wants to reduce it to 2 percent. Give two scenarios that will achieve that goal. A complex problem for the short-run model Suppose that the economy is initially at a long-run equilibrium. Then the Fed increases the money supply. a) Assuming any resulting inflation to be unexpected, describe any changes in GDP, unemployment, and inflation that are caused by the monetary expansion. Explain your conclusions using three diagrams: one for the IS– LM model, one for the AD–AS model, and one for the Phillips curve. b) Assuming instead that any resulting inflation is expected, describe any changes in GDP, unemployment, and inflation that are caused by the monetary expansion. Once again, explain your conclusions using three diagrams: one for the IS–LM model, one for the AD–AS model, and one for the Phillips curve.