Transcript Slide 1

Great divide of macroeconomics
Aggregate supply
and “economic growth”
Aggregate demand
and business cycles
1
The Great Divide
Classical macro:
- Full employment
- Flexible wages and prices
- Perfect competition and rational expectations
- Only “real” business cycles, and all unemployment is voluntary
and efficient
Keynesian macro:
- Underutilized resources
- Inflexible (or fixed) wages and prices
- Imperfect competition and behavioral expectations
- Yes, business cycles, with persistent slumps, involuntary
unemployment, and macro waste.
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Understanding business cycles
Major elements of cycles
–
–
–
–
short-period (1-3 yr) erratic fluctuations in output
pro-cyclical movements of employment, profits, prices
counter-cyclical movements in unemployment
appearance of “involuntary” unemployment in recessions
Historical trends
– lower volatility of output, inflation over time (until 2008)
– movement from stable prices to rising prices since WW II
3
The incomplete recovery
Unemployment rate (%)
10
8
6
Full employment
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
4
4
Output gaps and business cycles
15,000
Real GDP (billions of 2005 $)
14,500
Real GDP (Actual)
Real Potential GDP
Large
GDP “gap”
14,000
13,500
13,000
12,500
12,000
2004
5
2005
2006
2007
2008
2009
2010
2011
2012
5
U.S. Beveridge curve
4.5
2001
4.0
Vacancy rate
3.5
3.0
2012
2.5
2008
2.0
1.5
3
4
5
6
7
8
9
10
Unemployment rate
Bureau of Labor Statistics
6
6
140
Business cycle duration, 1857-2012 (months)
120
Recessions
Expansions
100
80
60
40
20
0
1854
1870
1891
1904
1919
1933
1954
1975
2001
7
The zoo of macro models
8
Major approaches to business cycles
• “Keynesian cross” (Econ 116): useful for intuition
• AS-AD with p and Y (Econ 116): obsolete
• IS-LM: for period of gold standard
• IS-MP (Econ 122)
• Dynamic AS-AD model: mainstream Keynesian macro
• Open-economy in short run: Mundell-Fleming:
Very important approach to open economy
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IS-MP model
The major tool for showing the impact of monetary and
fiscal polices, along with the effect of various shocks, in a
short-run Keynesian situation.
Key assumptions
•
•
•
•
Fixed prices (P=1 and π = 0); or can have fixed inflation
Unemployed resources (Y < potential Y = Jones’s natural Y)
Closed economy (in Jones, but inessential and considered later)
Goods markets (IS) and financial markets (MP)
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IS curve (expenditures)
Basic idea: describes equilibrium in goods market.
Finds Y where planned I = planned S or planned
expenditure = planned output.
Basic set of equations:
1.
2.
3.
4.
5.
Y=C+I+G
C = a + b(Y-T)
T = T0 + τ Y
I = I0 – dr
G = G0
[note assume income tax, τ = marginal tax rate]
[note i = r because zero inflation]
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r = real
interest rate
IS diagram
which gives the IS curve:
(IS) Y =
(IS)
Y
E
re
a - bT0 + G0 + I0 - dr
1 - b(1- τ)
= μ [A0 - dr]
IS(G, T0, …)
Ye
Y = real output (GDP)
where
A0 = autonomous spending = a - bT0 + G0 + I0
μ = simple Keynesian multiplier = 1/[(1 - b(1- τ)]
which we graph as the IS curve.
Note that changes in fiscal policy, investment “animal spirits,”
consumption wealth effect SHIFT IS CURVE
HORIZONTALLY.
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IS curve
r = real
interest rate
IS(G, T0, …)
Y = real output (GDP)13
IS curve
r = real
interest rate
IS(G’, T0, …)
IS(G, T0, …)
Y = real output (GDP)14
MP curve (monetary policy/financial markets)
The simplest MP curve says that the Fed sets the short term
interest rate (i). Inflation gives real interest rate. This is
Chapter 12 in Jones.
(MP)
r=i-π
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IS-MP diagram in Jones
r = real
interest rate
E
re
MP(π*)
IS(G, T0, …)
Ye
Y = real output (GDP)16
Let’s go right to the real stuff
• In reality, the Fed has a “dual mandate”(see below).
• This is usually represented by the Taylor rule.
• Let’s skip the simple case and go right there. (This is
Yale.)
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The Dual Mandate
Fed’s dual mandate (Federal Reserve Act as amended):
“promote effectively the goals of maximum employment, stable
prices and moderate long-term interest rates.”
In practice (FOMC statement January 2012):
“The Committee judges that inflation at the rate of 2 percent, as
measured by the annual change in the price index for personal
consumption expenditures, is most consistent over the longer
run with the Federal Reserve's statutory mandate.”
“The maximum level of employment is largely determined by
nonmonetary factors that affect the structure and dynamics of
the labor market…In the most recent projections, FOMC
participants' estimates of the longer-run normal rate of
unemployment had a central tendency of 5.2 percent to 6.0
percent”
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The Taylor rule
1. John Taylor suggested the following rule to implement
the dual mandate:
(TR) i = π + r* + b(π-π*) + cy
(b, c > 0)
Here r* is the equilibrium real interest rate, π inflation rate,
π* is inflation target, y is % output gap [(Y-Yp)/Yp],
b and c are parameters.
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Actual and Taylor rule federal funds rate
10
8
6
4
2
0
-2
Actual
Taylor rule
-4
-6
88
90
92
94
96
98
00
02
04
06
08
10
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The Taylor rule
1. John Taylor suggested the following rule to implement the
dual mandate:
(TR) i = π + r* + b(π-π*) + cy
Here r* is the equilibrium real interest rate, π inflation rate, π* is
inflation target, y is % output gap [(Y-Yp)/Yp], b and c are
parameters.
2. We will ignore inflation for now to simplify. So π = π* = 0 and
we have the simplified monetary policy rule:
(MP)
r = r* + c[(Y- Yp) /Yp]
Later on, we will introduce inflation but that doesn’t change
anything important.
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Taylor’s rule
(IS)
Y = μ [A0 - dr]
(MP) r = r* + c[(Y- Yp) /Yp]
And the equilibrium is:
Y = μ {A0 – d[r* + c(Y- Yp)/Yp]}
Y = μ {A0 – dr* –dcY + ξ}
Y = μ {A0 – dr* + ξ }/(1+ μdc)
Y = [μ/(1+ μdc)]A0 + φ = μ* A0 + φ
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IS-MP
Algebra
of Equilibrium
IS-MP Analysis
This is Main Street + Wall Street
Y = μ* A0 + φ
where μ* = μ/(1 + μdc) = multiplier with monetary policy.
μ = simple multiplier > μ* ;
A0 = autonomous spending = a - bT0 + G0 + I0
Note impacts on output:
Positive: G, I0, NX, -T
Negative: risk premium, inflation shock (do later)
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IS-MP diagram
r = real
interest rate
MP(r*, π, π*)
E
re
IS(G, T0, trade…)
Ye
Y = real output (GDP)
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1. What are the effects of fiscal policy?
• A fiscal policy is change in purchases (G) or in taxes (T0, τ),
holding monetary policy constant.
• In normal times, because MP curve slopes upward,
expenditure multiplier is reduced due to crowding out.
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Fiscal policy in normal times
r = real
interest rate
MP
re
IS’
IS
Y = real output (GDP)
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Multiplier Estimates by the CBO
3.0
Multiplier from G,T on GDP
2.5
2.0
1.5
1.0
0.5
0.0
G: Fed
G: S&L
Trans: indiv
Tax:
Mid/Low
Income
Tax: High
Income
Congressional Budget Office, Estimated Impact of the ARRA, April 2010
Bus Tax
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What about the abnormal times?
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6
US short-term interest rates, 1929-45 (% per year)
Liquidity
trap in US in
Great
Depression
5
4
3
2
1
0
1930
1932
1934
1936
1938
1940
1942
1944
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US in current recession
Federal funds rate (% per year)
20
Policy has
hit the
“zero lower
bound” four
years ago.
16
12
8
4
0
1975
1980
1985
1990
1995
2000
2005
2010
30
Japan short-term interest rates, 1994-2012
Liquidity trap from 1996 to today:
15 years and counting.
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Fiscal policy in liquidity trap
r = real
interest rate
IS
IS’
MP
re
Y = real output (GDP)
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Can you see why macroeconomists emphasize the
importance of fiscal policy in the current environment?
“Our policy approach started with a major commitment to fiscal
stimulus. Economists in recent years have become skeptical about
discretionary fiscal policy and have regarded monetary policy as a
better tool for short-term stabilization. Our judgment, however, was
that in a liquidity trap-type scenario of zero interest rates, a
dysfunctional financial system, and expectations of protracted
contraction, the results of monetary policy were highly uncertain
whereas fiscal policy was likely to be potent.”
Lawrence Summers, July 19, 2009
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