Macroeconomics in the World Economy:Theory and Applications
Topic 6: Putting It All Together
Dennis Plott
University of Illinois at ChicagoDepartment of Economics
http://blackboard.uic.edu
Spring 2014
Plott (ECON 221) Spring 2014 1 / 28
Goals & Readings
Goals
Derivation and study of the IS−LM equilibrium. The Goods and theMoney Markets (mostly a review).Construction of the aggregate demand (AD) curve.Construction of the Short-Run Aggregate Supply (SRAS) curve.Define Short-Run equilibrium and Long-Run equilibrium.Analyze demand and supply shocks.Discuss and demonstrate examples.
Readings
Abel, Bernanke, Croushore (2013) Chapters 8-11
Plott (ECON 221) Spring 2014 3 / 28
Note on the IS−LM Equilibrium
Remember: you can always see the problem as a system of two
equations.
Sometimes having an analytical representation of the problem helps.
One simplified example is the following (closed) IS−LM system:
(IS) Y = MPC · (Y −T)+ I(r)+G
(LM)M
P= L(Y ,r+πe)
Where MPC is the marginal propensity to consume out of disposable
income (assumed constant here) and I is a negative function of the
real interest rate. You can graph the two equations in {r,Y }−space.
Note: see Appendix 9.A in the textbook to have an analytical
representation of the IS−LM model.
Plott (ECON 221) Spring 2014 4 / 28
Understanding IS−LM: A Brief Roadmap
At the point of crossing of IS and LM the equilibrium interest rate and
desired output that simultaneously satisfy goods and money markets
are determined.
We will now study how the endogenous variables in our model (Y and
r) change when we change exogenous variables like the money supply
(M) and government spending (G). That is, if I change M or G what are
the new Y and r that satisfy the IS = LM condition?
We then relax the assumption that the price level is fixed and we show
that the IS−LM model implies a negative relationship between the
price level and national income.
The IS−LM model provides a theory of the slope and position of the
aggregate demand (AD) curve.
Plott (ECON 221) Spring 2014 5 / 28
The Aggregate Demand Curve
The AD curve is drawn in {P,Y }−space. It represents how the demand
side of the economy responds to a change in prices.
As P decreases (ceteris paribus – including M),M
Pwill increase. As real
money balances increase, interest rates will fall, Investment will rise
and Y will rise.
Prices affect the demand side of the economy through interest rates
(and consequently investment).
Plott (ECON 221) Spring 2014 6 / 28
The Aggregate Demand Curve (Continued)
Changes in prices do not affect consumption (consumption is only
affected by PVLR – or real wages – if wages change 1 for 1 with prices
(W
Pis constant), PVLR will not change.
The AD curve comes directly from the IS−LM equilibrium. So, in
essence, the AD curve is a representation of BOTH the IS curve AND
the LM curve.
Plott (ECON 221) Spring 2014 7 / 28
What Shifts the AD Curve?
Remember: the AD curve represents the demand side of the economy:
Y d = Cd + Id +G+NX
Anything that causes the IS curve to shift to the right, will cause the AD curve
to shift to the right (both the IS curve and the AD curve represent the demand
side of the economy).
Anything that causes the LM curve to shift to the right (except price changes)
will cause the AD curve to shift to the right. A change in prices will cause the
LM curve to shift, but will cause a movement along the AD curve.
Example: Nominal money (M) increases, r will fall, I will increase, AD will shift
rightward.With changes in money:
LM shifts rightMove along the IS curveInterest rates fallI increasesAD shifts rightward
Plott (ECON 221) Spring 2014 8 / 28
Why Does the AD Slope Downward?
The Wealth (Real-Balances) Effect: a decrease in the price level raises the real value of
money and makes consumers wealthier, which in turn encourages them to spend
more. The increase in consumer spending means a larger quantity of goods and
services demanded. Conversely, an increase in the price level reduces the real value of
money and makes consumers poorer, which in turn reduces consumer spending and
the quantity of goods and services demanded.
The Interest-Rate Effect: a lower price level reduces the interest rate, encourages
greater spending on investment goods, and thereby increases the quantity of goods
and services demanded. Conversely, a higher price level raises the interest rate,
discourages investment spending, and decreases the quantity of goods and services
demanded.
The Exchange-Rate (Foreign Purchases) Effect: When a fall in the U.S. price level
causes U.S. interest rates to fall, the real value of the dollar declines in foreign
exchange markets. This depreciation stimulates U.S. net exports and thereby increases
the quantity of goods and services demanded. Conversely, when the U.S. price level
rises and causes U.S. interest rates to rise, the real value of the dollar increases, and
this appreciation reduces U.S. net exports and the quantity of goods and services
demanded. This would apply to Topic 8.
Plott (ECON 221) Spring 2014 9 / 28
Labor Market: Some Definitions
In the Short-Run (N adjusts, but it need not be at N , K is fixed)
Nominal Wages are ’Sticky’ (although firms may be able to adjust prices).
W is fixed, but notW
P(because firms may be able to adjust P)
K by definition is fixed.
Because Wages are sticky in the Short-Run, the labor market can be in
’dis-equilibrium’; i.e., labor demand not equal to labor supply (cyclical
unemployment can occur).
In the Long-Run (N adjusts to N , K is still fixed).
W adjusts.
We will be at N (labor market is in equilibrium), but capital still does not
adjust. (K is fixed. This assumption is okay if capital stock moves slowly).
Note: In Really Long-Run (Growth – N adjusts to N and K is not fixed)
Capital can adjust labor market is in equilibrium. See Topic 2 on
economic growth. For the following analysis consider K fixed.
Plott (ECON 221) Spring 2014 10 / 28
Aggregate Supply Curve in the Long Run (LRAS)
In the Long-Run, the labor market always clears (We are at N).
Define: LRAS (full-employment level of output) gives the level of
output Y associated with N :
Y = AF(K ,N ,Raw Materials)
Note: slight modification (inclusion of raw materials; e.g., oil)
LRAS Curve is vertical at Y – the potential level of GDP. N is the level ofoutput generated when the economy employs N . Also know as the FE(full-employment) line.
N= hours worked in labor market equilibrium(W
P
)equilbrium
What shifts the LRAS: N or A (by definition K is fixed in the long-runsave for some natural disaster like an earthquake)
Plott (ECON 221) Spring 2014 11 / 28
Notes on the Potential Level of GDP (Y ) and LRAS
The Equilibrium level of Y is not necessarily optimal: tax distortions
can mean Y is lower than is economically efficient. Equilibrium just
means balance between private costs and benefits (in this case to
household supply of labor and firm demand for labor). At an
equilibrium, there is no incentive for people to change their behavior.
The Equilibrium is not constant: changes to A, K and N change Y , and
hence shift the LRAS. Y trends upward in most countries (because A
and K and population grow over time – shifting out N). Many
economists believe its growth rate is fairly stable.
Plott (ECON 221) Spring 2014 12 / 28
Aggregate Supply Curve in the Short Run (SRAS)
The Short-Run Aggregate Supply Curve (the relationship betweenoutput and prices) in the short-run is positive.
If firms get a demand shock, they may chose to produce more (at a givenfixed nominal wage) to satisfy demand. To take advantage of the higher
demand, firms may raise prices (optimally) which drives downW
P. The
lower real wages causes firms to optimally hire more labor – causingoutput to increase.NOTE: Nd has not shifted! Firms decide to meet the increase in demandfor their product by hiring more workers because of the lower real wage(as prices increase). In short-run, firms remain on their labor demandcurve, while workers are off their labor supply curve temporarily(workers have little bargaining power, options in the short-run).In the Short-Run there is disequilibrium in the labor market.NOTE: the textbook assumes a different SRAS firms always produce tomeet demand. See chapter 9 for details.
Plott (ECON 221) Spring 2014 13 / 28
Notes on AS in Short-Run
If firms get a positive demand shock (demand for goods increase),
firms will raise prices and keep labor costs fixed. This will reduce real
wages causing firms to hire more labor and produce more.
The Short-Run AS curve slopes upwards because and increase in
prices reduces real wages and causes firms to higher more workers and
consequently to produce more.
Consequence, N > N and Y > Y and u < u
u = current unemployment rateu = Natural Rate of Unemployment (only frictional and structural, nocyclical unemployment)
See text for a discussion of the utilization rate of labor (and capital).
Plott (ECON 221) Spring 2014 14 / 28
Notes on AS in Short-Run (Continued)
What Shifts the SRAS curve?
SRAS = F(A,K ,N , raw materials).
K is fixed save for a natural disaster
A is exogenous (i.e. I tell you when changes)
Raw materials is the new twist. Anything that effects the nominal price of
raw materials will effect the quantity of raw materials purchased and will
shift the short-run AS. For every given labor and capital – if the price of
raw materials get more expensive, firms will produce less (i.e. oil prices).
Nominal wages will adjust between the short-run and the long-run that
will cause the SRAS to shift between the short-run and the long-run.
For our discussion – only input prices (nominal wages and nominal oil
prices) and technology will shift the SRAS. Higher costs of production
means SRAS will shift leftward, ceteris paribus.
Plott (ECON 221) Spring 2014 15 / 28
The Self-Correcting Mechanism
Let us focus on SRAS. It has a better link to the labor market.
When the economy is in short-run disequilibrium (Yshort-run not equal
to Y ), the economy will naturally move towards Y .
Reason: the labor market will eventually clear. The reason that Y does
not equal Y is because N does not equal N . As soon as the labor
market clears, we will be back at N .
How does the labor market eventually clear? Workers will not continue
to work off their labor demand supply for long periods of time.
Plott (ECON 221) Spring 2014 16 / 28
The Self-Correcting Mechanism (Continued)
When N > N , workers will be working more than their desired amount
and will require the firm to raise nominal wages (W ) so as to
compensate them for their additional effort. Doing so, will cause labor
market to clear.
But, if W increases, the SRAS will shift in (the cost of production has
increased).
The exact opposite will work when N < N .
As the labor market starts to clear, the SRAS will adjust to bring us back
to Y .
Plott (ECON 221) Spring 2014 17 / 28
Notes on SRAS (Continued)
Some Macroeconomists (starting from Keynes) had the notion that prices
are fixed in the short-run. This is a second type of SRAS. It is costly to keep
changing your prices when faced with every given shock. As a result, prices
in the market tend to change slowly. Think about the price of milk at
Walgreens or Jewel-Osco. Macroeconomic conditions are changing all the
time and the price of milk – over the last half-year has been approximately
$1.79 per quart.
In this case firms keep prices and wages fixed and just meet demand by
requiring workers to work a little harder sometimes and a little less hard
during other times. This is how they meet changes in demand without
changing prices. It adds a dimension to our problem: utilization rate of labor
(and an associated concept labor hoarding).
In this case the labor market isn’t really in equilibrium at all in the short-run.
In such a case prices are fixed and the SRAS curve is horizontal.
NOTE: we will work with both the upward sloping (short-run) and the
horizontal (Keynesian) SRAS curves.
Plott (ECON 221) Spring 2014 18 / 28
Neoclassical Approach to AD−AS
Money neutrality in the Long-Run. However the Short-Run is very
"short". Prices and wages are assumed to adjust quickly and markets
are in equilibrium.
This approach faces two main empirical obstacles.1 Disequilibrium in the Labor Market (i.e. Unemployment is > 0 and
counter-cyclical).2 Money has real effects in the short-run (Money is non-neutral to real
outcomes – even Friedman admits it – and leads the cycle. Increasing Mincreases Y above Y ).
Can we match these two facts and maintain that there is no
sluggishness in prices and wage adjustments?
Plott (ECON 221) Spring 2014 19 / 28
Neoclassical Approach to AD−AS (Continued)
Solution to 1: Unemployment is justified by search frictions and
reallocation of workers to new business or industries. This requires
time and produces unemployment.
Solution to 2: Misperceptions theory (Milton Friedman and RobertLucas). Because of costs in collecting information concerning thenature of price changes in the economy, agents may be fooled bynominal shocks into considering aggregate price hikes as increases inrelative prices of the goods they produces (shock to the demand of thegoods they produce) and hence they supply more goods. However, ifchanges in money supply (and hence prices) are expected all theinformation will be immediately incorporated and no mistake will bemade (rational expectations [more on this in Topic 7]).
The misperceptions theory: an unexpectedly low price level leads somesuppliers to think their relative prices have fallen, which induces a fall inproduction.
Plott (ECON 221) Spring 2014 20 / 28
Neoclassical Approach to AD−AS (Continued)
Alternative explanations to arrive at an upward sloping SRAS curve:
The sticky-wage theory: an unexpectedly low price level raises the realwage, which causes firms to hire fewer workers and produce a smallerquantity of goods and services.The sticky-price theory: an unexpectedly low price level leaves somefirms with higher than desired prices, which depresses their sales andleads them to cut back production.
Plott (ECON 221) Spring 2014 21 / 28
One Caveat on the Shape of the SRAS Curve
The shape of the SRAS curve is believed not to be linear.
The shape of the SRAS curve looks more curved; going from left to
right it is flat then becomes much steeper.
It is bounded at some "technological constraints".
It flattens out at low levels of output.
Plott (ECON 221) Spring 2014 22 / 28
What is Equilibrium for the Economy?
Short-Run equilibrium:
AD = SRAS & IS = LMThe Labor Market need not be in equilibrium (nominal wages are sticky,remember).We need not be at the potential level of GDP.
Long-Run equilibrium:
AD = SRAS = LRAS = Y & IS = LM = FE = Y & Nd = N s = NIn the long-run, by definition, we will move to Y .In the long-run, by definition, the labor market will clear.
Plott (ECON 221) Spring 2014 23 / 28
More on Equilibrium
Equilibrium is a point of attraction for the economy.
Most macroeconomists believe that, in the absence of shocks, the
economy would reach equilibrium after perhaps 5 years. Thus the
economy is in equilibrium in the "long-run" (after 5 years).
Is the economy ever in long-run equilibrium?
Given that shocks are always hitting, the economy is not likely to be in
long-run equilibrium at any point in time. Yet the force of attraction of
equilibrium keeps the economy hovering around the equilibrium.
Note: there are alternative theories we will briefly discuss in Topic 7.
Why is the long-run equilibrium point attractive?
Because there the labor market clears. Away from Y workers are not on
their labor supply curve (and firms may be off their labor demand
curve). Maximizing behavior by workers and firms push the economy
towards long-run equilibrium. Shocks push the economy away
temporarily.
Plott (ECON 221) Spring 2014 24 / 28
How Do We Represent Recessions?
Unofficial definition – two consecutive quarters of negative real GDP growth. Remember
the NBER officially dates recessions using more involved criteria.
Our model: Y < Y
We define the output gap as Y −Y s−req
Remember: Y trends upward overtime (even though in our model – we have it constant –
population growth, K grows (we abstract from these trends in our model), TFP is growing
every period). It makes things easier to keep Y constant initially.
Our model removes the trends in N and K due to population growth and K (by
assumption).
To put things in perspective: all economic models in courses like ECON 221 or the
upper-level electives (e.g. ECON 331 or ECON 333) only use, at most, static-deterministic
general equilibrium models. Eventually to have more complete models you would need
dynamic stochastic general equilibrium (DSGE) models . . . but then you hate life because
that means you are in grad school.Questions for the rest of class:
What causes recessions?Why would the fed be concerned about inflation when Y < Y s−r
eq ?How do we get out of recessions once we are in them?Can the economy correct itself?
Plott (ECON 221) Spring 2014 25 / 28
Where Do Recessions Originate?
Temporary or Permanent changes in technology (or productivity); i.e.,
productivity shocks, drought?
Shocks to Expectations (individual beliefs about the future); i.e., stocks
are overvalued, a recession will be coming (self-fulfilling prophesies),
etc.
Increases in relative prices of inputs (like oil prices; e.g., the 1970s)
Bad (or good) Economic Policy (monetary or fiscal)
External Crises ( for small open economies). [More on this in Topic 8]
Plott (ECON 221) Spring 2014 26 / 28
Analysis of the Business Cycle: Examples
We now start analyzing shocks to the economy that move it away from
full-employment output.
In the examples that follows such shocks are permanent. You can also
study their temporary counterparts.
Convention: the initial "shocked variable" (say, G, M , consumer
confidence, etc.) has a "2" subscript (example if I tell you we are
increasing G then we move from G1 to G2 where G2 > G1).
Plott (ECON 221) Spring 2014 27 / 28
Some Examples
1974 Recession: OPEC – rapid increase in oil prices
1980 Recession: OPEC II – Iranian Revolution
1982 Recession: "Good" Fed Policy (Volker’s Recession)
1990 Recession: Consumer Confidence
1990s Japan: End to speculative bubbles, bad policy, debt overhung
and liquidity traps
2001 Recession: Consumer Confidence (Burst of Stock Market bubble
– The Economist "The Kiss of Life?").
2009 Recession: Credit Crunch and Home Prices Collapse
Plott (ECON 221) Spring 2014 28 / 28