Macroeconomics Lecture 8.

Macroeconomics Lecture 8 Part 2: The Short Run Questions: • What causes short-term fluctuations in production and employment? • Is there a choice between low inflation and low unemployment? 2 Introduction: Growth 1961-2011 (GDP fixed prices) GDP growth UK 10 5 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 -5 1960 0 GDP growth uk GDP growth US 10 5 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 -5 1960 0 GDP growth us 3 Introduction: Inflation 1950-2011 Inflation UK 25 20 15 10 5 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010 1985 1980 1975 1970 1965 1960 1955 -5 1950 0 inflation uk Inflation US 25 20 15 10 5 1985 1980 1975 1970 1965 1960 1955 -5 1950 0 inflation us 4 Introduction to Part 2 • Long run: – – – – Prices and wages flexible (that is, adjust to shocks) Production/employment is in equilibrium Supply factors determine production Real interest rate is equal to the natural interest rate • Short run: – – – – Prices and wages are sluggish Production/employment can deviate from equilibrium Aggregated demand determines production Expected real interest rate can deviate from the natural rate 5 Introduction to Part 2 Plan: • Interest and production in the short run (the IS-LM model) • Economic activity and inflation in the short run (the Phillips curve) 6 The interest rate and aggregate demand: The IS-LM model (Chapter 8) The IS-LM model: • A formalisation of Keynes's ideas • Shows how the nominal interest and production (income) are determined with a given price level • Analyses the interaction between the goods and money markets 7 Aggregate demand: The IS-LM model We already have the two equations that make up the IS-LM model: • IS equation – goods market equilibrium Y = C (Y,Y e, r, A) + I ( r,Y e, K ) r =i-pe • LM equation – money market equilibrium M Y = P V (i) 8 Aggregate demand: The IS equation 9 Aggregate demand: The IS equation Effect of increased willingness to invest Multiplier effect: The increase in production will be greater than the original demand increase 10 Aggregate demand: The IS equation The multiplier: • • • • Investments increase Production/incomes increase Consumption increases Production/incomes increase… 1 DI 1- c Total effect: where c is the marginal propensity to consume (MPC) DY = DI + cDI + c 2 DI + c3DI +... = 11 Aggregate demand: The IS equation What is the effect of an increase in the interest rate? Here we also have a multiplier effect 12 Aggregate demand: The IS equation 13 Aggregate demand: The IS equation The IS curve: • Shows demand & production for each interest rate level • Has a negative slope because a higher rate of interest leads to lower consumption and investments • The slope is determined by how much the interest rate affects C and I and the size of the multiplier • Changes in interest and production lead to movements along the IS curve • Changes in exogenous variables (Y e , p e etc. ) lead to shifts of the IS curve 14 Aggregate demand: The IS equation The IS curve and long-term equilibrium production (note that i = r + p ) e If i = r n + p e production will be on the natural level i > rn + p e If production will be below the natural level 15 Aggregate demand: The IS equation mathematically Consumption function: C = a0 + a1Y + a2Y e - a3r + a4 A Investment function: I = b0 - b1r + b2Y e - b3 K Goods’ market equilibrium: Y = a0 + a1Y + a2Y e - a3r + a4 A+ b0 - b1r + b2Y e - b3 K ( ) ( ) ( ) Y 1- a1 = a0 + b0 - a3 + b1 r + a2 + b2 Y e + a4 A- b3 K a0 + b0 a3 + b1 b3 a2 + b2 e a4 Y= r+ Y + AK 1- a1 1- a1 1- a1 1- a1 1- a1 16 Aggregate demand: The IS equation - example Y= a0 + b0 a3 + b1 b a +b a r + 2 2 Y e + 4 A- 3 K 1- a1 1- a1 1- a1 1- a1 1- a1 Effect of an increase in interest rate: a3 + b1 1 DY = Dr = a3 + b1 Dr 1- a1 1- a1 ( ) The size of the effect depends on: • The interest rate sensitivity of consumption and investments (a3+b1) • The multiplier that depends on the marginal propensity to consume (a1) 17 Aggregate demand: The LM equation Household assets: • Money • Loans to companies • Shares in the companies, which we assume they retain The interest rate adjusts so that supply = demand on loans, which is the same as supply = demand on money: M Y = P V (i) 18 Aggregate demand: The LM equation 19 Aggregate demand: The LM equation An increase in the money supply leads to a drop in the interest rate The central bank can influence the interest rate by changing the money supply 20 Aggregate demand: The LM equation With a given money supply, an increase in production causes the interest rate to rise 21 Aggregate demand: The LM equation 22 Aggregate demand: The LM equation The LM curve: • Shows what the interest rate will be for each level of production • Slopes upwards since higher production leads to more transactions and an increased demand on money • The slope is determined by how production and interest rate affect the demand on money • Changes in production and interest rate lead to movements along the LM curve • Changes in exogenous variables (like M) lead to shifts of the LM curve 23 Aggregate demand: Equilibrium in the IS-LM model Y =C+I Goods’ market equilibrium C = C (Y,Y e,i - p e, A) Consumption function I = I (i - p e,Y e, K ) Investment function Y M = P V (i) Money market equilibrium Four endogenous variables: Y, C, I, and i 24 Aggregate demand: Equilibrium in the IS-LM model 25 Aggregate demand: Equilibrium in the IS-LM model Y = C (Y,Y e,i - p e, A) + I (i - p e,Y e, K ) Y M = P V (i) (IS) (LM) A: Both markets in equilibrium B: Goods’ market not in equilibrium (Y must go down) C: Money market not in equilibrium (i must go up) 26 Aggregate demand: Equilibrium in the IS-LM model How to use the IS-LM model to analyse the effects of a change in some exogenous variable: • Determine whether disturbance shifts IS and/or LM curve(s) and draw new curves in the diagram • From the diagram, read what is the effect on interest rate and production (if they are going up or down) • Present an economic explanation for what is happening in the goods’ and money markets (direct and indirect effects) • Investigate and explain the effects on other variables (employment, consumption, investments, etc.) 27 Aggregate demand: Equilibrium in the IS-LM model What happens if the money supply increases (M  0 )? 28 Aggregate demand: Equilibrium in the IS-LM model What happens if consumers and investors become more optimistic about the future (DY e > 0 )? 29 Aggregate demand: How do we know if the model is right? There are many studies of microdata that show that prices are sluggish. It is harder to use macroeconomic data to test the model. 30 Aggregate demand: How do we know if the model is right? How can we test if monetary policy has any effects on the real economy? • Study the correlation between changes in interest rate and changes in production? • Carry out experiments with monetary policy? • Use statistical methods (VAR) to identify effects of ‘exogenous’ shocks to the interest rate. Studies using this method suggest that monetary policy has substantial effects on GDP 31 Aggregate demand: Effects of an unexpected change in the interest rate in the USA 32