Principles of Macroeconomics Professor Jeffrey Nilsen. The Economy in the Short Run Chapters 20 - 24. Chapter 20 Short-term Economic Fluctuations. If you’ve lost your job in recession, you won’t care that living standards will improve in long-run from gdp growth
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Principles of MacroeconomicsProfessor Jeffrey Nilsen
The Economy in the Short Run
Chapters 20 - 24
Trough
Peak
Trough
Peak
C= 100 + ¾ (Y – T)
spending
income
Consumption
function
mpc
1
C = 100 + ¾ (Y – T)
Induced
Expenditure
(depends on
income)
Autonomous
(independent
of income)
PAE = 325 + ¾ Y
Slope:mpc
(same as in consumption function)
Rise in autonomous expenditure
shifts expenditure line up
Autonomous
Expenditure
Output or income too small for PAE (not enough inventories) so firms raise output
Output or income too large for PAE (too many inventories) so firms cut output
When Y rises by 100, PAE rises only by (mpc * 100) or 75
income
PAE
PAE
Y = 1500
PAE =1450
mpc
325
Keynesian Cross
1500
At Y = 1500:
Y > PAE
C+I+G+NX > C+IP+G+NX
I > IP
Firms building up inventory
so cut Y
YSR.EQBM
Y output
300
1200
1300
Y = 1220
¼ Y = 285
Y = 1140
PAE
mpc
PAE =1300
285
Y = 1140
1500
305
Y = 1220
Y*
PAE
mpc
PAE =1300
325
If i = 0 => PAE = 325 + ¾ Y Y > Y*
Then BNB raises rates to 5%
Y = 1300
1500
305
Y = 1220
Y*
r
r*
π*
π
Flat slope => Fed weakly cuts π (higher π gives small r rise)
Steep slope => Fed aggressively raises r to slow π
Rise in i increases opportunity cost of holding M
=> MD curve downward sloping
If Y rises, MD shifts out (people wantto hold more M
at each interest rate
MS is determined by the central bank (and banks & public)
MS
MS
iLO
Money market eqbm occurs
where MS = MD
If iLO, MD > MS(excess demand for money)
Bonds must offer higher i, so people cut MD
MS
If central bank wants to expand MS to cut i,
it executes open market purchases
MS shifts outward and i falls
If central bank wishes to raise interest rates, it will undertake open market sales
B
r
π
PAE
A
A
A.D.
r*
Monetary
Policy
Rule
B
π*
Y
Y
π
PAE declines due
To higher r => lower
SR EqbmY
If inflation rises, Fed raises r
(from A to B)
r
PAE
A
B
C
r*
Monetary
Policy
Rule
A
π*
Y
π
B
π**
A.S.
π
A
π*
Y*
Y
Low Inflation
Slower rise in
W & production
costs
Low expected
inflation
Vicious cycle:
higher π leads to higher πe and thus
accelerating firms’ costs => still higher π
A.S. Curve
π
B
A
π1
Y*
Y
Let inflation expectations = π1
If output gap = 0, π = π1
If output gap > 0 (B), π> π1
If output gap < 0 (C) , π< π1
C
Y
Y
A.S. Curve
B
π
A
π1
πe rise, AS rises parallel since any output
gap has same effect on actual π
Y*
Y
π2
Adverse πshock, e.g. higherimported oil
P (has effect on all sectors)
(C.f. favorable πshock shifts AS downward
A.S.
π
A
π1
Y*
Y
LRAS
A.D.
A.S.
π
A
π2
Y*
Y
Adjustment to LR eqbm
LRAS
A.D.
2
π1
1
YSR-EQBM
A.S.
π
A
π1
Y
Y*
1
LRAS
A.D.
3
π2
2
2
1
Y2
3
YSR-EQBM
A.S.
π
A
π1
Y
Y*
1
LRAS
A.D.
3
π2
2
2
1
1
Y2
YSR-EQBM
3
π
A
π1
(Simplified to ignore effects on AS curve)
Y
Y*
1
LRAS
A.D.
2
π2
2
1
Y2
YSR-EQBM