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Chapter 20Short-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
- Ch. 21’s basic Keynesian Model explains business cycle caused by spending
- Ignores inflation
- Ignores economy’s longer term self-correction mechanisms

Expansion (boom): when Y grows significantly faster than normal

- Recession (contraction): when Y grows significantly slower than normal
- Depression: very long & severe recession

- Solving simultaneous equations?

Trough

Peak

Trough

Peak

Business Cycle is mis-named

- “Cycle” doesn’t actually occur at regular intervals but has irregular length & strength
- Difficult to know exactly when peak & trough occurs
- A single business cycle affects nearly all industries & may affect all nations

Potential (or “full-employment”)Output Y*

- The maximum sustainablereal GDP an economy can produce
- “Sustainable”: economy may be able to utilize its inputs above this rate for short time
- Y* grows over time due to growth in labor, capital and/or technological change

Causes of Recessions

- I. Slow Y growth, normal Y* growth(economy doesn’t fully use K & L available)
- Output gap (Y – Y*) arises: Y below Y* recession & high unemployment
- If Y above Y* gap positive, tendency for higher inflation
- Policy makers may want to “stabilize” economy (i.e. close output gap)
- II. Slow Y* growth due to slower growth in technology (or reduced K & L):
- If use K & L at normal rates, Y slows too
- ZERO Output gap
- Policy goal: promote saving, human capital & other investment to speed up Y* growth

Recession Features:

- High unemployment
- High U rate signals poor utilization of resources (labor willing but unable to work)
- Slow real wage growth
- Durable goods industries slow down more than nondurable goods industries
- Durable = “long-lasting” e.g. cars, houses

Unemployment Concepts

- Natural rate U* = frictional U + structural U
- U* changes over time; difficult to measure
- Cyclical U = U – U* (actual – natural U )
- Recessionary output gap Y < Y* so (U – U*) > 0, i.e. positive cyclical U
- Expansionary output gap Y > Y* so (U – U*) < 0, i.e. negative cyclical U
- When U = U* (natural rate), cyclical U = 0. No output gap exists

Reasons for U* Changes over time

- Internet job matching reduces frictional U
- Baby boom aging reduces both frictional & structural U:
- Older workers make fewer job changes
- Young more likely to change jobs, to not have requisite skills

Okun’s Law: Recessionary Output Gap brings Cyclical U

- Empirical estimate of relation between output gap & cyclical U:
- 1% cyclical U rise brings 2% fall in output gap
- (Y – Y*)/Y* = -2 (U – U*)
- If actual U = 7% & U* = 5% (high unemployment)
- Then output gap = – 4%
- Okun’s law specifies loss of GDP due to high U

Some GDP Fluctuations due to Output Gaps:

- Output gap due to fall in C or I or NX can be “closed” by rise in G
- Over time, output gap causes P changes
- Deflation from recessionary gap (workers willing to work for lower wages if out of work)
- Inflation from expansionary gap (workers want higher wages due to more jobs than workers)
- Firms’ P changes will eventually eliminate output gap (actual Y = Y*)
- Output then fixed by economy’s productive capacity, not spending

Preview: How Output Gaps Develop & Possible Policy Responses

- In short run, firm’s capacity (Y*) fixed by K & L in place
- Most sales changes due to fluctuating spending (not Y* changes)
- Evidence shows P adjusts slowly: Y ≠ Y*
- Firms estimate sales & pre-set appropriate P to “meet demand” (keeping P fixed in short run)
- In short run, spending (C + I + G + NX) determines Y
- In long run, firms change their Y* & also their P to be more appropriate to future expected demand

Chapter 21: Spending & Output in the Short Run

- Vicious cycles & the Keynesian Cross

Economic Model

- Implements theory’s explanation of an economic phenomenon
- Like a road map, it abstracts from details like mountains, buildings to give clear & simple info on the desired route
- Simplifying assumptions eliminate inessential details
- Express Keynesian Model’s ideas in:
- Precise words
- Tabular form
- Graphs
- Equations

Keynes’ ModelKey P Assumptions

- Short-run: firms meet demand using earlier-set P set (data shows realistic!!)
- Firms delay changing prices due to menu costs including:
- Market survey, managerial time to find “best” P
- Informing & perhaps angering customers with P changes
- Firm chooses to raise P if Benefits (additional revenues) > Menu costs

Keynes’ (Short run) Model

- Aggregate spending changes cause business cycles
- Story: planned aggregate expenditure PAE determines (actual) Y
- ActualYmay differ from (potential) Y*
- Fall in PAE leads to recessionary output gap
- Rise in PAE leads to expansionary output gap
- Policy goal to eliminate output gaps (“stabilization” policy)

PAE determines Y in short run

- PAEcomponents:
- C = consumption by households
- G = gov’t spending (no transfer payments)
- NX = net exports (EX – IM)
- Recall, imports subtracted, since counted in C, I, G
- PAE = C + IP + G + NX
- Assume actual C, G, NX = planned C, G, NX

Consumer Spending, CLargest part of PAEinfluenced by:

- Higher disposable income (Y – T) induces people to consume more
- Autonomous consumption (C unrelated to disposable income): rises when
- Confident: consume more, save less
- Greater wealth: stock boom increases wealth, consume more at each level of disposable income
- Lower interest rates: cuts borrowing cost so can buy cars and other consumer durables

Keynes Consumption Function

- Summarizes consumer spending motives
- : autonomous consumption
- mpc : “marginal propensity to consume” (rise in consumption due to next $1 of disposable income)
- With next dollar income, save part & spend part => mpc between 0 & 1

Planned & Actual Investment May Differ

- If Actualsales < Expected sales(sales disappointing) => (unsold) inventories rise
- I > IP(actual inventory investment greater than planned)
- If Actualsales > Expected sales (sales are good) firm’s inventories shrink
- IP > I (planned inventory investment greater than actual)

Keynesian Model’sVicious Cycle

- Production cut => lower income => spending cut => further production cut …
- If firms cut production, workers’ & owners’ incomes fall
- So workers & owners cut spending & production falls further
- Consumption function shows link from production& income to spending

C= 100 + ¾ (Y – T)

spending

income

From the Consumption Function to PAE

- LetC = 100 + ¾ (Y – T)
- Let G = 120, T = 100, IP = 200, NX = - 20
- Then PAE = C + IP + G + NX
- PAE = 100 + ¾ (Y – 100) + 200 + 120 + (- 20)
- PAE = 100 + ¾ Y – 75 + 200 + 120 – 20
- PAE = 325 + ¾ Y
- $1 higher income increases PAE by 0.75 (through the consumption function mpc again)

Induced

Expenditure

(depends on

income)

Autonomous

(independent

of income)

PAE or Expenditure Line

PAE = 325 + ¾ Y

Slope: mpc

(same as in consumption function)

Rise in autonomous expenditure

shifts expenditure line up

Autonomous

Expenditure

Short-Run Eqbm OutputUsing Table

- Eqbm when firms produce Y equalling PAE

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

Short run Eqbm OutputUsing Algebra

- PAE = 325 + ¾ Y
- Short run Eqbm requires PAE = Y, so
- Y = 325 + ¾Y
- ¼Y = 325 => Y = 1300

income

PAE

Y = 1500

Short run Equilibrium OutputCalculating by GraphPAE =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

PAE falls: a Recession is Born(worsened by Vicious Cycle)

- PAE = 325 + ¾ Y:
- Initial SR eqbm for Y* = 1300 and
- Output Gap (Y– Y*) = 0
- Shock: share prices fall, people feel poorer so
- Autonomous expenditure falls (assume to 300)
- => PAE line shifts down 25 (lower planned spending at each level of income)
- (Y* = 1300 still)
- Find new SR eqbm Y by algebra
- Y= 300 + ¾ Y => Y= 1200
- Y < Y*, now 100 recessionary gap

300

1200

1300

The Vicious Cycle (Income-Expenditure Multiplier)

- PAE’s Drop 25 caused Y to fall by 100
- «New» output gap since Y* constant
- Initial spending cut reduces output & income in all sectors. The drop in Y leads to further spending cuts
- Vicious Cycle: Initial spending cut reduces spending & income by multiple
- Size ofmultiplierrelatedtompc
- For given fall in spending, larger mpc => greater reduction in eqbm spending

Stabilization policy: adjust PAE to try to close output gap

- Fiscal (gov’t) or Monetary (ch 22) (central bank) Policy
- Expansionary Policy: goal to raise Y to close recessionary gap
- Contractionary Policy: to cut Y to close expansionary gap
- NO WAY to use stabilization policy to fight slow Y* growth recessions

Fiscal Policy: Change G

- Stock crash cuts spending by 25 and shifts down PAE line
- Gov’t raises spending by 25 to restore expenditure (PAE line shifts up to initial location)

Difficulties with Fiscal Policy

- 1. May not only affect PAE but also Y* (new highways may increase Y*)
- 2. Higher deficits raise interest rates to «crowd out» investment spending
- 3. INflexible
- Legislation time-consuming
- Gov’t may have conflicting goals (e.g. want economic expansion but to cut defense spending)
- Automatic stabilizers more flexible: in recession lower income cuts T while U payments rise

Problem 21.1

- Assume for Acme Corp:
- It produces 4,000,000 in goods and expects to sell all its output
- It plans to buy 1,500,000 in new equipment
- It has 500,000 in inventory at the beginning of the year
- What is actual & planned investment if:
- It actually sells 3,850,000 of goods
- It actually sells 4,000,000 of goods
- It actually sells 4,200,000 of goods

Problem 21.2Benjelloun Family

- Graph the family consumption functionand find their marginal propensity to consume
- How much would the family consume if their income was 32,000 and they paid taxes of 5,000
- Family wins a lottery so consumes more at each level of after-tax income (excluding prize). How does it affect the graph of their consumption function? Their mpc?

Problem 21.3, 21.4 & 21.5

- Economy described by equations:
- C = 1,800 + 0.6(Y-T)
- IP = 900
- G = 1,500
- NX = 100
- T = 1,500
- Y* = 9,000
- A. Find numerical equation linking PAE to output. Identify autonomous expenditure & induced expenditure
- B. Construct table to find short-run eqbm output (try from 8,200 to 9,000)
- C. Show short-run eqbm using Keynesian Cross
- D. Solve for short-run eqbm using algebra
- E. What is output gap%? If U* = 4%, use Okun’s Law to find actual U.
- F. Find effect on short-run eqbm Y of rise in gov’t purchases to 1,600

Chapter 22Stabilization: Monetary Policy & The Central Bank

- Central Bank policy decisions (changes in target interest rates) strongly influence financial markets & the macroeconomy
- Goal: to eliminate output gaps
- Monetary policy is more responsive than fiscal policy

The Central Bankin the Banking System

- Bank runs are chronic problem in fractional reserve banking system
- When many depositors try to withdraw at same time, bank reserves may go to zero (bank fails)
- If run, even profitable bank can fail
- Institutions set up to limit bank runs after great depression:
- Regulate banking system so banks sound
- Require banks to hold level of reserves
- Central bank ready to lend reserves to banks
- Deposits insured by gov’t so public should not fear loss

Policy Influences on PAEHigher rates cut:

- Consumption Spending(autonomous part): raises saving at any Y so cuts consumption at any Y
- PlannedInvestment: discourages firms from buying new capital (and public from building new homes)

Central Bank’s Influence on Interest Rates

- Influences nominal & also real interest rate (i – π = r) since inflation changes slowly
- Affects r only in short run (savings & investment determines r in the long run)
- BNB target rate: interbank rate (rate on very short-term loans of reserves from one bank to another)
- Open market operations strongly influence interbank rates (banks’ lending rates often follow interbank rate)
- Less influence over other market interest rates

IntroducingInterest Sensitive PAE

- Previously:
- C = 100 + ¾ (Y – T)
- G = 120, T = 100, IP = 200, NX = - 20
- PAE= C + IP + G + NX = 325 + ¾ Y
- Interest sensitive PAE by hh & firms:
- C = 100 + ¾ (Y – T) – 200 r
- IP = 200 – 200 r
- Unchanged:G = 120, T = 100, NX = - 20
- PAE = 100 + ¾ Y – 75 – 200 r + 200 – 200 r + 120 – 20
- PAE = [325 – 400 r] + ¾ Y
- Term in brackets is autonomous expenditure

PAE negatively related to interest rates

- PAE = [325 – 400 r] + ¾ Y
- If r = .05 (i.e. 5%), PAE= [305] + ¾ Y
- Short-run eqbm: Y = PAE so
- Y = [305] + ¾ Y
- If r = .10 PAE= [285] + ¾ Y
- Short-run eqbm: Y = 285 + ¾ Y

- ¼ Y = 305

Y = 1220

¼ Y = 285

Y = 1140

Recessionary Output Gap

- Assume r = 10% and Y < Y* (so high U)
- BNB cuts interest rate from 10% to 5%.
- Households & firms increase spending so PAE rises to close output gap

Expansionary Output Gap

- Persistent high demand induces firms to raise prices => inflation
- Central bank can raise real interest rate to slow economy and shrink (Y – Y*)

Expenditure Line shifts down with rise in interest rates

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*

A Monetary Policy Rule (MPR)

- Graph reflects systematic policy:
- To cut inflation, Fed raises r, PAE fall & Y falls via multiplier
- When low inflation (i.e. U high), Fed cuts r, PAE rises => Y rises via multiplier
- MPR summarizes relation of π changes to Fed policy r rate changes
- π*: target inflation rate
- When π = π*, Fed sets r = r*

Long run Targets of MPR

- Fed sets r* target at level where SNAT = Investment
- Fed chooses π*that brings best long-run Y* performance
- In short-run, π ≠ π*, so r ≠ r*

Central Bank alters Reserves to achieve r*

- To examine this, need to understand equilibrium in the market for money

Demand for Money (cash & checking accounts)

- Holding Money is in Portfolio Allocation Decision (family decides which assets to store wealth). Allocation depends on:
- Assets’ risk & return
- Liquidity preference (want some assets easy to spend)
- Benefit/Cost of Mdemand:
- Benefit: useful for transactions. Person with higher income holds more money (makes more transactions)
- Opportunity cost: could earn higher returns on other asset e.g. bonds (nominal interest rate on money = 0)

Macro Influences on Money Demand

- i (nominal rate): opportunity cost of holding money (vs. bonds)
- All interest rates tend to rise or fall together
- Y higher real income allows people to make more transactions so hold more M
- Pwith higher P level, need more money to buy same quantity of goods, so hold more M

Money Demand Curve

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

Money Supply

MS is determined by the central bank (and banks & public)

Money Market Eqbm

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

Monetary Expansion

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

Other Central Bank Instruments to Change MS

- Discount window lending: when banks lacking reserves borrow from BNB
- Discount rate: the rate BNB charges the commercial bank for a loan of reserves
- Vs. interbank interest rate, the rate one bank charges another for a loan of reserves
- Reserve Requirements: if BNB lowers rrr, commercial banks can make more loans with same amount of reserves

Problem 22.1, 2

- C = 2,600 + 0.8 (Y – T) – 10,000 r
- IP = 2,000 – 10,000 r
- G = 1,800
- NX = 0
- T = 3,000
- A. Find equation relating PAE to output
- B. Use equation method to find SR eqbm Y
- C. Show result using Keynesian Cross
- D. Suppose Y* = 12,000, what r would BNB set to have zero output gap?
- E. Show that r set in part D makes national savings = investment when Y = Y* (so r at zero output gap is consistent with S = I).

Problem 22.5

- During holiday season, all stores’ sales rise significantly.
- A. What will happen to the M demand curve during the holiday season ? Show on a graph.
- B. If BNB took no action, what would happen to nominal interest rates during holiday season ?
- C. How can BNB ensure that nominal interest rates will not change during the holiday season ? Show on graph.

Problem 22.7, 8

- How would M demand be affected by each phenomenon?
- A. Competition between brokers cuts commission charges for selling bonds & stocks
- B. Grocery stores begin to accept credit cards in payment.

Chapter 23Aggregate Demand & Aggregate Supply

- Vs. Keynesian Cross:
- Easy to compare Y vs. Y*
- Both short & long runs
- Includes inflation (price changes)

Aggregate Demand

- Firms produce what is needed to meet demand => PAE determines Y
- Summarizes negative linkage between Inflation & Y:
- Rise in inflation
- Central Bank increases r
- C and IP fall, so PAE falls
- Y falls

r

π

PAE

The Negative Linkage Inflation vs. GDP through policyA

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)

Shifts in A.D. Curve

- Curve shifts if any factor changes PAE at all π levels
- Consumption (wealth/confidence)
- Fiscal policy
- NX
- AD shifts outward if:
- Rise in Wealth: Autonomous consumption rises so PAE rises
- Rise in Gov’t spending

PAE

Monetary Policy also shifts A.D. curveA

B

C

r*

Monetary

Policy

Rule

A

- Fed may target higher or lower π level at its r*
- Fed accepts higher π at r* => expansionary policy
- So at current π*, Fed will cut r to expand PAE

π*

Y

π

B

π**

π

The A.S. relation:Y Changes Affect InflationA

π*

- Relation drawn for given level of πe
- Up-sloping since
- Y > Y* actual π > πe
- Y < Y*, actual π<πe

Y*

Y

Inflation Inertia

- Observed: Inflation remains roughly constant so long as output gap = 0 without any P shocks
- Inflation adjusts slowly due to:
- Forward nominal W & P setting includes
- Expected inflation
- For long term contracts, current inflation built into contracts
- Higher πe => input costs tend to rise faster
- Then firms must raise actual P to cover higher wage/material costs so higher πe leads to higher actual π
- πe influenced by recent experience of actual πin level& volatility

Inflation Inertia - 2

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

Output Gap and Inflation

- (Y – Y*) = 0: firms will raise prices to the extent that costs are rising
- => π remains at same level
- (Y – Y*) > 0: firms face demand in excess of their supply so they’ll raise P by more than cost increase
- => π will accelerate
- (Y – Y*) < 0: firms face excess supply so have incentive to cut P to sell more
- => π will decelerate

π

B

Deriving A.S. CurveA

π1

- π = πe + (change in π due to output gap)

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

B

π

A.S. Shifts UpA

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

π

A.S. – A.D. EqbmA

π1

- Conditions for eqbm:
- Y = Y*
- π = πe
- π = π* (policy target)
- This occurs where A.S. = A.D. = LRAS
- Short-run eqbm when A.S. = A.D.
- If AS = AD but not at LRAS, non-zero output gap (will disappear over time)

Y*

Y

LRAS

A.D.

π

A.S. – A.D. Short-run eqbmwith Expansionary GapA

π2

- SR eqbm at YSR & π1
- Y > Y* (expansionary gap)
- AD doesn’t move (since no change in central bank policy)

- Most firms, facing excess demand, raise P more rapidly than costs => general P level rises => π, πe ↑ AS shifts up
- Fed raises r to slow π using MPR => Y falls

Y*

Y

Adjustment to LR eqbm

LRAS

A.D.

2

π1

1

YSR-EQBM

π

Source of Inflation 1:Excessive Aggregate SpendingA

π1

- A case of “too much money chasing too few goods”

- Initially at , Y = Y*.
- G rise shifts AD out
- Y rises to Y2(expansionary gap (Y – Y*) & π rising to π2
- Without change in M policy, AD stays dashed position
- But π > πe so workers raise πe, shifting AS left to whereY returned to Y* (zero gap)

Y

Y*

1

LRAS

A.D.

3

π2

2

2

1

Y2

3

YSR-EQBM

Central Bank Can Prevent Excessive Aggregate Spending

- If Fed raises r after the G rise, AD will shift in due to lower C and IP

π

Source of Inflation 2:Adverse Inflation ShockA

π1

- Initially at , Y = Y*, π = πe =π*
- AS shifts left & π begins to rise
- Fed hikes r so Y falls (Y – Y*) < 0 & π rises to π2 (stagflation)
- Policy dilemma:
- Do nothing, falling P eventually returns Y to Y* back at (long recession)
- Expansion in fiscal or Monetary policy shifts AD to right, Y back to Y* but with higher π

Y

Y*

1

LRAS

A.D.

3

π2

2

2

1

1

Y2

YSR-EQBM

3

Money & Inflation

- Inflation does not always originate from excessive M growth
- But in absence of M easing, inflation dies out
- Sustained inflation requires easy M policy

Sources of Inflation 3:Adverse Y* shocks

A

π1

- Initially at , Y = Y*, π = πe =π*
- LRAS shifts left as Y* falls
- Y > Y* (expansionary output gap): π rises to π2 and Y falls
- Stagflation again
- Difference Y* and inflation shocks (both “AS shocks”)
- After adverse inflation shock, economy self-corrects
- After Y* shock, economy left at lower Y than prior to the shock, and it’s permanent

(Simplified to ignore effects on AS curve)

Y

Y*

1

LRAS

A.D.

2

π2

2

1

Y2

YSR-EQBM

Problem 23.4

- Economy initially in recession.What are costs and benefits of following policies?
- Expansionary monetary policy
- No change to monetary policy

Problem 23.5

- AD curve: Y = 13,000 – 20,000 π
- Initially π = 0.04 and Y* = 12,000
- A. Find inflation and output in SR eqbm.
- B. Find inflation and output in LR eqbm.

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