TOPIC 6

1. TOPIC 6 Putting the Economy Together: A Review (Mostly)

2. Money Supply (Summary) Remember: MS = [(cu + 1)/(cu + m*) ]* BASE Define Nominal Money Supply (Ms): Fed conducts monetary policy to increase Money Supply: - Open market purchases (increase Base) - Decrease the reserve ratio (decrease m) - Decrease the discount rate (decrease m*) - Decrease the interest rate on reserves (decrease m*) Also influenced by the public: - Bank runs (increase in cu) - Bank precautionary motives (increase in m* above m)

3. Money Market: Money Demand Our model for the demand for real money balances takes the following form: Md/P = Ld(Y, r + πe) where Md = demand for nominal money balances (demand for M1) Ld = demand for liquidity function P = aggregate price level (CPI or GDP deflator) Y = real income (real GDP) πe = expected inflation i = nominal interest rate on non-money assets • Reference: Supplemental Notes 8

4. Money Market Equilibrium Money Market Ms re Md = Ld(Y,πe) M/P

5. Interest Rates and Output There are two effects between interest rates and output: 1) The IS curve: As interest rates fall, Investment increases and Y increases. r falling causes Y to increase (negative relationship - the IS curve) 2) The transaction motive for holding money (the monetary feedback mechanism): As Y increases, demand for money increases and r increases. Y increasing causes r to increase (positive relationship - the LM curve)

6. Market 2 (Goods Market) - IS/LM Y = Output = Aggregate Supply (optimizing firm behavior) Y = Expenditures = C + I + G + NX = Goods Demand IS curve - a quick review….. • How does the demand side of the economy change when interest rates change? • As real interest rates increase, I falls (user cost of capital rises), Y falls. • The above is how we modeled investment (firms optimize - user cost) • C and G (and NX) do not change with interest rates (NX likely will, but we will defer that for now). So, as r changes, total demand in the economy will increase. • In {Y, r} space, the demand for output slopes downward - we call this the IS curve.

7. IS - Curve IS Curve = Y = C + I + G + NX = Y = C(.) + I0(.) – dIr + G + NX(.) r Y I = f(r); C and G are not Will discuss NX(.) later in course

8. Investment/Savings (IS) Remember: Snational = I + NX Further SHH + (T - G - Tr) = I + NX The IS Curve basically says that the investment in the economy must equal the savings. A fall in r today (all else equal), will cause I to increase, which will cause Y to increase. An increase in Y today (all else equal - including holding future Y constant), will cause S (private) to increase today - causing r to fall.

9. What Shifts the IS curve (review)? Things that will shift the IS curve to the Right • Through higher C(.) demand: • higher A • higher PVLR (including wealth effects) • higher Tr or lower T • higher consumer confidence and/or lower uncertainty • magnitudes depend on type of consumers • Through higher I0(.) demand: • higher A (permanent) • higher business confidence and/or lower uncertainty • lower liquidity constraints on banks (less credit crunches) • higher investment tax credits • Through higher G demand: higher G • Through higher NX(.) demand: discuss later in class

10. The LM (Liquidity-Money) Curve LM Curve: (drawn in (Y-r) space) - represents the relationship of Y and r through the money market (specifically - Y’s affect on money demand). The LM Curve relates real interest rates to real changes in output in the money market. As Y increases - Md shifts upwards - causing real interest rates to rise (increase in transactions demand increases the demand for money). Key Insight: What shifts the LM curve? Money: Increasing Money Supply increases M/P causing the LM curve to the right. Prices: Increasing Prices causes real Money Balances to fall shifting LM curve to the left. πe: Increasing expected inflation causes returns on bonds (assets other than money) to increase making it less attractive to hold cash. Causes LM curve to shift right!

11. IS-LM Equilibrium Y* = f(N*,K,A) r LM = f(M,P,πe) re IS = f(G,PVLR,taxes,Af) Y* Y

12. Understanding the IS-LM Equilibrium: M increasing Suppose M increases…. r LM = f(M0) LM = f(M1) M increases re 0 1 r1 IS = f(G) rz z Y* Y Y1

13. Understanding the IS-LM Equilibrium: G increasing Suppose G increases…. Y* = f(N*,K,A) r LM = f(M,P,πe) G increases 1 r1 re z 0 IS = f(G1) IS = f(G0) Y* Y Yz Y1

14. Understanding the IS-LM Equilibrium: P decreasing Suppose P decreases…. r LM = f(P0) LM = f(P1 < P0) P decreases re 0 1 r1 IS = f(G) rz z Y* Y Y1

15. The Aggregate Demand Curve You may not have realized it yet, but we just made an aggregate demand curve! The AD curve is drawn in {Y,P} space. It represents how the demand side of the economy responds to a change in prices. See the previous slide-- we just did this! As P decreases (holding everything else fixed - including M), M/P will 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). 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/P is 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.

16. What Shifts the AD curve? • Remember - the AD curve represents the demand side of the economy: Y = C+I+G+NX Key Insights: • 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. Example: Nominal money (M) increases, r will fall, I will increase, AD will shift right. With changes in money: LM shifts right Move along the IS curve Interest rates fall I increases AD shifts right. A change in prices will cause the LM curve to shift - but, will cause a movement along the AD curve.

17. Shifting the AD curve (an example) P G increases P0 AD1 AD Y0 Y1 Y • Suppose prices are held fixed (at P0). • Suppose that G increases and the Fed does not change M. • This implies that M/P will not change (i.e., the LM curve is fixed). • An increase in G will shift out IS curve. This will cause Y to increase. • An increase in G will lead to an increase in Y, holding P fixed. • The AD curve will shift right!

18. Market 3: The Supply Side (a review) Labor Market Review: Ns(PVLR,taxes,value of leisure, population) W0/P0 Nd(A,K) N* What is set in this market: N* (and real wages).

19. Some Definitions In Short Run (N adjusts, but it need not be at N*, K is fixed!) • Nominal Wages are ‘Sticky’ (although firms can adjust prices). • W is fixed, but not W/P (because firms can adjust P) • K by definition is fixed! Because Wages are sticky in Short Run, the labor market can be in ‘disequilibrium’ – i.e., labor demand need not equal labor supply (cyclical unemployment can occur). In Long Run (N adjusts to N*, K is fixed) • We will be at N* (labor market is in equilibrium), but capital still does not adjust. (K is fixed!) In Really Long Run (Growth - N adjusts to N* and K is not fixed!) • Capital can adjust, labor market is in equilibrium • Reference: Supplemental Notes 9

20. Aggregate Supply Curves in the Long Run (LRAS) In the long run, the labor market clears! (We are at N*) Define: LRAS (full employment level of output) gives the level of output Y* associated with N*: Y* = A F(K, N*, Raw Materials). Note Slight Modification (inclusion of raw materials) LRAS Curve is vertical at Y* - the potential level of GDP. Y* is the level of output generated when the economy produces N*. Also known as the FE (full employment) line. (w/p)* = the real wage in labor market equilibrium N* = hours worked in labor market equilibrium What shifts the Long Run AS Curve? N*, A or raw material prices (by definition K is fixed in long run)

21. Notes on the Potential Level of GDP (Y*) 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, raw material prices 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.

22. The Long Run AS Curve LRAS P, r Y Y*

23. The Aggregate Supply: Short Run 1 The Short Run Aggregate Supply Curve (the relationship between output and prices) in the short run is positive. Firms, if they get a demand shock, may chose to produce more (at a given fixed nominal wage) to satisfy demand. To take advantage of the higher demand, firms may raise prices (optimally) which drives down W/P. The lower real wages causes firms to optimally hire more labor - causing output to increase. NOTE: Nd has not shifted!!!!!!Firms decide to meet the increase in demand for their product by hiring more workers because of the lower real wage (as prices increase). In short run, firms remain on their labor demand curve, while workers are off their labor supply curve temporarily (workers have little bargaining power, options in the short run). There is disequilibrium in the labor market!

24. The Short Run AS Curve (SRAS) - The Intuition 1. Labor Demand Curve 4. Short Run Aggregate Supply W/P0 P1 As prices increase, W/P falls P0 W/P1 N0 N1 Y0 Y1 3. 45 degree line 2. Production Function Y1 Y0 Y0 N0 N1 Y0 Y1

25. Aggregate Supply in the Short Run (Part 1) Labor Market Review: Ns W0/P0 W0/P1 Nd N* N’

26. Notes on AS in Short Run (Part 1) 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. Key insight: the Short Run AS Curve slopes upwards because an 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 rate U* = Natural Rate of Unemployment (only frictional and structural, no cyclical unemployment)

27. More Notes on AS in Short Run (Part 1) What Shifts the SRAS curve? SRAS = F(A, K, N, raw materials). o K is fixed o A is exogenous (i.e., I tell you when A changes) o Raw materials are the new twist (raw material prices are also exogenous): - Anything that effects the nominal price of raw materials will affect the quantity of raw materials purchased and will shift the short run AS. For every given unit of labor and capital - if the price of raw materials get more expensive, firms will produce less (ie, oil prices). o 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 – Nominal wages and shifters of labor demand (like TFP and raw material prices) will shift the SRAS. Remember we are off our labor supply curve in the short run.

28. The Expenditure - Output Equilibrium (AD, AS) Y* = f(N*,K,A) P SRAS(1) = f(input prices) Pe AD = f(G,PVLR,taxes,Yf,M,Πe) Y* Y

29. The Self-Correcting Mechanism When the economy is in long run disequilibrium (Y (short run) not equal Y*), the economy will naturally move towards Y*. Reason: 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. When N > N*, workers will be working more than their desired amount and will require the firm to raise nominal wages (W) to compensate them for their additional effort. Doing so, will cause labor market to clear. But, if W increases, the short run AS 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*.

30. Let the Fun Begin! Examples and rules - bring lots of extra pages - we are going to do lots of examples! o Why did the 1991 recession occur? o How about the 1975 recession occur? 0 How about the 1982 recession? What if I wanted to run for president? Suppose I had control of the Money Supply - What could I do in the short run? What about the long run? What did the tech boom in the 1990s do to the economy? Why did Greenspan ‘RAISE’ interest rates in 2000? What was he thinking?

31. Foreshadowing: How Do I Start These Problems? 1. I look at the Supply Side of the Economy (I like to know where the economy will end up in the long run). o What happened to labor demand, labor supply, and long run aggregate supply? • I, then, look at the Demand Side and SRAS. A. Did IS or LM change? B. Did AD change? C. Did SRAS change? Then I need to look at how the labor market will be represented in the short run! Remember, in the short run, the labor market could be in disequilibrium (on the labor demand curve but off the labor supply curve: W is fixed but P is adjusting). In the long run - we always end up at Y* and Y* is determined in the labor market (along with A).