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Economics 154

Economics 154. Business Cycles and the IS-MP Model. Let’s review our voyage to date:. We have analyzed: Measuring economic activity Aggregate production functions and distribution Classical AS and AD (flexible w and p) Financial macro (including money) Open-economy macro.

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Economics 154

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  1. Economics 154 Business Cycles and the IS-MP Model

  2. Let’s review our voyage to date: We have analyzed: • Measuring economic activity • Aggregate production functions and distribution • Classical AS and AD (flexible w and p) • Financial macro (including money) • Open-economy macro

  3. Major approaches to business cycles Classical: market clearing: supply-side cycles with vertical AS curve: • “Misperceptions”theories of Lucas: largely extinct • Real business cycles: major active classical species today Keynesian and offshoots: non-market clearing with non-vertical AS • Essential to have non-classical AS • Fixed or sticky p and w; AD shifts affect output and employment • Different people combine these in different ways (monetarist, fiscal, open economy...) Basic models in Keynesian approach • “Keynesian cross” (Econ 116) • AS-AD (Econ 116) • IS-MP (Econ 154) Open-economy in short run: Mundell-Fleming (154, later in course)

  4. Recall our earlier “matrix of schools” • We discussed classical approach • We now turn to mainstream Keynesian model

  5. “When you hear the term business cycles, what picture do you see in your mind?” Paul Samuelson: “Note that the pattern of cycles is irregular. No two business cycles are quite the same. No exact formula, such as might apply to the revolutions of the planets or of a pendulum, can be used to predict the duration and timing of business cycles. Rather, in their irregularities, business cycles more closely resemble the fluctuations of the weather.”

  6. Understanding business cycles Major elements of cycles • short-period (1-3 yr) erratic fluctuations in output • pro-cyclical movements of employment, profits, prices, productivity • counter-cyclical movements in unemployment • appearance of “involuntary” unemployment in recessions, depressions • often involve disturbances in financial markets (credit, foreign exchange, bank panics, …) Historical trends • lower volatility of output, inflation over time • movement from stable prices to rising prices since WW II • lower unemployment rates after WW II, but no clear trend

  7. Are cycles alike?

  8. The “Great Moderation” Major decline in the volatility of GDP Definition of volatility (often used in finance): the standard deviation of returns or rates of growth, usually at an annual rate.

  9. IS-MP diagram r = real interest rate MP(Y; π-1, e, π*) E r* IS(G, T0, …) Y* Y = real output (GDP)

  10. You are responsible for the AS-AD and “Keynesian cross” models, but we will only present the IS-MP in class. Brief reminder on AS-AD Brief reminder on Keynesian cross (now) and Mundell-Fleming (in month or so)

  11. Keynesian Cross Diagram: Output where planned expenditure equals output Expenditures Equilibrium output C+I+G+NX E* Y* Real output (Y)

  12. AS-AD diagram Price (P) AS P* AD Y* Real output (Y)

  13. AD shift Price (P) AD shift from new equilibrium in IS-MP relation P* P** AD AD’ Y** Y* Real output (Y)

  14. Now let’s go back to the IS-MP analysis for some more cases.

  15. Real output targeting by the central bank Consider first case where Fed targets real output -This is realistic for a country with low and stable inflation Equivalent to vertical MP curve at potential output (forgetting about the lags). In this case, can you explain: - why increase in output raises interest rates and lowers bond and stock prices? - why “good real news is bad financial news.”?

  16. Output targeting case interest rate (r) MP Note strange impacts of IS shock r** r* IS’ IS Y Potential output

  17. Case 2. Small open economy with fixed ER Say you are President of the Central Bank of Belgium. What kind of macro analysis should you use for short run? Small open economy with fixed exchange rates (Mundell-Fleming model with fixed exchange rates and mobile financial capital) Other extreme of IS-MP model: flat MP curve: - With real interest rates at world levels given exogenously, you get full impact of fiscal (IS) shocks and monetary policy is passive. - In more subtle view, monetary policy is devoted to ensuring equality of domestic and foreign interest rates. We will review in a couple of weeks.

  18. Small open economy interest rate (r) IS IS’ rw MP 0 Y* Y**

  19. Case 3. Liquidity trap These are cases where monetary policy is ineffective and “only fiscal policy matters”. The liquidity trap. Today, this is taken to be where nominal interest rate is zero and Fed “runs out of bullets.” • The US in the mid-1930s • Japan over last decade with i = 0. • US may be approaching liquidity trap today.

  20. Liquidity trap in US in Great Depression

  21. Japan short-term interest rates, 1994-2006 Liquidity trap from 1999 to early 2006

  22. Is the US approaching liquidity trap?

  23. Liquidity trap interest rate (i) IS MP MP’ Y*=Y*’

  24. Summary on IS-MP Model This is the workhorse model for analyzing short-run impacts of monetary and fiscal policy Key assumptions: - Fixed or rigid prices - Unemployed resources Now on to analysis of Great Depression

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