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Slides 3

Slides 3. After the Second Midterm Exam. Long Run Classical Model. Price is flexible The long run AS (LRAS) curve is vertical Price adjusts and output remains unchanged when AD curve shifts Output changes only when LRAS curve shifts; recession occurs when L or K falls

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Slides 3

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  1. Slides 3 After the Second Midterm Exam

  2. Long Run Classical Model • Price is flexible • The long run AS (LRAS) curve is vertical • Price adjusts and output remains unchanged when AD curve shifts • Output changes only when LRAS curve shifts; recession occurs when L or K falls • Monetary and fiscal policies are useless since they only cause AD curve to shift

  3. Short Run Keynesian IS-LM Model • Price is sticky • The short run AS (SRAS) curve is horizontal • Output adjusts when AD curve shifts • AD curve shifts to left (and recession happens) when money supply falls, G falls, C falls, or I falls. • Typically recession starts with crash in stock or housing market, which causes C or I to fall.

  4. Keynes’ View on Policy • Policy is needed because • animal spirit • self-destructing deflation • people cannot wait; In long run we all die. This view is in sharp contrast to the classical model’s view that policy is useless.

  5. Sometimes Policy Becomes Less effective For example, expansionary monetary policy becomes less effective when • nominal interest rate is close to zero (liquidity trap) • IS curve gets steeper (after MPC falls) • money creation slows down

  6. 2007-2009 Recession: I

  7. 2007-2009 Recession: II • Case study on page 326 • Low interest rate + community reinvestment act→ subprime borrowers → bubble in housing market • Bubble burst in 2007 →mortgage defaults → banks in trouble→money creation slows down • C and I fall → Recession

  8. 2007-2009 Recession: III Government’s reaction: • Fed cuts federal fund rate • Treasury bailouts the banking system

  9. SRAS Curve Revisited • The view that SRAS curve is horizontal is extreme • A more general view is that SRAS curve is upward-sloping (Chapter 12), so both output and price rise when AD shifts to right. • Sticky-Price model

  10. Expectation and Policy • Policy is more effective if it is unexpected • For example, unexpected rise in money supply causes output to rise in short run • Expectedrise in money supply has no effect on output in short run • In long run change in money supply has no effect on output.

  11. Quantitative Easing (QE) • http://www.youtube.com/watch?v=PTUY16CkS-k Discuss: what is QE? why is QE needed? what is the short run consequence of QE? what is the long run consequence of QE?

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