SGPE Summer School: Macroeconomics Lecture 8 · Lecture 8. Questions: • What causes short-term...

SGPE Summer School:

Macroeconomics

Lecture 8

Questions:

• What causes short-term fluctuations in production and

employment?

• Is there a choice between low inflation and low

unemployment?

Part 2: The Short Run

2

Introduction: Growth 1961-2011 (GDP fixed

prices)

-5

0

5

10

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

GDP growth UK

GDP growth uk

-5

0

5

10

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

GDP growth US

GDP growth us

3

Introduction: Inflation 1950-2011

-5

0

5

10

15

20

25

19

50

19

55

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

Inflation UK

inflation uk

-5

0

5

10

15

20

25

19

50

19

55

19

60

19

65

19

70

19

75

19

80

19

85

19

90

19

95

20

00

20

05

20

10

Inflation US

inflation us

4

• Long run:

– Prices and wages flexible (that is, adjust to shocks)

– Production/employment is in equilibrium

– Supply factors determine production

– Real interest rate is equal to the natural interest rate

• Short run:

– Prices and wages are sluggish

– Production/employment can deviate from equilibrium

– Aggregated demand determines production

– Expected real interest rate can deviate from the natural rate

Introduction to Part 2

5

Introduction to Part 2

Plan:

• Interest and production in the short run

(the IS-LM model)

• Economic activity and inflation in the short run

(the Phillips curve)

6

The IS-LM model:

• A formalisation of Keynes's ideas

• Shows how the nominal interest and production

(income) are determined with a given price level

• Analyses the interaction between the goods and money

markets

The interest rate and aggregate demand:

The IS-LM model (Chapter 8)

7

Aggregate demand: The IS-LM model

We already have the two equations that make up the

IS-LM model:

• IS equation – goods market equilibrium

• LM equation – money market equilibrium

Y =C Y,Y e,r,A( )+ I r,Y e,K( )

M

P=Y

V (i)

r = i-p e

8

Aggregate demand: The IS equation

9

Aggregate demand: The IS equation

Effect of increased willingness to invest

Multiplier effect: The increase in production will be

greater than the original demand increase

10

Aggregate demand: The IS equation

The multiplier:

• Investments increase

• Production/incomes increase

• Consumption increases

• Production/incomes increase…

Total effect:

where c is the marginal propensity to consume (MPC)

DY = DI +cDI + c2DI + c3DI +... =1

1- cDI

11

Aggregate demand: The IS equation

What is the effect of an increase in the interest rate?

Here we also have a multiplier effect

12

Aggregate demand: The IS equation

13

Aggregate demand: The IS equation

The IS curve:

• Shows demand & production for each interest rate level

• Has a negative slope because a higher rate of interest

leads to lower consumption and investments

• The slope is determined by how much the interest rate

affects C and I and the size of the multiplier

• Changes in interest and production lead to movements

along the IS curve

• Changes in exogenous variables ( ) lead to shifts

of the IS curveY e ,p e etc.

14

Aggregate demand: The IS equation

The IS curve and long-term equilibrium production

(note that )i = r+p e

If

production will be

on the natural

level

If

production will be

below the natural

level

i = rn +p e

i > rn +p e

15

Aggregate demand: The IS equation

mathematically

Consumption function:

Investment function:

Goods’ market equilibrium:

C = a0+a

1Y +a

2Y e -a

3r+a

4A

I = b0-b

1r+b

2Y e -b

3K

Y = a0+a

1Y +a

2Y e -a

3r+a

4A+b

0-b

1r+b

2Y e -b

3K

Y 1-a1( ) = a0

+b0- a

3+b

1( )r+ a2+b

2( )Y e +a4A-b

3K

Y =a

0+b

0

1-a1

-a

3+b

1

1-a1

r+a

2+b

2

1-a1

Y e +a

4

1-a1

A-b

3

1-a1

K

16

Aggregate demand: The IS equation - example

Effect of an increase in interest rate:

The size of the effect depends on:

• The interest rate sensitivity of consumption and

investments (a3+b1)

• The multiplier that depends on the marginal propensity

to consume (a1)

Y =a

0+b

0

1-a1

-a

3+b

1

1-a1

r+a

2+b

2

1-a1

Y e +a

4

1-a1

A-b

3

1-a1

K

DY = -a

3+b

1

1-a1

Dr = -1

1-a1

a3+b

1( )Dr

17

Aggregate demand: The LM equation

Household assets:

• Money

• Loans to companies

• Shares in the companies, which we assume they retain

The interest rate adjusts so that

supply = demand on loans, which is the same as

supply = demand on money:M

P=Y

V (i)

18

Aggregate demand: The LM equation

19

Aggregate demand: The LM equation

An increase in the money supply leads to a drop in the

interest rate

The central

bank can

influence the

interest rate by

changing the

money supply

20

Aggregate demand: The LM equation

With a given money supply, an increase in production

causes the interest rate to rise

21

Aggregate demand: The LM equation

22

Aggregate demand: The LM equation

The LM curve:

• Shows what the interest rate will be for each level ofproduction

• Slopes upwards since higher production leads to moretransactions and an increased demand on money

• The slope is determined by how production andinterest rate affect the demand on money

• Changes in production and interest rate lead tomovements along the LM curve

• Changes in exogenous variables (like M) lead to shifts ofthe LM curve

23

Aggregate demand: Equilibrium in the IS-LM

model

Goods’ market equilibrium

Consumption function

Investment function

Money market equilibrium

Four endogenous variables: Y, C, I, and i

Y =C+ I

M

P=Y

V (i)

C =C Y,Y e, i-p e,A( )

I = I i-p e,Y e,K( )

24

Aggregate demand: Equilibrium in the IS-LM

model

25

Aggregate demand: Equilibrium in the IS-LM

model

(IS)

(LM)

A: Both markets in equilibrium

B: Goods’ market not in

equilibrium (Y must go down)

C: Money market not in

equilibrium (i must go up)

Y =C Y,Y e, i-p e,A( )+ I i-p e,Y e,K( )

M

P=Y

V (i)

26

Aggregate demand: Equilibrium in the IS-LM

model

How to use the IS-LM model to analyse the effects of a

change in some exogenous variable:

• Determine whether disturbance shifts IS and/or LMcurve(s) and draw new curves in the diagram

• From the diagram, read what is the effect on interestrate and production (if they are going up or down)

• Present an economic explanation for what is happeningin the goods’ and money markets (direct and indirecteffects)

• Investigate and explain the effects on other variables(employment, consumption, investments, etc.)

27

Aggregate demand: Equilibrium in the IS-LM

model

What happens if the money supply increases ( )?0M

28

Aggregate demand: Equilibrium in the IS-LM

model

What happens if consumers and investors become more

optimistic about the future ( )?DY e > 0

29

Aggregate demand: How do we know if the

model is right?

There are many studies of microdata that show that prices

are sluggish.

It is harder to use macroeconomic data to test the model.

30

Aggregate demand: How do we know if the

model is right?

How can we test if monetary policy has any effects on the

real economy?

• Study the correlation between changes in interest rateand changes in production?

• Carry out experiments with monetary policy?

• Use statistical methods (VAR) to identify effects of‘exogenous’ shocks to the interest rate. Studies usingthis method suggest that monetary policy hassubstantial effects on GDP

31

Aggregate demand: Effects of an unexpected

change in the interest rate in the USA

32