Lecture III Keynesian ModelLecture III Keynesian Model

Keynes’ General Theory, by all accounts, is Keynes’ General Theory, by all accounts, is difficult to understanddifficult to understand

For this reason, Keynes’ ideas have come down to For this reason, Keynes’ ideas have come down to us filtered through the eyes of those that either us filtered through the eyes of those that either were there when the ideas were being worked out were there when the ideas were being worked out or by later writers that have more or less guessed or by later writers that have more or less guessed at what the “great master” had in mindat what the “great master” had in mind

In this way, Keynes is very much like Jesus Christ, In this way, Keynes is very much like Jesus Christ, whose words and meaning have come to us whose words and meaning have come to us through the “apostles”; although in the case of through the “apostles”; although in the case of Keynes, we do have his actual writings to fall Keynes, we do have his actual writings to fall back onback on

What Keynes was proposingWhat Keynes was proposing

He was trying to work out a new way of looking at He was trying to work out a new way of looking at the economy that could explain the existence of the economy that could explain the existence of widespread unemployment when so many people widespread unemployment when so many people were willing to work for wages well below the were willing to work for wages well below the market wagemarket wage

He referred to this phenomenon as “involuntary” He referred to this phenomenon as “involuntary” unemploymentunemployment

The classical view was that this cannot occur; the The classical view was that this cannot occur; the wage rate will simply fall to the equilibrium wage wage rate will simply fall to the equilibrium wage and all markets, including the labor market, will and all markets, including the labor market, will be in equilibriumbe in equilibrium

Thus general equilibrium at full employment is Thus general equilibrium at full employment is maintainedmaintained

The idea of “effective” The idea of “effective” demanddemand

Keynes begins with the notion that aggregate Keynes begins with the notion that aggregate demand for the goods and services in the demand for the goods and services in the economy can be decomposed into two parts: a economy can be decomposed into two parts: a part that depends on the level of output and a part that depends on the level of output and a second part that is exogenoussecond part that is exogenous

Thus, D = D1(Y) + D2Thus, D = D1(Y) + D2 We can think of these two as D1(Y) = C and D2 = We can think of these two as D1(Y) = C and D2 =

I, which is exogenous to YI, which is exogenous to Y Unlike classical theory, Keynes does not really Unlike classical theory, Keynes does not really

look upon investment demand as depending look upon investment demand as depending strongly on the interest rate, although that will strongly on the interest rate, although that will not be a major problem to his modelnot be a major problem to his model

Keynes on investmentKeynes on investment

It is critical to his theory to understand how he felt It is critical to his theory to understand how he felt about the decision to invest or notabout the decision to invest or not

He viewed investment decisions by firms and He viewed investment decisions by firms and entrepreneurs as dependent on their “animal entrepreneurs as dependent on their “animal spirits”, that is, once businesses are frightened off spirits”, that is, once businesses are frightened off from the market, perhaps due to continued losses from the market, perhaps due to continued losses sustained by themselves and other investors, it may sustained by themselves and other investors, it may be next to impossible to convince them to returnbe next to impossible to convince them to return

As a sidebar, much of the discussions we here today As a sidebar, much of the discussions we here today about what to do after the financial crisis, concerns about what to do after the financial crisis, concerns the “credibility” of central banks actions; more on the “credibility” of central banks actions; more on this laterthis later

IS-LM modelIS-LM model

John Hicks in John Hicks in Mr. Keynes and the “Classics”Mr. Keynes and the “Classics” first introduced the IS-LM analysisfirst introduced the IS-LM analysis

Some of Keynes’ contemporaries argued that Some of Keynes’ contemporaries argued that Keynes never used such models; however, Keynes never used such models; however, writings of Keynes discovered after his death writings of Keynes discovered after his death did find the he worked on such equationsdid find the he worked on such equations

The IS curve is the locus of points in i-Y space The IS curve is the locus of points in i-Y space at which the product market is in equilibrium at which the product market is in equilibrium while the LM curve does the same for the while the LM curve does the same for the loanable funds marketloanable funds market

The IS curveThe IS curve

Keynes starts with the premise that expenditures E Keynes starts with the premise that expenditures E = output Y = C + I in a closed economy with no or = output Y = C + I in a closed economy with no or limited governmentlimited government

C depends primarily on Y, but let’s suppose some C depends primarily on Y, but let’s suppose some saving is generated through a rise in I, so C = c(i,Y) saving is generated through a rise in I, so C = c(i,Y) which implies that S = s(i,Y) where Si and SY > 0.which implies that S = s(i,Y) where Si and SY > 0.

Investment depends only on I and Ii < 0Investment depends only on I and Ii < 0 Equilibrium requires that S = I or I – S = 0; Equilibrium requires that S = I or I – S = 0;

furthermore, for it to be maintained, the change in I furthermore, for it to be maintained, the change in I – S must = 0, so d(I – S) = Ii di – (Si di + SY dY) = 0– S must = 0, so d(I – S) = Ii di – (Si di + SY dY) = 0

Solving for di/dY, we get di/dy = SY dY/(Ii di – SY dY) Solving for di/dY, we get di/dy = SY dY/(Ii di – SY dY) < 0; thus, the IS curve is down-sloping< 0; thus, the IS curve is down-sloping

The LM curveThe LM curve

The demand for money depends on both Y and i, The demand for money depends on both Y and i, where people hold more money to finance where people hold more money to finance transactions at higher levels of Y and economize transactions at higher levels of Y and economize on money holdings as i riseson money holdings as i rises

The supply of money is either fixed or rises with i The supply of money is either fixed or rises with i say as financial institutions reduce excess say as financial institutions reduce excess reserves as the return on loans increasesreserves as the return on loans increases

Again, we need Demand for money L to equal M, Again, we need Demand for money L to equal M, the money supply and along the LM curve, d(L – the money supply and along the LM curve, d(L – M) = 0M) = 0

So, Li di + LY dY – Mi di = 0 and solver for di/dY So, Li di + LY dY – Mi di = 0 and solver for di/dY we get di/dY = LY/(Mi – Li) > 0 we get di/dY = LY/(Mi – Li) > 0

Graph of IS and LM curvesGraph of IS and LM curves

IS LM Curves

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IS-LM in equation formIS-LM in equation form

E = A + cY – ai = Y, so (1 – c)Y = A – ai E = A + cY – ai = Y, so (1 – c)Y = A – ai Real money demand M/P = mY – bi = Ms/P for monetary Real money demand M/P = mY – bi = Ms/P for monetary

equilibriumequilibrium Thus, i = [mY – Ms/P]/b; substituting into first equation we getThus, i = [mY – Ms/P]/b; substituting into first equation we get (1 – c)Y = A – a[mY – Ms/P]/b(1 – c)Y = A – a[mY – Ms/P]/b Solving for Y we get [1 – c + (a/b)m] Y = A + (a/b)(Ms/P)/b Solving for Y we get [1 – c + (a/b)m] Y = A + (a/b)(Ms/P)/b

andand Y = A/[1 – (c – m(a/b))] + Ms/P[1/[m + (b/a)(1-c)]Y = A/[1 – (c – m(a/b))] + Ms/P[1/[m + (b/a)(1-c)] Keynes assumed both consumption and investment were Keynes assumed both consumption and investment were

relatively insensitive to i (that is, a is small) and demand for relatively insensitive to i (that is, a is small) and demand for money was very sensitive to i when rates are close to 0 (that money was very sensitive to i when rates are close to 0 (that is, b is large)is, b is large)

These two imply that changes in the money supply have very These two imply that changes in the money supply have very little influence on aggregate supply while the Keynesian little influence on aggregate supply while the Keynesian multiplier is close to 1/(1-c)multiplier is close to 1/(1-c)

The Keynesian consol The Keynesian consol exampleexample

A consol is a perpetuity bond that pays a fixed amount each period, say a A consol is a perpetuity bond that pays a fixed amount each period, say a yearyear

S = ∑1/(1+r)S = ∑1/(1+r)nn, n = 1, ∞ = 1/(1+r) + 1/(1+r), n = 1, ∞ = 1/(1+r) + 1/(1+r)22 + … + 1/(1+r) + … + 1/(1+r)nn + … + … (1+r)S = 1 + S => (1+r)S – S = rS = 1 and S = 1/r(1+r)S = 1 + S => (1+r)S – S = rS = 1 and S = 1/r So I pay $20 for this consoleSo I pay $20 for this console If the rate falls to 4%, I make $5, or 20% return for a 1% drop in interest If the rate falls to 4%, I make $5, or 20% return for a 1% drop in interest

rates; if r goes up to 6%, on the other hand, the price falls to $16.67 and I rates; if r goes up to 6%, on the other hand, the price falls to $16.67 and I lose $3.33 or 16.67%lose $3.33 or 16.67%

What if the interest rate is near 0%? The rate can hardly fall, so the next What if the interest rate is near 0%? The rate can hardly fall, so the next move in interest rates must be upward; that is, I can only lose money (or move in interest rates must be upward; that is, I can only lose money (or stay the same) if I buy a consol nowstay the same) if I buy a consol now

But I can earn the same return by simply hoarding my cashBut I can earn the same return by simply hoarding my cash This Keynes referred to as the zero-bound or the liquidity trapThis Keynes referred to as the zero-bound or the liquidity trap

The Keynesian Model in The Keynesian Model in Undergraduate EconomicsUndergraduate Economics

Let Y = C + I = a + cY + I, a and I are exogenously Let Y = C + I = a + cY + I, a and I are exogenously determineddetermined

Then at equilibrium Ye = [1/(1–c)](a + I), and 1/(1-c) = k, Then at equilibrium Ye = [1/(1–c)](a + I), and 1/(1-c) = k, the Keynesian multiplierthe Keynesian multiplier

Now suppose Ye < Yp, potential, or full-employment, outputNow suppose Ye < Yp, potential, or full-employment, output Keynes argued that government should fill the expenditure Keynes argued that government should fill the expenditure

gap, which he referred to as the recessionary gap.gap, which he referred to as the recessionary gap. Now Y = a + cY + I + G, and we assume the government Now Y = a + cY + I + G, and we assume the government

expenditures do not affect a, c, or I.expenditures do not affect a, c, or I. Then solving for Ye gives Ye = k(a + I + G) which is greater Then solving for Ye gives Ye = k(a + I + G) which is greater

than the previous equilibrium outputthan the previous equilibrium output So if kG = (Yp – Ye), so the recessionary gap is g = 1/k(Yp – So if kG = (Yp – Ye), so the recessionary gap is g = 1/k(Yp –

Ye)Ye)

Example 1Example 1 Y = C + I = 400 + .6Y + 1000 = 1400 + .6Y Y = C + I = 400 + .6Y + 1000 = 1400 + .6Y

and solving for Y gives [1/(1-c)] (a +I0) = and solving for Y gives [1/(1-c)] (a +I0) = (1/.4)(1400) = 2.5*1400 = 3500, and k = 2.5(1/.4)(1400) = 2.5*1400 = 3500, and k = 2.5

Keynesian Cross Diagram

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We see that AD = AS at the equilibrium AS of 3500

Now if I declines to 900, AD will decline Now if I declines to 900, AD will decline by k*d(AD) = - 250, so AD = 3250 by k*d(AD) = - 250, so AD = 3250

This is shown on the Keynesian cross This is shown on the Keynesian cross diagram belowdiagram below

To restore the equilibrium level of AD to To restore the equilibrium level of AD to the desired 3500 we need add G = 100 the desired 3500 we need add G = 100 and we will be back to the original AD and we will be back to the original AD curvecurve Keynesian Cross Diagram

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I = 900

When I = 1000, we see that AD = AS at the equilibrium AS of 3500

Aggregate demand for I = 900; AD = AS at AS = 3250

What about budget deficits?What about budget deficits?

David Ricardo considered the case of debt financing of David Ricardo considered the case of debt financing of government expenditures and conjectured that, if the government expenditures and conjectured that, if the public perceived the increase in debt as a future tax public perceived the increase in debt as a future tax liability, it might elect to save more, even and equal liability, it might elect to save more, even and equal amount to the debt, as a way to pay the future liabilityamount to the debt, as a way to pay the future liability

Apparently, Ricardo rejected the idea of such foresight Apparently, Ricardo rejected the idea of such foresight of the public, but the notion, called the Ricardian of the public, but the notion, called the Ricardian Equivalence Theorem, still bears his nameEquivalence Theorem, still bears his name

But let’s suppose we decide to finance the But let’s suppose we decide to finance the expenditures with lump-sum tax todayexpenditures with lump-sum tax today

Then Y = a + c(Y – T) + I + G, T = G is a lump-sum taxThen Y = a + c(Y – T) + I + G, T = G is a lump-sum tax

Lump-sum tax multiplierLump-sum tax multiplier

Now our model is Y = a + c(Y – T) + INow our model is Y = a + c(Y – T) + I00 + G, where + G, where

T = G T = G Then solving for YThen solving for Y

ee we get Y we get Yee = [1/(1-c)](a – cT + I = [1/(1-c)](a – cT + I

00

+ G) = [1/(1-c)] (a + I+ G) = [1/(1-c)] (a + I00 + G – cG) = [1/(1-c)][a + I + G – cG) = [1/(1-c)][a + I

00 + +

(1-c)G] = [1/(1-c)] (a + I(1-c)G] = [1/(1-c)] (a + I00) + G, since T = G ) + G, since T = G

Thus, the “balanced budget multiplier” is 1; if the Thus, the “balanced budget multiplier” is 1; if the government spends an amount just equal to Ygovernment spends an amount just equal to Y

pp – –

YYee equilibrium is restored at full employment equilibrium is restored at full employment

Income Tax financingIncome Tax financing

Since taxes are collected from individuals and not the country Since taxes are collected from individuals and not the country as a whole (since passage of the 16as a whole (since passage of the 16thth amendment in 1909), a amendment in 1909), a more realistic model ismore realistic model is

Y = a + c(Y – tY) + I + G, tY = GY = a + c(Y – tY) + I + G, tY = G Then Y(1 – c + tc) = Y(1 – c(1 – t)) = a + I + G, so YThen Y(1 – c + tc) = Y(1 – c(1 – t)) = a + I + G, so Yee = 1/[1 – = 1/[1 –

c(1-t)] (a + I + G) and k* = 1/(1-c(1-t)) is smaller than beforec(1-t)] (a + I + G) and k* = 1/(1-c(1-t)) is smaller than before Thus the recessionary gap has increased to 1/k*(Thus the recessionary gap has increased to 1/k*( Y Ypp – Y – Yee))

In our earlier example, suppose t = .2, then k* = 1/(1 - .6(1 In our earlier example, suppose t = .2, then k* = 1/(1 - .6(1 - .2)) = 1/.52 or around 2- .2)) = 1/.52 or around 2

It appears we now need to increase G to 250/2 = 125It appears we now need to increase G to 250/2 = 125

Uh-oh!Uh-oh!

When we substitute the numbers back, they When we substitute the numbers back, they don’t work; Y = 2(a + I + G) = 2(400 + 900 don’t work; Y = 2(a + I + G) = 2(400 + 900 + 125) = 2850+ 125) = 2850

The reason is we collect too much in The reason is we collect too much in taxes; .2*2850 = 570, but we only need 125taxes; .2*2850 = 570, but we only need 125

So let’s let the model tell us the optimal tax So let’s let the model tell us the optimal tax rate t*; t*Y = G, which we also need to solve rate t*; t*Y = G, which we also need to solve forfor

The second equation is (1-c(1-t*))Y = a+I+G; The second equation is (1-c(1-t*))Y = a+I+G; so (1-.6(1-t*))3500 = 400+900+G = 1300+Gso (1-.6(1-t*))3500 = 400+900+G = 1300+G

Optimal t* and GOptimal t* and G

We get 3500 = (1/(.4+.6t*))(1300+G); but G = We get 3500 = (1/(.4+.6t*))(1300+G); but G = 3500t*3500t*

So we solve for t* in the following equation 3500 So we solve for t* in the following equation 3500 = 1/(.4+.6t*) (1300+3500t*)= 1/(.4+.6t*) (1300+3500t*)

Dividing both sides by 3500, we get 1=1/(.4+.6t*)Dividing both sides by 3500, we get 1=1/(.4+.6t*)(1300/3500+t*) so(1300/3500+t*) so

.4+.6t* = 1300/3500 +t* => .4t* = .4-13/35 .4+.6t* = 1300/3500 +t* => .4t* = .4-13/35 t* = 1-13/14 = 1/14t* = 1-13/14 = 1/14 G = t*(3500) = 3500/14 = 250!G = t*(3500) = 3500/14 = 250! The same answer as we got with a lump-sum taxThe same answer as we got with a lump-sum tax Thus, the balanced budget multiplier is again 1; is Thus, the balanced budget multiplier is again 1; is

this just a coincidence? Let’s see.this just a coincidence? Let’s see.

Solving using algebraSolving using algebra YYpp = a + c(Y = a + c(Ypp –t*Y –t*Ypp) + I + G; G = t*Y) + I + G; G = t*Ypp

So YSo Ypp = a + c(Y = a + c(Ypp –t*Y –t*Ypp) + I + t*Y) + I + t*Ypp

(1-c)Y(1-c)Ypp = a – ct*Y = a – ct*Ypp + I + t*Y + I + t*Ypp = (a + I) + t*Y = (a + I) + t*Ypp(1-c)(1-c)

Thus, YThus, Ypp = (a + I)/(1-c) + t*Y = (a + I)/(1-c) + t*Ypp = (a + I)/(1-c) + G = (a + I)/(1-c) + G

That is, Y changes 1 for 1 with G; the multiplier on G financed That is, Y changes 1 for 1 with G; the multiplier on G financed using the optimal tax is still 1using the optimal tax is still 1

In general, however, a proportionate tax does reduce the In general, however, a proportionate tax does reduce the multiplier to 1/(1 – c(1 – t))multiplier to 1/(1 – c(1 – t))

What about an open What about an open economy?economy?

With trade the equation becomes Y = a + c(Y With trade the equation becomes Y = a + c(Y – T) + I + X – M, where X = exports and M = – T) + I + X – M, where X = exports and M = importsimports

While exports are generally considered as While exports are generally considered as determined externally to our economy, determined externally to our economy, imports should grow with Yimports should grow with Y

In fact, it is often the case that fast growing In fact, it is often the case that fast growing economies are great exporters; just think economies are great exporters; just think about Chinaabout China

This issue will be covered later when we This issue will be covered later when we discuss the monetary approach to the discuss the monetary approach to the balance of paymentsbalance of payments

The general modelThe general model

Y = a + c(Y – tY = a + c(Y – t00 – t – t11Y) + I + G + X – MY) + I + G + X – M00 – mY – mY

Then Y – cY + ctThen Y – cY + ct11Y + mY = (1-c(1-tY + mY = (1-c(1-t11)+m) = a )+m) = a

+ I + G + X+ I + G + X In the literature, the right-hand side variables In the literature, the right-hand side variables

are called injections; savings, taxes and are called injections; savings, taxes and imports are referred to as leakagesimports are referred to as leakages

At equilibrium, injections must equal leakagesAt equilibrium, injections must equal leakages

How does the degree of openness How does the degree of openness affect the slope and location of the affect the slope and location of the

IS curve?IS curve?

The more open an open is economy the The more open an open is economy the less “bang for the buck”, that is the less “bang for the buck”, that is the additional leakage from imports increases additional leakage from imports increases the slope so that a monetary change – a the slope so that a monetary change – a movement along the IS curve – will have movement along the IS curve – will have less affect on Y and more on Iless affect on Y and more on I

The addition of export demand, say from The addition of export demand, say from greater world output, the further to the greater world output, the further to the right the IS curve will lieright the IS curve will lie

IS-LM ExercisesIS-LM Exercises

Exercise 1: Draw a set of IS-LM curvesExercise 1: Draw a set of IS-LM curves What is the effect of an increase in What is the effect of an increase in

Government spending?Government spending? What happens to equilibrium i and Y?What happens to equilibrium i and Y? Now, how can the Fed reduce crowding Now, how can the Fed reduce crowding

out?out? What now happens to equilibrium i and What now happens to equilibrium i and

Y?Y? What happens to the budget deficit?What happens to the budget deficit?

Exercise 2: Draw a set of IS-LM curvesExercise 2: Draw a set of IS-LM curves What is the effect of an increase in What is the effect of an increase in

central bank credit to lending central bank credit to lending institutions?institutions?

What happens to equilibrium i and Y?What happens to equilibrium i and Y? What happens to the budget deficit?What happens to the budget deficit? What happens to equilibrium i and Y?What happens to equilibrium i and Y?

The real wealth effects of The real wealth effects of deficitsdeficits

One issue with deficits financed by bond creation is One issue with deficits financed by bond creation is the public perception of their increased bond holdingsthe public perception of their increased bond holdings

At one end is the Ricardian Equivalence, which At one end is the Ricardian Equivalence, which believes that these holdings are viewed as both wealth believes that these holdings are viewed as both wealth and as a liability at its limit one for oneand as a liability at its limit one for one

At the other end of the spectrum is the belief that the At the other end of the spectrum is the belief that the public sees these bonds only as wealth and therefore public sees these bonds only as wealth and therefore will spend even more than the Keynesian model will spend even more than the Keynesian model predicts (although this effect was never included in the predicts (although this effect was never included in the model; we could show this as C = a + cY + gB, where model; we could show this as C = a + cY + gB, where B is the stock of government bonds held by the public)B is the stock of government bonds held by the public)

Since some of the expansion in the economy is Since some of the expansion in the economy is financed by increased tax revenues, the amount financed by increased tax revenues, the amount needed to be financed through bonds is reduced and if needed to be financed through bonds is reduced and if a portion of the bonds held increases private spending a portion of the bonds held increases private spending through the wealth effect, the negative impact of the through the wealth effect, the negative impact of the deficits can be reduced, making the Keynesian deficits can be reduced, making the Keynesian argument even strongerargument even stronger

Arguments for and against the Arguments for and against the wealth effect of government wealth effect of government

bondsbonds To the extent that future generations may be To the extent that future generations may be

impacted by the tax liability, the negative impacted by the tax liability, the negative Ricardian effect is reducedRicardian effect is reduced

Barro argues, however, that the fact that people Barro argues, however, that the fact that people bequeath wealth to their heirs indicates that they bequeath wealth to their heirs indicates that they care about the higher tax liabilities they are care about the higher tax liabilities they are leaving themleaving them

But some don’t care; either they have no heirs or But some don’t care; either they have no heirs or they figure the next generation will be so much they figure the next generation will be so much better off that they can pay the taxes themselvesbetter off that they can pay the taxes themselves

Plus the government can borrow more cheaply Plus the government can borrow more cheaply than the private sector, so the burden is reducedthan the private sector, so the burden is reduced

““Normal Case” with flexible wages and prices and no liquidity trapNormal Case” with flexible wages and prices and no liquidity trap

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With flexible wages and prices and the interest rate well above its lower boundthe economy adjusts to full-employment equilibrium via monetary policy alone

Flexible wage and prices; liquidity trap (inflexible r)Flexible wage and prices; liquidity trap (inflexible r)

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Pushing out the LM curve does not lower the interest, which is already at its lower bound.

““Almost” in a liquidity trapAlmost” in a liquidity trap

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With flexible wages and prices and the interest rate close to its lower boundthe economy adjusts to less than full-employment equilibrium via monetary policy alone

The Pigou EffectThe Pigou Effect

Arthur Pigou, a contemporary and (kind of) a Arthur Pigou, a contemporary and (kind of) a friend of Keynes, argued that the price friend of Keynes, argued that the price declines will increase the real wealth of the declines will increase the real wealth of the public and thereby increase their expenditurespublic and thereby increase their expenditures

Critiques are compelling: effect can be too Critiques are compelling: effect can be too slow; the fall in prices have negative effect on slow; the fall in prices have negative effect on business optimism; increased bankruptcies business optimism; increased bankruptcies reduce investment; postponement of reduce investment; postponement of consumption awaiting further price declines; consumption awaiting further price declines; etc. etc.

The Keynes-Pigou DebateThe Keynes-Pigou Debate Pigou may have won the intellectual debate, showing Pigou may have won the intellectual debate, showing

that the economy, given enough time and flexible that the economy, given enough time and flexible wages and prices, would return to full employment on wages and prices, would return to full employment on its ownits own

On the policy side, however, concerns about the speed On the policy side, however, concerns about the speed of adjustment (“In the long run we’re all dead”) led of adjustment (“In the long run we’re all dead”) led most western economies to adopt Keynesian style most western economies to adopt Keynesian style fiscal policiesfiscal policies

Even today, this is the most often used model by most Even today, this is the most often used model by most politicians and their staffspoliticians and their staffs

Central banks, on the other hand, have begun to use Central banks, on the other hand, have begun to use the alternative DSGE model for their analysesthe alternative DSGE model for their analyses

This incorporates more of the elements of rational This incorporates more of the elements of rational expectations and take into account the Lucas Critique expectations and take into account the Lucas Critique by allowing parameters of their models to adjust and by allowing parameters of their models to adjust and by disaggregating the economy into several sectorsby disaggregating the economy into several sectors

Even these models, however, are limited as to the Even these models, however, are limited as to the amount of disaggregation they employamount of disaggregation they employ

Open Economy & the Balance of Open Economy & the Balance of PaymentsPayments

Let’s look at the BP line where BOP = 0Let’s look at the BP line where BOP = 0 As Y increases a country wants to import As Y increases a country wants to import

moremore As i increases, more capital flows inwardAs i increases, more capital flows inward Thus as Y increases i must also increase to Thus as Y increases i must also increase to

maintain balance, so BP is positively slopedmaintain balance, so BP is positively sloped The slope depends on the interest elasticity The slope depends on the interest elasticity

of capital flows and the income elasticity of of capital flows and the income elasticity of imports; the more the interest elasticity of imports; the more the interest elasticity of capital flows, the smaller the adjustment in I capital flows, the smaller the adjustment in I needed to balance flows, so the flatter the BP needed to balance flows, so the flatter the BP curve; the greater the income elasticity of curve; the greater the income elasticity of imports the greater the interest rate change imports the greater the interest rate change needed to balance payments, so the steeper needed to balance payments, so the steeper the BP linethe BP line

Stimulative fiscal policy under Stimulative fiscal policy under a fixed exchange ratea fixed exchange rate

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IS'

ISY

Starting from an initial point of triple intersection of the IS, LM and BP curves.If the LM curve is steeper than the BP curve, then a positive fiscal stimulusincreases the interest rate by more than enough to compensate for the higher income and a BOP surplus results. The additional inflows of capitalmay push down the interest rate. Under fixed exchange rates, capital inflows increase the money supply and, assuming no sterilization of these flows,pushes out the LM curve to a new triple intersection at point C.

BP steeper than LMBP steeper than LM

BP LM

B

CA

IS'

ISY

If the LM curve is flatter than the BP curve, then a positive fiscal stimulusincreases the interest rate by less than enough to compensate for the higher income and a BOP deficit results. The outflow of capital decreasesthe money supply and and pulls inward the LM curve to a new triple intersection at point C.

Keynesian model and the Phillips Keynesian model and the Phillips CurveCurve

Keynes worked in real values since Keynes worked in real values since inflation was not an issue in times of inflation was not an issue in times of depression; if anything, prices felldepression; if anything, prices fell

But Keynesians had to address the issue of But Keynesians had to address the issue of what happened as the economy what happened as the economy approached full employmentapproached full employment

Let us look at the “stripped down” version Let us look at the “stripped down” version of the aggregate supply-aggregate of the aggregate supply-aggregate demand diagramdemand diagram

Price

AD'

Y = ASAD

In the original version, the economy is in one of two states: full employmentor less than full employment. In the latter case, the economy faces no priceincreases until it attains full employment, after which any shift in AD is metwith higher prices and no additional output

Price

AD"

AD'AD AS

In the revised version, there is an intermediate range in which prices risewith aggregate demand and supply. This range corresponds perfectly to thePhillips Curve. As AS increases in response to the outward shift in demand,prices rise as Y increases, ie unemployment decreases. This is the PhillipsCurve. So the publication of Phillips' article gave a story for Keynesiansto tell.

The Phillips ControversyThe Phillips Controversy

So the idea of a permanent and stable So the idea of a permanent and stable tradeoff relationship between inflation and tradeoff relationship between inflation and unemployment provided additional armor unemployment provided additional armor against attacks from those that would against attacks from those that would worry about the hyper-inflationary danger worry about the hyper-inflationary danger of permanent deficits or monetary of permanent deficits or monetary stimulusstimulus

In fact, a thorough reading of Phillips In fact, a thorough reading of Phillips himself shows that he did not intend for himself shows that he did not intend for the empirical results to be inerpreted by the empirical results to be inerpreted by policy makers as an excuse to inflate the policy makers as an excuse to inflate the economy so as to reduce unemploymenteconomy so as to reduce unemployment

Stagflation and the end of the Stagflation and the end of the Phillips CurvePhillips Curve

The events that occurred starting in 1970 The events that occurred starting in 1970 demonstrated that the critics were correct after demonstrated that the critics were correct after all; continued attempts to stimulate the economy all; continued attempts to stimulate the economy in the face of real supply side shocks took its toll in the face of real supply side shocks took its toll and inflation hit double digits with little effect on and inflation hit double digits with little effect on the unemployment ratethe unemployment rate

This period became known as stagflation, and This period became known as stagflation, and was only ended with the recession of 1981-83 was only ended with the recession of 1981-83 caused by Paul Volckercaused by Paul Volcker

During this recession unemployment hit 10% for During this recession unemployment hit 10% for the first time since the Great Depressionthe first time since the Great Depression

Now we are once again experiencing such high Now we are once again experiencing such high rate of unemploymentrate of unemployment

The vertical long-run Phillips The vertical long-run Phillips CurveCurve

The events in that began at the time of The events in that began at the time of stagflation led most economists to abandon the stagflation led most economists to abandon the conventional view and to adopt Friedman view conventional view and to adopt Friedman view that there is no long-run Phillips Curvethat there is no long-run Phillips Curve

Friedman viewed the relationship as a short-term Friedman viewed the relationship as a short-term fix that would eventually lead to expectations of fix that would eventually lead to expectations of inflation that would nullify the short-term benefits inflation that would nullify the short-term benefits

Later he adopted the rational expectations view Later he adopted the rational expectations view that even the short run Phillips Curve tradeoff that even the short run Phillips Curve tradeoff would disappear in favor of a vertical Phillips would disappear in favor of a vertical Phillips Curve at the permanent natural rate of Curve at the permanent natural rate of unemployment unemployment