IntroductionDefinition and importance of macro economics• Economics can also be viewed, as the social science concerned with

the problem of using scarce resources to attain the maximum fulfillment of society’s unlimited wants.

• Subject matter of economics is divided in to 2 parts: Macro and Micro economics

• Study of macro economics is important for its own sake ….it tells how the economy as a whole works

• What is true and valid in the case of an individual may not be true and valid for the whole economy.

• Eg great depression and wage cuts….wage cuts may be valid valid to increase employment for the single firm..but may not be valid for the whole economy

• Also savings to the individual and savings for the whole economy….individual savings increase incomes, while whole society savings may lead to “the paradox of thrift”

• Paradox of thrift:-more savings than before lead to decrease of aggregate demand leading to a lower savings

• Initial increase in savings will not only lead to a lower national income and output but eventually will even depress the savings of the society as a whole….hence lesser investments. Important nature of macroeconomic issues

• Macro economic problems include: Unemployment, inflation, exchange rates.

• Unemployment is a waste of resources and potential outputs.• Inflation erodes real incomes or the purchasing power of the people• Inflation redistributes incomes in favor of the rich and thus creates

more income inequalities. • Depreciation of domestic currency encourages capital flight and

increases the prices of imports and thereby adds to inflationary pressures in the economy

• Macro economics explains the causes of such important problems and helps in formulating economic policies to tackle them. Macro economics summarized in three models

• The study of macroeconomics is organized around three models that describe the world as follows:

• i) The very long run: concerned with the long run behavior of the economy. It is the domain of growth theory, which

focuses on the growth of productive capacity i.e the factors of production and the technology that firms use to produce goods and services.

• ii) The long run: here the product capacity is treated as given. The level of productive capacity determines output, and fluctuations in demand relative to this level of supply determine prices and inflation.

• iii) The short run: where fluctuations in demand determine how much of the available capacity is used and thus the level of output and unemployment

National Income ACCOUNTING• We start the lecture by quickly reviewing what you learned in DBA

104• It will be important for you to follow through the lecture carefully as

this will form the basis for our discussions in the subsequent lectures.• We shall consider the circular flow of income for a two sector

economy and how Gross Domestic Product (GDP) is measured. Finally we shall look at weaknesses of GDP as a measure of standards of living.

• National Income Accounting refers to the measurement of aggregate economic activities, particularly national income and its components.

• GDP is often considered the best measure of how well the economy is performing.

• The goal of GDP is to summarize in a single number the monetary value of economic activity in a given period of time.

• The value of final output produced in a given period, measured in the current prices is referred to as Nominal GDP.

• GDP per capita relates the total value of annual output to the number of people who share that output; it therefore refers to the average GDP per person. It is commonly used as a measure of a country’s standard of living.

• However GDP does not, tell us what portion of output every citizen is getting.

• There are two ways to view this statistic:-One way to view GDP is the total income of everyone in the economy. -Another way to view GDP is as the total expenditures in the economy

• Consider the following two sector economy.• Imagine an economy that produces a single good, bread, from a

single input labour. • Figure 1-1 illustrates all the economic transactions that occur

between households and firms in this economy.• Pg 14 Ahuja • The inner loop represents the flow of bread and labour

(expenditures). • The households sell their labour to the firms and the firms use the

labour to produce goods and services, which in turn they sell to the households.

• The outer loop represents the corresponding flow of shillings (incomes). The households buy bread from the firms.

• The firms use some of the revenue generated from the sale of bread to pay workers and the remainder is the profit which belongs to the owners of the firms.

• The two loops combined in the above figure gives us what is referred to the Circular flow of income. (Discuss the weakness of GDP as a measure of the standards of living)The components of Gross Domestic Product:

• The National income accounts divide GDP into four broad categories of spending.

• Consumption: Consists of the goods services bought by households. It is divided into three subcategories: non-durable goods, durable goods and services.

• Investment: Consists of goods bought for future use. • Government Purchases: are the goods and services bought by the

state, and local governments. This includes such items as military equipment, highways, and the service that government workers provide.

• Net exports: Takes into account trade which other countries. Net exports are the value of goods and services exported to other countries minus the value of goods and services that foreigners provide us. Net exports represent the net expenditure from aboard on our goods and services, which provide income for domestic producers. In other words it is exports (X) minus imports (M).

• A closed economy has three uses of goods and services it produces. These three components are expressed in an equation as follows.

• Y = C+ I+ G

• This equation is an identity. It must hold because of the way the variables are defined. It is called a national income accounts identity.Real GDP vs. Nominal GDP

• You will recall that Nominal GDP has been defined as the value of goods measured at current prices. Real GDP is the value of goods and services measured using a constant set of prices.

THE CLASSICAL THEORY OF INCOME AND EMPLOYMENT

• Before explaining the Keynesian theory of income and employment we first look at the classical theory regarding income and employment determination

Classical economists believed that in a free market economy there was always a tendency towards the establishment of full employment of labour and there was sufficient demand for the output produced• Classical theory was propounded by Ricardo and Adam Smith• Classical theory of employment and output is based on the following

two basic notions-Says law-Wage price flexibilitySays Law and classical theory• Was put forward by French economist JB say: Supply creates its own

demand• Every increase in production made possible by the increase in

productive capacity (the stock of fixed capital) will be sold in the market and there will be no problem of lack of demand.

• Thus over production is ruled out by classical economists.• According to says law, greater production automatically leads to a

greator money income which creats the market for the greator flow of the goods produced.

• Process of capital accumulation and expansion of productive capacity continues till all people are employed (no deficient demand)

• Income not spent on consumption is saved and it becomes investment expenditure. Hence investment equals savings

Role of prices for full employment determination• Prices should work freely and are fully adjustable.• When ever there are lapses from full employment they are removed

automatically by the working of free price mechanism.

• Incase savings increase and consumption is likely to fall, prices are fully flexible and there will be no lack of demand. (real output and employment will not fall)

• Prices of factors of production like wages are also fully flexible. • When prices are lowered wages will also be lowered to adjust for

profitability. • Workers not willing to work at low wages then they are voluntarily

unemployed (which is not real unemployment). • Hence it is the involuntary unemployment which is not possible in a

free capitalist economy according to the classical economists. Keynes’s criticism of says law

• Keynes theory was constructed during the great depression (1929-1933). that was characterized by falling prices and rising unemployment. Keynes criticized says law especially the view that general cut in wages will increase employment.

• According to Keynes wages are not only costs of production but are also income for households and affect demand for goods and services.

• According to classical economists the level of employment depended on money wages. but keynes argued that it depended on Aggregate demand.

• According to your own judgment do you see any problem with classical theory of economics?

• If so What?• Further reading on classical economics refer: Macroeconomics theory

and policy by Ahuja Chap 3• Keynes theory of income and employment determination is a short

run theory. • Employment depended on the level on national income and

production.Principle of effective demand occupies a significant place.

• Classical theory concerning wages and employment is valid for the single firm. Even if prices fall, the firm can sell more to other consumers who are not necessarily the ones whose incomes have been reduced.

• The fundamental flow in pigous analysis is that he applied partial equilibrium analysis which is valid in the case of one industry.

• The determination of the level of aggregate income and employment in the whole economy should be analyzed using a general equilibrium analysis rather than with partial equilibrium analysis

LECTURE TWONATIONAL INCOME DETERMINATION: Algebraic analysisLECTURE OUTLINE

– Introduction– Objectives– Consumption, Investment, Savings and Tax functions– Determination of Equilibrium income– The multiplier– Summary– Further Reading

ExerciseLECTURE OBJECTIVES

• At the end of this lecture you should be able to:• Define the Consumption, Investment, Savings and Tax

functions• Derive the equilibrium Income• Define equilibrium in the financial markets• Define the multiplier

• We can use simple algrabra to determine national income• National income is at equilibrium when Ag. Demand equals

Ag. Supply• In a simple closed model of income determination without

gov. expenditure, taxation, then Y=C+ISuppose the consumption function is of the form:C=a+bY suppose investment demand equals I0

(Autonomous)

• We get the following 3 equations for the determination of equilibrium level of national income.Y=C+IC=a+bY

I=I0

Substitute C and I in the first equation we have: Y=a+bY+I0

Y-bY=a+I0

Y(1-b)=a+I0 Y=1/1-b (a+I0)

• The last equation shows the equilibrium level of national income when ag. Demand equals. Ag. Supply

• Equilibrium level of income can be known by multipling the sum of autonomous consumption and expenditure with the multiplierSuppose an economy has autonomous investment of 600 and the consumption function is given by C=200+0.8Y. Find equilibrium level of incomeThe issues of consumption investment and savings will be explored further in the subsequent lecture

CONSUMPTION, INVESTMENT, SAVINGS AND TAX FUNCTIONSConsumption and Savings

• We start our discussion of this lecture by considering consumption and savings assuming a closed economy. A closed economy has three uses for the goods and services it produces. These three components of GDP are expressed in the national income accounts identity as:

• Households consume some of the economy’s output; firms and households use some of the output for investments; and the government buys some of the output for public purposes. Aggregate demand is the total amount of goods demanded in the economy. Output is at equilibrium when the quantity of output produced is equal to the quantity demanded. Thus, the national accounts identity can be expressed as:

AD = Y= C+I+GY = C + I + G

• In practice the demand for consumption goods increases with income. The relationship between consumption and income is described by the consumption function. Households receive income from their labor and their ownership of capital, pay taxes to the

government, and then decide how much of their after tax income they will consume and how much to save.

• Assuming that households receive income equal to the output of the economy Y and that the government then taxes the households an amount T, we can define income after taxes (Y-T), as disposable income. Households divide their disposable income between consumption and savings.

• We assume that the level of consumption is directly depends on the level of disposable income. The higher is the disposable income, the greater is consumption. Thus

• C = C (Y-T) which is the same as C = C (Yd ) and C = co + c1Yd co > 0, 0<c1<1 …………(1)

• The variable co, the intercept, represents the level of consumption when income is zero. The coefficient c1 is known as the marginal propensity to consume. It measures the amount by which consumption changes when income increases by one shilling. In our case, the marginal propensity to consume is less than one, which implies that out of a shilling increase in income, only a fraction, c1 is spent.

A Consumption Function (Keynesian)

C

Yd

Co

mpc

• After a household spends in consumption what remains must be saved. More formally saving is equal to income minus consumption. Thus

• S = Yd-C• The savings function relates to the level of income. Substituting the consumption

function in equation one we get a savings function as follows:S = Yd-C = Yd- co - c1Yd = -co +(1- c1 )Yd …………. 2

• From equation 2 we see that saving is an increasing function of the level of income because the marginal propensity to save, s= (1- c1 ), is positive. In other words, savings increases as income rises. For instance, suppose the marginal propensity to consume is 0.8, meaning that 80 cents out of each extra shilling of income is consumed. Then the marginal propensity to save s, is 0.2, meaning that the remaining 20 cents of each extra shilling of income is saved.

Taxes• Taxes play a major role in financing gov. expenditure• We shall now analyze the effects of taxes on the equilibrium level of

income keeping gov. expenditure constant.• Simplest kind of tax is the lumpsum tax in which a given amount of

revenue is collected irrespective of the level of income.• After taxes people consume less and save less. However

consumption will not fall by the full amount of taxes.This is because part of the disposable income income was being consumed and part was being saved prior to taxation.

• Hence the decline disposable income due to the lumpsome tax will partly cause a decline in consumption and savings.

• Consumption will fall by the amount of tax multiplied my MPC. If Yd is change in disposable income, T for tax, then the decline in consumption (-ΔC)is given by

-ΔC=T.MPCSince T= ΔYd-ΔC=ΔYd.MPC

• For example : Suppose government imposed 500 lumpsome tax. The MPC is 0.75 then decline in consumption is 500 X 0.75=375.

• If taxes were reduced consumption will increase by the amount of lumpsum tax multiplied by MPC ie +ΔC=ΔYd.MPC

• Imposition of Taxes shift the consumption function downwards while a reduction in taxes shift consumption function upwards.

• A fall in NI after imposition of taxes is not equal to the amount of tax collected, but by a multiplier of it. The multiplier is equal to: -b/1-b where b is the MPC. This is called the tax multiplier

Investment• Both firms and households purchase investment goods, Firms buy

investment goods to add to their stock of capital and to replace existing capital as it wears out. Households buy new houses, which are also part of investment. The quantity of investment goods demanded depends on interest rate, which measures the cost of the funds used to finance investment.

• We can distinguish between nominal interest rate, which is interest rate as usually reported, and the real interest rate, which is the nominal interest rate corrected for the effects of inflation. If the nominal interest rate is 10 percent and the inflation rate is 3 percent, then the real interest rate is 7 percent. Here it is important to note that the real interest rate measures the cost of borrowing, and thus determines the quantity of investment.

• Thus I = I(r) The figure below shows this investment function. It slopes downwards, because as the interest rate rises, the quantity of investment demanded falls.

Government PurchasesThe government purchases are a third component of the demand for goods and services. The governments buys guns, build roads and other public

r

I

works. It also pays salaries to civil servants. If government purchases equal taxes then the government has a balanced budget. If G exceeds T then the government runs into a budget deficit. If G is less than T then the government runs a budget surplus. For our discussion we take Government purchases and taxes as exogenous variables.

Thus G = Go

• T = To

• Numerical examples: Suppose the level of autonomous investment in an economy is 200 and and the consumption function is

• C=80 +0.75Y• Find the equilibrium level of income• What will be the increase in national income if investment increases

by 25• Suppose the level of planned investment in an economy is 200 and

the savings function is given by S=-80+0.25Y, Find equlibrium level of income

• Suppose the consumption function is given by C=20+0.6Y and the following investment function is given I=10+0.2Y find the equilibrium level of income.

Equilibrium in the market for goods and servicesUsing the relationships discussed above we can get the equilibrium level of income or output as follow:

• Y = C + I + G• C = co + c1Yd

• I = I (r)• G = Go

• T = To

We can combine these equations to obtain equilibrium level of income• Y = co + c1 (Y-To) + I(r) + Go

• The above model of income determination is known the Keynesian model of income determination.

Equilibrium in the Financial Markets• The supply and demand for loanable funds • We can be able to analyze the financial markets by examining the

interest rate, which is the cost of borrowing and the return to lending in the financial markets.

• We can rewrite the national income identityY = C + I + G

• as Y-C-G = I

• The term on the left hand side is the output that remains after the demands of consumers and the government have been satisfied. It is called national saving. In this form the national income accounts identity shows that saving equal investment. Savings represent the supply of loanable funds while investment represents the demand for these funds. The quantity of investment demanded will depend on the cost of borrowing.

• At equilibrium interest rate the households’ desire to save balances firms’ desire to invest and the quantity of loans supplied equals the quantity demanded.

Equilibrium in the Financial Market

The expenditure Multiplier• This is the amount by which equilibrium output changes when

autonomous aggregate demand increases by one unit.

r

I, SS

I(r)

• Assuming the absence of the government and foreign sector the multiplier is defined as

• α = 1 1-c

• From the above equation you observe that the larger the marginal propensity to consume the larger the multiplier.

• The multiplier suggests that output changes when autonomous spending changes and that the change in output can be larger than the change in autonomous spending.

Lecture 4LECTURE OUTLINE• Objectives• The Keynesian Cross• Derivation of the IS Curve• The government Purchases multiplier• Shifts in the IS Curve• A loanable-Funds interpretation of the IS Curve

3.1  INTRODUCTION Welcome to lecture 4. Recall that in lecture 3 we discussed the national income equilibrium determination in both the goods market and the financial market. We concluded the lecture by defining the multiplier. In this lecture we take that concept further and discuss the Goods market with a view of establishing equilibrium in this market.OBJECTIVES

• At the end of this lecture you should be able to: • a)      Define the Goods Market• b)      Write the Goods Market Equation for a closed economy• c)      Define the IS curve • d)      Derive the IS curve graphically• e)      Define the government purchases multiplier• f) Explain the loanable funds interpretation of the IS curve

Definition• The Goods market also common known as the commodity or the

product market is one where output (Y) is produced and later consumed by the economic agents. It is from the goods market that we have the national income identity, which we defined using the equation

Y = C + I + G• To develop this relationship we use a basic model called the

Keynesian cross.

• In The General Theory Keynes proposed that an economy’s total income was in the short run, determined largely by the desire to spend by households, firms and the government.

• The more people want to spend, the more goods and services firms can sell. The more firms can sell, the more output they will choose to produce and the more workers they will choose to hire.

Actual / Planned expenditures• Actual expenditure is the amount households, firms and the

government spend on goods and services = GDP. Planned expenditure is the amount households, firms and the government would like to spend on goods and services. Actual differs from planned expenditure since firms engage in unplanned Inventory Investment because their sales do not meet their expectations. For example

Planned expenditures• When firms sell less of their stock than they planned, their stock of

inventories actually rise and vise verse.• Since these unplanned changes in inventories are counted as

investment spending by firms, actual expenditure can be either above or below planned expenditures. Planned expenditures Now assuming closed economy planned expenditure is the sum of consumption, planned investment I, and government purchases G we can obtain the following equation.

• E = C+I+G• C=C(Y-T) disposable Income• I=I• G=G• T=T• Substituting these equations in the planned expenditure equation we

obtain

• E = C(Y-T) + I + G• This equation shows planned expenditure as function of Y and the

exogenous variables I, T and G. The relationship between planned expenditure and Income or Output can be graphed as shown below.  Relationship between planned expenditure and output

Planned expenditures• Planned expenditure depends on income because higher income

leads to higher consumption, which is part of planned expenditure. • The slope of the planned expenditure function is the marginal

propensity to consume.The Economy in EquilibriumAccording to the Keynesian Cross the economy is in equilibrium when actual expenditure (AE) is equal planned expenditure (PE). This assumption is based on the idea that when people’s plans have been realized, they have no reason to change what they are doing.

•  • AE = PE• Y=E• This condition is held by plotting a 45-degree line as shown in the

diagram above.• How does the economy get to the equilibrium?• inventories play an important role in the adjustment process• Whenever the economy is not in equilibrium firms experience

unplanned changes in inventories, and this induces them to change production levels. Changes in production in turn influences total income and expenditure moving the economy towards equilibrium.

Equilibrium condition• For example whenever Y is below the equilibrium level, planned

expenditure is greater than actual expenditure.

Y

E

450

PE

AE

Y*

E*

• Firms will meet the high levels of sales by drawing down their inventories.

• To do so, they hire more workers and increases output.Equilibrium GDP rises and the economy approaches the equilibrium.

• On the other hand whenever Y is above the equilibrium level, planned expenditure is less than actual expenditure. Firms are selling less than they are producing.

• They add unsold goods to their stock of inventories. • This unplanned rise in inventories induces firms to lay off workers and

reduce production, and these actions in turn reduce GDP.Fiscal Policy and the Government Purchases Multiplier

• A fiscal policy is the policy of the government with regard to the level of government purchases, the level of transfers and the tax structure.

• Transfers are payments to households such as welfare to the poor and pensions to the elderly.They are the opposite of taxes. They increase households’ disposable income, just as taxes reduce disposable income.

Govt. expenditures• Consider how changes in government purchases affect the economy.

Because government purchases are one component of expenditure, high government purchases result in high planned expenditure for any given level of income. If the government purchases rise by ΔG, then the planned-expenditure schedule shifts upwards by ΔG and the equilibrium moves from point A to B.

An increase in government purchases

Govt. expenditures• This graph shows that an increase in government purchases leads to

an even greater increase in income. That is ΔY is larger than ΔG. The ratio ΔY/ ΔG is called the government multiplier. It tells how much income rises in response to a unit monetary value increase in government purchases. In this case it is greater than one. 3.3.1 Interest rate, investment and the IS curve

• The keynesian cross is basic to developing the IS-LM model.• To be able to conclude our discussion, we introduce the investment

function. The level of planned investment is a function of interest rate and is given as follows:

• I = I(r)

Is curve• The IS curve shows combinations of interest rates and levels of

output such that planned spending equals income. (IS curve is a locus of all the points where the goods market is in equilibrium)

• It plots the relationship between the interest rate and the level of income that arises from the market for goods and services. To derive this curve, we use both The Keynesian cross and the Investment function.

Y

A

AEE

450

PE

B

G

Y* Y1

Y

IS curve• Panel A Shows the investment function, a decrease in the interest

rate r1 to r2 increases planned investment. • Panel B shows the keynesian cross, an increase in planned

investment shifts planed expenditure upwards and thereby increases income.

• Panel C shows the IS curve summarizing this relationship between interest rate and income. Higher interest rate lowers income. While lower interest rates rises national income

• The IS curve is negatively sloped because an increase in the interest rate reduces planned investment spending and therefore reduce aggregate demand, thus reducing the equilibrium level of income.

3.3.2 Shifts in the IS Curve• As we learnt from the Keynesian Cross, the level of income depends

on fiscal policy. The IS curve is drawn for a given fiscal policy: that is when we construct the IS Curve, we hold G and T fixed. When fiscal policy changes, the IS curve shifts.

Shift in the IS Curve

AE

E

450

PE

BI

Y*

Y1

Y

A

I(r)

r

I

r

Y

r1r2 I(r1

)I(r2

)Y*

Y1

r2

r1

AB

AB

• An increase in government purchases shifts IS curve outwards.

• Panel A shows that an increase in government purchases raises planned expenditure. For any given interest rate the upward shift in planned expenditure leads to an income of Y of ΔG/(1-MPC).

Therefore in panel B, the IS curve shifts to the right by this amount.

Loan able funds interpretation of the IS curve

• Earlier we noted equivalence between the supply and demand for goods and the supply and demand for loan able funds. This equivalence provides a way to interpret the IS curve.

• Recall that the national income accounts identity can be written as

AE

E

450

PE

BG

Y*

Y1Y

r

Y

r*

Y* Y1

A

A B

• Y-C-G = I

S = I

• The left hand side of this equation is national savings S, and the right-hand side is Investment, I. National savings represent the supply of loanable funds and investment represents the demand for these funds. Assuming

• C = C(Y-T)

• We obtain

• Y –C(Y-T)-G = I(r)

• The left hand side shows that the supply of loanable funds depends on income and fiscal policy. The right hand side shows that demand for loanable funds depends on the interest rate. The interest rate adjusts to equilibrate the supply and demand for loans.

a) The Market for loanable funds b) The IS Curve

• Panel A shows that an increase in income from Y1 to Y2 raises savings and thus lowers equilibrium interest rates interest rates.

• Panel B expresses this negative relationship between interest rates and income

• In this regard the IS curve can be interpreted as showing the interest that equilibrates the market for loanable funds given any level of income.

rr1 r2

r2 r1 rS(Y

1 )S(Y

2 )

I,SI(r)

ISY

1 Y2

Y

• With an increase in income, national savings increase, hence an increase in the supply for loanable funds. This leads to a fall in interest rates and the IS curve summarizes this relationship. Thus higher incomes lead to low levels of interest rates. For this reason the IS curve is down ward sloping.

Lecture 5 The money Markets

Lecture Outline

• Introduction

Objectives

• The Theory of Liquidity Preference

• Derivation of the LM Curve

• Shifts in the LM Curve

• A Quantity-Equation Interpretation of the LM Curve

• In the last lecture we derived the IS curve after discussing the goods market.

• In this lecture we discuss the money market with a view of obtaining and equilibrium and deriving the LM curve.

Lecture Objectives

At the end of this lecture you should be able to:

• Define the Money market

• Write the Money Market Equation for a closed economy

• Define the LM curve

• Derive the LM curve graphically

• Explain the Quantity-Equation Interpretation of the LM curve

• Discuss the factors that would cause a shift in the LM curve

Theory of liquidity preference

• The LM curve plots the relationship between interest rate and the level of income that arises in the market for money balances.

• To understand this relationship, we begin by looking at a theory of the interest rate, called the theory of liquidity preference.

• In his book “General Theory”, Keynes offered his view of how the interest rate is determined in the short run.

• He argued that interest rate adjusts to balance the supply and demand for the economy’s most liquid asset-money.

Supply for real money balances

• If M stands for the supply of money and P stands for the price level,

• Then M/P is the supply of real money balances. The theory of liquidity preferences assumes there is a fixed supply of real money balances.

• The money supply M is an exogenous policy variable chosen by a central bank.

• The price level P is also an exogenous variable in this model. These assumptions imply that the supply of real balances is fixed, in particular does not depend on interest rate.

Demand for real money balances

• The theory of liquid preference posits that interest rate is one of the determinants of how much money people choose to hold.

• The reason is that the interest rate is the opportunity cost of holding money; it is what you forgo by holding some of your assets as money, which does not bear interest, instead of as interest bearing bank deposits or bonds.

• When interest rate increase people want to hold less of their wealth in the form of money.

• Graph

• Thus, we can write the demand for real money balances as

(M /S )s=M / P

(M /P )d=L (r )

• The dd curve slopes downwards because higher interests rates reduce the quantity of the real balances demanded.

• This theory argues that the interest rate adjusts to equilibrate the money market. At the equilibrium interest rate, the quantity of real balances demanded equals the quantity supplied

Graph

How does adjustments for equilibrium happen

• The adjustment occurs because whenever the money market is not in equilibrium, people try to adjust their portfolios of assets and , in the process, alter the interest rate –

• e.g. if interest rate is above the equilibrium level, the quantity of real balances supplied excess the quantity dd. Individuals holding the excess supply of money try to convert some of their non-interest –bearing money into interest – bearing bank deposits or bonds.

• Banks and bond issuers, who prefer to pay lower interest rates, respond to this excess supply of money by lowering the interest rate they offer.

• Conversely if interest rate is below equilibrium level so that quantity of money demanded exceeds the quantity of money supplied, individuals try to obtain more money by selling bonds on making bank withdrawals.

• To attract now scarcer funds, bank and bond issuers respond by increasing the interest rate they offer.

Derivation of the LM curve

• Before we derive the LM curve it is important to consider how a change in economy’s level of income affects the market for real money balances. The level of income affects the demand for money. When income is high, expenditure is high, so people engage in more transactions that require the use of money. Thus, greater income implies greater money demand. This can be expresses using the money demand function as follows:

(M /P )d=L (r ,Y )

• The quantity of real money balances demanded is negatively related to the interest rate and positively related to income.

• Using the theory of liquidity preference we can figure out what happens to equilibrium interest rate when the level of income changes.

• A change in the level of income, given fixed supply of real money balances leads to a rise in interest rates. Therefore according to the theory of liquidity preference, higher income leads to a higher interest rate.

• The LM curve plots this relationship between the level of income and interest rate. The higher the level of income, the higher the demand for real money balances, and the higher the equilibrium interest rate. For this reason, the LM curve slopes upward.

• Graph mankiw pg 275

Shifts in the LM curve

• The LM curve tells us the interest rate that equilibrates the money market given any level of income. Interest rate too depends on the supply of real balance, M/P. This means that the LM curve is drawn for a given supply of real money balances. If real balances change- for- example, if the central bank alters the money supply- the LM curve shifts.

• Graph mankiv pg 276 (shifts in lm CURVE)

• In summary, the LM curve shows the combinations of the interest rate and the level of income that are consistent in the market for real money balances.

• The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve upwards. An increase in the supply of real money balances shifts the LM curve downwards.

A Quantity-Equation Interpretation of the LM Curve

• Money x Velocity = Price x Income

M x V = P x Y

• P is the price of a typical transaction- the number of monetary value exchanged.

• M is the quantity of money. V is called the transactions velocity of money and measures the rate at which money circulates in the economy.

• In other words, velocity tells us the number of times a monetary value bill changes hands in a given period of time.

• Assuming that velocity is constant, it implies that for any given price level (P) the supply of money by itself determines the level of income Y.

• Since Y does not depend on interest rate the quantity theory is equivalent to a vertical LM curve.

How do we realize the more realistic upward sloping LM curve ?

• By relaxing the assumption of constant velocity of money.

• The assumption that V is constant derives from the assumption that the demand for real money balances depends on income.

• Yet we have so far seen that the demand for real money balances also depends on interest rates.

• Higher interest rates rises the costs of holding money and reduces money demand.

• Hence the velocity of money must increase when people respond to higher interest rate by holding less money: Each coin they hold must be used more often to support a given volume of transactions.

• We can write this as

MV(r) = PY

• The velocity function V(r) indicates that velocity is positively related to the interest rate.

• This form of the quantity equation yields an LM curve that slopes upwards.

• Because an increase in the interest raises the velocity of money, it raises the level of income for any given money supply and price.

• The LM curve expresses this positive relationship between the interest rate and income.

• This equation shows why changes in money supply shift the LM curve.

• For any given interest rate and price level, the money supply and the level of income must move together.

• NB: Quantity equation is only is just another way to express the theory behind the LM curve.

• The Lm curve by itself does not determine either income or interest rates that will prevail in the economy.

• Just like the IS curve, the Lm curve is only a relationship between these two endogenous variables.

• The Lm and the IS curve together determine the economy's equilibrium.

Equilibrium in the economy

• Recall, the IS curve represents equilibrium in the goods market.

• The LM curve represents equilibrium in the money market.

• The intersection of the two curves determines output and interest rates in the short run, that is, for a given price level.

Expansionary fiscal policy moves the IS curve to the right, raising both income and interest rates

• Contractionary fiscal policy moves the IS curve to the left, lowering both income and interest rates. Expansionary monetary policy moves the LM curve to the right, raising income and lowering interest rates.

• Contractionary monetary policy moves the LM curve to the left lowering the level of income and raising the interest rates.

Crowding Out and Liquidity Trap

• Crowding out occurs when expansionary fiscal policy causes interest rates to rise, thereby reducing private spending, particularly investment.

• As interest rate increases due to increased government spending, crowding out effect is greater.

• If the economy is in liquidity trap, and thus the LM curve is horizontal, an increase in government spending has its full multiplier effect on the equilibrium level of income.

• There is no change in interest rates associated with the change in government spending, and thus no investment spending is cut off.

• If the LM curve is vertical, an increase in government spending has no effect on the equilibrium level of income and increases only the interest rate.

• If the government spending is higher and output is unchanged, there must be an offsetting reduction in private spending.

• In this case, the increase in interest rates crowds out an amount of private spending particularly investment equal to the increase in government spending. Thus there is full crowding out if the LM curve is vertical.

Importance of Crowding Out

• Assuming that prices are given and that output is below the full-employment level.

• when fiscal expansion increases demand, firms can increase output level by hiring more workers.

• In real life crowding out occurs through a different mechanism as high demand leads to high price levels and a reduction in real money balances.

• Also, in an economy that is not fully utilizing its recourses, there can never be full crowding out since the LM curve is not vertical.

• Crowding out is therefore a matter of degree.

• Thirdly, with unemployment, and low output levels, interest rates need not rise at all when government spending rises, and there need not be any crowding out.

• This is true because the monetary authorities can accommodate the fiscal expansion by an increase in the money supply.

The Transmission Mechanism of a monetary policy

• The process by which changes in monetary policy affect aggregate demand are essential.

• The first is that an increase in real money balances generates a portfolio disequilibrium; that is, at the prevailing interest rate and level of income, people are holding more money than they want.

• As a result they start depositing extra money in banks or use it to buy bonds.

• The interest rate r then falls until people are willing to hold all the extra money created and this brings the money market to equilibrium.

• The lower interest rates stimulate planned investment, which increases planned expenditure, production and income.

This process is commonly known as the monetary transmission mechanism

Derivation of the Aggregate Demand Curve

• The aggregate demand schedule maps out the IS-LM equilibrium holding autonomous spending and the nominal money supply constant and allowing prices to vary.

• Recall that the aggregate demand curve describes a relationship between the price level and the level of national income.

• To explain why the aggregate demand curve slopes downwards, we examine what happens in the IS-LM curve when price level changes.

• From the figure below, for any given money supply, M a higher price level P reduces the supply of real money balances.

• A lower supply of real money balances shifts the LM curve upwards, which raises the equilibrium interest rate and lowers the equilibrium level of income as shown in the figure below.

• Here the price level rises from P1 to P2 and income falls from Y1 to Y2. The aggregate demand curve then plots this relationship between national income and the price level.

• The events that shift the IS curve or the LM curve cause the aggregate demand curve to shift.

• A change in the IS-LM model resulting from a change in the price level represents a movement along the aggregate demand curve.

• A change in income in the IS-LM model for a fixed price level represents a shift in the aggregate demand curve.

Lecture 6 The labour market

Demand and Supply in the labor market

• The cost of work is free time (leisure)

• Households value both work (source of consumption income) and leisure, and have to balance.

• Assuming all earnings are consumed each period, The preference between consumption and leisure can be shown in the following diagram.

• An indifference curve shows the rate at which a representative household substitutes consumption for leisure holding utility constant.

• Higher curves respond to higher levels of utility. Maximum amount of time available is L hours.

• The shape of the indifference curve reflects a decreasing rate of substitution:-

• The greater is household consumption relative to its leisure the more consumption it is willing to give up for an additional unit of leisure, or the higher is the marginal rate of a substitution of consumption for leisure.

The budget constraint

• The budget constraint is fixed by the total amount of time (L) available in every given period.

• The price of an hour of leisure is the opportunity cost: How much can be earned from working instead.

• The price of leisure is measured in terms of consumption goods that can not be consumed for lack of earned income.

• The price of leisure is then called the real consumption wage.

• It is measured as the ratio of nominal wages (W) to the consumer price index (P).

• With L hours and an hourly real wage w=W/P, the total time endowment (L) can be allocated between consumption (C) and leisure (lw)

The budget constraint is shown below:

Its negative slope measures the trade off of consumption offered in the market: how much consumption must be given up to get additional unit of leisure.

Optimal individual labour supply

• Utility is maximized by choosing the highest possible indifference curve without violating the budget constraint.

• This is achieved at a point where the indifference curve is tangent to the budget line.

• At this point welfare can not be improved by further trading leisure against consumption.

• An increase in real wage changes consumption leisure choice from A to B

• When real wage increases the budget line rotates around point C (Time endowment remains unchanged) and becomes steeper, since a unit of leisure is now being exchanged for more units of consumption.

• This allows both consumption and leisure to increase at the same time (income effect).

• Since leisure is more expensive ,some is given up (substitution effect).

• In panel A ( Burda &wyplozs 139)Income and substitution effects exactly cancel the labour supply curve is vertical

• In Panel B substitution effects dominate leisure is reduced, and the labour supply schedule is upward sloping ( workers work more when wages increase)

• In panel C income effect dominate leisure increases, and labour supply is backward bending. (workers work less with increases in wages)

Aggregate labour supply curve

• The aggregate labour supply curve is the sum of many individual decisions to work or not to work.

• Aggregate supply is measured in man hours

• When wages rise there is generally more willingness to work (given modifications of those who were not working before and those who were already working)

• Hence the aggregate labour supply is upward sloping.

Demand for labour

• When capital stock is given, a firm can vary amount of output by adjusting its demand for labour.

• The link between output and employment is given by the production function.

• The slope of the production function measures the marginal productivity of labour (MPL) ie the quantity of additional output produced when one more unit of input is used.

The shape reflects the principle of decreasing marginal productivity, MPL is declining as the amount of labour employed increases

• How much to employ depends on the highest possible profits given the real wage.

• OR (straight line from origin) represents the cost of labour to the firm: the slope is w since L hours of work cost wL

• For each level of employment Profit is measured by the vertical distance between the production function and the labour cost line

• At maximum profit the production function is parallel to the labour cost line.

• Equilibrium in the labour market occurs when the supply and demand for labour are equal.

• At that point the real wage clears the market at employment level (L*)

• If total labour endowment is L the difference between L and L* is voluntary unemployment.

MODELS OF AGGREGATE SUPPLY

• Aggregate supply behaves different ly in the short run than in the long run

• In the long run prices are flexible and the aggregate supply curve is vertical.

• When ag supply is vertical shifts in ag. Demand affect prices but output remins at its natural rate.

• In the short run, prices are sticky, and ag. Supply curve is not verticle. In this case shifts in ag. Demand curve do cause fluctuations in output.

• Economists differ on the explanations of the ag. Supply curve in the short run.

• We present 4 prominent models of Ag. Supply that have been supported

• Although the models differ in some significant detail, they all share a common theme about what makes the short run and long run ag. Supply different but all conclude that the short run ag. Supply curve is upward sloping.

• The short aggregate supply curve implies a trade off between two measures of economic performance:- Inflation and unemployment.

4 models of aggregate supply

• In all four models market imferfections causes output of the economy to deviate from full employment.

• As a result ag. Supply curve is upward sloping other than vertical and shifts of the ag. Demand curve cause output to deviate temporary from the natural rate.

• These temporary deviations cause the booms and busts of the business cycle.

• The short run ag. Supply curve is of the form

Y=Y`+α(P-Pe), α>0

Where Y is output, Y’ is natural rate of output, p is price level, Pe is expected price level.

• The equation shows that output deviates from natural rate when prices deviate from expected price level.

• Alpha is a parameter measuring hiow output responds to un expected changes in the price level 1/alpha is the slope of the Ag. Supply curve.

• Each of the 4 models tell a diffeent story of what is behind the short run ag. Supply equation.

Sticky wage model

• Sluggish adjustment of nomial wages, Long term contracts, even without contracts wages can be sticky in the short run.

• When nominal wages ares tuck, a rise inn price level lowers the real wage making labour cheaper

• Lower wages induce firms to hire more labour

• Additional labour produces more output.

• This positive relationship between real wages and output means that supplu curve slppes upward when nominal wages can not adjust.

Worker misperception model

• This model assumes that wages adjust freely and quickly to balance the supply and demand for labour

• Its key assumptions is that unexpected movements in the price level influence labour supply because workers temporarily confuse real wages and nominal wages.

• Two components of the model are labouir supply and labour demand.

• Quantity of of labour depends on real wages

• Workers know their nominal wage but not their real wage, but they do not know the overall price level.

• When deciding how much to work workers consider the expected real wage which equals nominal wage divided by their expectation of the price level

• Hence quantity of labour supplied depends on real wage and the workers percention of the price level.

• When ever the price level changes the reaction of the economy depends on wheter workers anticipated the change or not. If they did expected prices rise proportinatley with price level in this case neither labopur supply nor demand changes.

• Nominal wage change by the same amount as prices and real wage and level of employmentremaion the same.

• If price changes caught workers by surprise, then expected prices remain the same when prices raise.

• The increase in price level causes a shift in the labour suply cutrve lowering real wage and raising level of employment.

• In this case workers believe that prices are actually lower thus real wage is higher than it is the case this induces them to supply more labour

• Firms are more informed than workers and recognise the fall in wages so they hire more labour and produce more outpuit.

• Like the sticky wage model the supply curve is upward sloping within the period when the workers miscoincive their wages.

• Once again output deviates from its natural rate when prices deviate from expected price levels.

The imperfect information model

• Assumes that market clears and that the short run and longrun agg. Supply curve differ because of temporary misperceptions about prices.

• Unlike worker misperception model it does not assume that firms are better informed about the price level thjan the workers.

• In its simplest form model does not distinuish worjkers and firms at all.

• Assumes that each supplier in economy produces a simple good and consumes many goods.

• Since goods are so many they can not observe all prices at all times.

• They monitor closely the prices of they produce but less closely the prices of all other goods they consume.

• Because of imperfect information they siometimes confuse changes in the overall price level with changes in relative prices.

• This confusion influences decisions about how much to supply and it leads to a short run relationship between price level and out put.

• If relative price of good produced is high more labour is supplied and more of the good is produced and vice versa.

• Unfortunately the relative prices of other goods are not known

• The relative price of the good produced is therefore estiamted using its nominal price and the expected price level.

• Supose all prices increase including for the good produced.

• If change was expected then estiamte of ecpected prices is unchanged and more labour is not supplied.

• If the price change was not expected, only prices of own good are observed and not sure if all other prices have increased. More labour is supplied.

• The imperfect information model therfore says that when prices exceed expected prices supl;liers raise their output and the aggregate supply curve is upward sloping.

Sticky price model

• Firms do not instantly adjust prices they charge in response to demand.

• Eg in cases of lon term contracts on prices, catalogue etc.

• This model departs from perfect competition where firms are price tkars and not setters.

• A firms desired price depends on two macro economic variable

• A) The overall prices,. A higher price level impies that the firms costs are higher, hence the higher the overall price level the higher the firm charges for its products.

• B) Level of ag. Income. A higher level of income raises the demand for the firms product. The higher the demand the higher the firms desired price.

• Hence a firms desired price is written as follows

P=P+a(Y-Y’) ie the desired price depends on the overall level of prices and the level of aggregate out put relative to the natural rate.

• Assume two types of firms. One with flexible prices and others with sticky prices.

• Firms with flexible prices set their prices according to the above eqaution.

• While the firms with sticky prices announce their prices in advance based on their expectations of the economic conditions. Ie P=Pe+a(Ye-Y’e) For simplicity assume that these firms expect output to be at its natural rate. So that the last term term Ye-Y’e is Zero.

• Then firms set prices according to expected prices. Ie firms with sticky prices set prices depending on what they expect other firms to charge.

• When firms expect a high price level they expect high costs. Those that fix their prices in advance cause other firms to set high prices also. Hence a high expected price level leads toa high actual price level.

• When output is high the demand for goods is also high. Those firms with flexible prices set their prices high which leads to a high price level . The effect of output on the price level depends on the ptro[portion of firms with flexible prices.

• Hence the expected price level depends on the expected price level and on the level of output.

The Open Economy• In the previous lectures we have been dealing with a closed

economy. Therefore there has not been any interaction with the rest of the world.

• In this lecture we look at a small open economy, and how fiscal and monetary policies affect the goods and money market in such an economy. This is a more realistic analysis as no single economy in the world can operate on its own without interacting with the rest of the world.

• When conducting monetary and fiscal policy, policy makers often look beyond their own country’s boarders. Even if domestic prosperity is their sole objective, it is necessary for them to consider the rest of the world.

• In this lecture we extend our analysis of aggregate demand to include international trade and finance.

Mundell-Fleming Model

– This is an open-economy version of the IS-LM model.

– Both models assume that the price level is fixed and then show what causes short-run fluctuations in aggregate income.

– The key difference is that the IS-LM model assumes a closed economy, whereas the Mundell-Fleming model assumes an open economy.

The key assumptions

• The model assumes that the economy being studied is a small open economy with perfect capital mobility.

• That is, the economy can borrow or lend as much as it wants in the world financial markets and, as a result, the economy’s interest rate is determined by the world interest rate.

• Mathematically we can write this assumption as

r = r*

• This world interest rate is assumed to be exogenously fixed because the economy is sufficiently small relative to the world economy that it can borrow or lend as much as it wants in world financial markets without affecting the world interest rate.

• Perfect capital mobility implies that if some event were to occur that would normally raise the interest rate such as a decline in domestic savings, in a small open economy, the domestic interest rate might rise by a little bit for a short time, but as soon as it did, foreigners would see the higher interest rate and start lending to this country by for instance buying the country’s bonds.

• The capital inflow would drive the interest rate back towards r*. Similarly if there were any event that were to start driving the domestic interest rate downwards, capital would flow out of the country to earn a higher return abroad, and this capital outflow, would drive the domestic interest rate back toward r*.

• Hence , the r = r* equation represents the assumption that the international flow of capital is sufficiently rapid as to keep the domestic interest rate equal to the world interest rate.

• The model also assumes that price levels at home and abroad are fixed, this means that the real exchange rate is proportional to the nominal exchange rate.

• That is, when the nominal exchange rate appreciates, foreign goods become cheaper compared to domestic goods, and this causes exports to fall and imports to rise.

The goods Market and the IS Curve

• The Mundell-Fleming model describes the market for goods and services much as the IS-LM model does, but it adds a new term for net exports. In particular, the goods market is represented with the following equations:

• Y = C(Y-T) + I(r*) + G + NX(e).

• This equation states that aggregate income is the sum of consumption C, investment I, government purchases G, and net exports NX.

• Consumption depends positively on disposable income Y-T. Investment depends negatively on the interest rate, which equals world interest rate r*.

• Net exports depend negatively on the nominal exchange rate e. As before, we define the exchange rate as the amount of foreign currency per unit of domestic currency. For example, e might be Kshs 75 per dollar.

• From the diagram below, the IS curve slopes downwards because higher exchange rates (appreciation of domestic currency) reduces net exports which in turn reduce the aggregate income.

• Using the diagram below (mankiw page 315) a change in the exchange rate from e1 to e2 lowers net exports from NX (e1) to NX (e2).In panel b the reduction in net exports leads to a downward shift in planned expenditure and income falls from Y2 to Y1. The IS curve summarizes this relationship between the exchange rate e and the level of income Y in panel c.

The money market and the LM curve.

• The mundell Fleming model represents the money market with an equation that should be familiar from the IS-LM model, With the additional assumption that the domestic interest rates equal the world interest rates.

• This equation states that the supply of real money balances,M/P equals the demand L(r*,Y)

• Demand for real money balances depends negatively on interest rates which is now set to the world interest rate, and positively on income Y.

• The money supply M is an exogenous variable controlled by the central bank.

• Since Mundell fleming model analyses short run fluctuations, then price level are also assumed to be fixed.

• We can represent this equation graphically with a vertical LM equation as in panel B

M /P=L (r¿ , Y )

• The Lm curve is vertical because the exchange rates do not enter in to the LM* equation.

• Given the world interest rates the LM equation determines aggregate income, regardless of the exchange rates.

• The figure shows (Mankiw 316) how the LM* curve arises from the world interest rate and the LM curve which relates the interest rate and income

• Panel a shows the standard LM curve (which graphs the equation M/P=L(r,Y) together with a horizontal line representing the world interest rate r*. The intersection of these two curves determines the level of income, regardless of the exchange rate, therefore as panel B shows the LM* curve is vertical.

Equilibrium of the small open economy

According to the Mundell Fleming model, a small open economy with perfect capital mobility can be described by two equations.

• The first describes equilibrium in the goods market

• The second describes equilibrium in the money market

r=r*

LM

LM*

(a) The LM curve

r

Exchange rates , e

Income, output

(b) The LM* Curve

Y=C (Y−T )+ I ¿¿¿

¿

• The exogenous variables are fiscal policy G and T, Monetary policy M, the price level P, and the World interest rates r*. The endogenous variables are income Y and the exchange rate.

• The two relationships are illustrated together below

The graph plots the goods market equilibrium condition IS* and the money market equilibrium LM*. Both curves are drawn holding interest rates constant at the world interest rates . The intersection of these two curves show the level of income and the exchange rate that satisfy equilibrium both in the goods and in the money market.

Private reading

• Give hand out on the open economy

• Exchange rates and how policies affect the real exchange rates.

• Mankiw pg 205-214

The Philliph’s curve

• Two goals of policy

-Low inflation

-Low Unemployment

• These goals are often in conflict

• Suppose government were to use expansionary fiscal and monetary policies to boost demand

• Economy would move to higher demand and higher prices.

LM*

IS*

Y

e

• Higher output means higher unemployment

• Higher price levels given previous prices may mean inflation

• This trade off between inflation and unemployment is called the philliphs Curve.

• The philliph’s curve is a reflection of the short run aggregate supply curve: As policy makers move the economy along the aggregate supply curve, unemployment and inflation move in opposite directions.

• The philliphs curve states that the inflation rate depends on 3 forces

-Expected inflation

-The deviation of unemployment from the natural rate called cyclical unemployment

-Supply shocks

• Inflation=Expected Inflation- (α *cyclical unemployment) +supply shocks

α Is a parameter measuring the response of inflation to cyclical unemployment.

The minus sign before cyclical unemployment term implies that high unemployment reduces inflation

• The equation therefore summarizes the relationship between inflation and unemployment.

Deriving The philliphs curve from aggregate supply curve

• The Philliphs curve could be derived from the equation for aggregate supply

• Recall aggregate supply equation is written as follows

• Add to the right hand side of the equation a supply shock V to represent exogenous event that alter the price level and shift the aggregate supply curve

∏ ¿∏e−β (u−un )+v

P=Pe+ (1/α ) (Y−Y )

P=Pe+ (1/α ) (Y−Y )+V

• To go from price level to inflation subtract last years price level P-1

from both sides of the equation to obtain

The term on the left hand side (P-P-1) Is the difference between the current price level and last years price level which is inflation. The term on the right hand side (Pe-P-1) is the difference between the expected price level and last years price level which is expected inflation

• Hence we have

• Okuns law states that the deviation of output from its natural rate is inversely related to the deviation of unemployment from its natural rate

• That is when output is higher than its natural rate unemployment is lower from its natural rate . This can be rewritten as

• We can substitute –β (u-un) for (1/α)(Y-Y) In the previous equation to obtain:

• Thus the short run aggregate supply equation and the philliphs curve represent the essentially the same macroeconomic ideas.

• According to the short run aggregate supply equation, output is related to unexpected movements in the price level.

• According to the Philliphs curve unemployment is related to unexpected movements in the inflation rate.

• The aggregate supply curve is more convenient when studying output and prices while the philliphs curve is more convenient when studying inflation and unemployment.

• Hence the philliphs curve and the aggregate supply curve are two sides of the same coin.

Adaptive expectations and inflation inertia

• People may form their expectations about inflation adaptively:

• For example if people expect this years inflation to be like last years inflation then

P−P−1=Pe−P−1+(1/α ) (Y−Y )+V

∏ ¿∏e− (1/α ) (Y−Y )+v

(1/α ) (Y−Y )=−β (u−un)

∏ ¿∏e−β (u−un )+v

∏ e=∏−1

In this case we can rewrite the Philliphs curve as

• I.e. inflation depends on past inflation, cyclical unemployment and a supply shock.

• The past term implies that inflation has inertia. It keeps going unless something acts to stop it.

• In particular if inflation is at its natural rate and if there are no supply shocks, the price level will continue to rise the same way it has been rising

• In a model of aggregate supply and aggregate demand inflation inertia is interpreted as upward shift of both supply and aggregate demand curve.

This will continue until something like a recession or a supply shock will change expectations about inflation it

• Aggregate demand curve will also shift upward. Most often the continued rise in aggregate demand is due to persistent growth in money supply.

• If money supply was to be halted, aggregate demand would stabilize causing a recession.

• High unemployment during recession would reduce inflation and expected inflation thus causing inflation inertia to subside.

Causes of rising and falling inflation

• The second and third term of the philliphs curve equation show the two forces that can change the rate of inflation

• The second term

Shows that cyclical unemployment (deviation of unemployment from its natural rate) exerts upwards or downward pressure on inflation.

• Low unemployment pulls the inflation rate up: This is demand pull inflation

∏ ¿∏−1 −β (u−un )+v

β (u−un)

• The parameter beta measures how responsive inflation is to cyclical unemployment

• The third term v, also shows that inflation also rises and falls due to supply shock.

• Supply shocks are thus either beneficial or negative.

• Negative supply shocks cause cost push inflation

• Beneficial supply shocks ease inflation

Short run trade off between inflation and unemployment

• Consider the options the philliphs curve offers the policy maker.

• By changing aggregate demand the policy maker can alter output unemployment and inflation.

• The following figure plots the phillips curve and shows the short run trade off (mankiw pg 370.

• In the short run there is a negative relationship between inflation and unemployment

• At any point in time a policy maker who controls aggregate demand can choose a combination of inflation and unemployment on the short run philliphs curve.

Expectations shift the Philliphs curve.

• The curve is higher when expected inflation is high

Disinflation and the sacrifice ratio

• Imagine an economy in which unemployment is at its natural rate and inflation is running at 6%.

• What would happen to unemployment and output if a policy to reduce inflation to 2% was pursued?

• The Philliphs curve shows that in the absence of a beneficial shock, lowering inflation requires a period of high unemployment and reduced output.

• Before deciding whether to reduce inflation, policy makers must know

how much output would be lost during the transition to lower inflation

• This is called the sacrifice ratio:- The percentage of a years GDP that must be forgone to reduce inflation by 1%.

Rational expectations and the possibility of painless disinflation

• Suppose expectations were to be formed rationally

• People use all available information including government policies:

• Lessens inflation inertia

• Hence options of the philliphs curve may not capture all options available to policy makers.

• If policy makers were committed to lowering inflation, rational people will understand the commitment and will quickly lower their expectations of inflation

• Disinflation will thus be less painful.

• A painless disinflation has 2 requirements:

-The plan to reduce inflation must be announced to workers and firms who form expectations about inflation

-The workers and firms must believe the announcement and the government commitment

• If both requirements are met, the announcment will immediately shift the short run trade off between unemployment and inflation downward permitting a lower rate of inflation without unemployment.

.