SGPE Summer School:
Macroeconomics
Lecture 8
Questions:
• What causes short-term fluctuations in production and
employment?
• Is there a choice between low inflation and low
unemployment?
Part 2: The Short Run
2
Introduction: Growth 1961-2011 (GDP fixed
prices)
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0
5
10
19
60
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65
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70
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75
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80
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85
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90
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95
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GDP growth UK
GDP growth uk
-5
0
5
10
19
60
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65
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70
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75
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80
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85
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90
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95
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00
20
05
20
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GDP growth US
GDP growth us
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Introduction: Inflation 1950-2011
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0
5
10
15
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25
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50
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55
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60
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65
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70
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75
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80
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85
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90
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95
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Inflation UK
inflation uk
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0
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10
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50
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Inflation US
inflation us
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• Long run:
– Prices and wages flexible (that is, adjust to shocks)
– Production/employment is in equilibrium
– Supply factors determine production
– Real interest rate is equal to the natural interest rate
• Short run:
– Prices and wages are sluggish
– Production/employment can deviate from equilibrium
– Aggregated demand determines production
– Expected real interest rate can deviate from the natural rate
Introduction to Part 2
5
Introduction to Part 2
Plan:
• Interest and production in the short run
(the IS-LM model)
• Economic activity and inflation in the short run
(the Phillips curve)
6
The IS-LM model:
• A formalisation of Keynes's ideas
• Shows how the nominal interest and production
(income) are determined with a given price level
• Analyses the interaction between the goods and money
markets
The interest rate and aggregate demand:
The IS-LM model (Chapter 8)
7
Aggregate demand: The IS-LM model
We already have the two equations that make up the
IS-LM model:
• IS equation – goods market equilibrium
• LM equation – money market equilibrium
Y =C Y,Y e,r,A( )+ I r,Y e,K( )
M
P=Y
V (i)
r = i-p e
8
Aggregate demand: The IS equation
9
Aggregate demand: The IS equation
Effect of increased willingness to invest
Multiplier effect: The increase in production will be
greater than the original demand increase
10
Aggregate demand: The IS equation
The multiplier:
• Investments increase
• Production/incomes increase
• Consumption increases
• Production/incomes increase…
Total effect:
where c is the marginal propensity to consume (MPC)
DY = DI +cDI + c2DI + c3DI +... =1
1- cDI
11
Aggregate demand: The IS equation
What is the effect of an increase in the interest rate?
Here we also have a multiplier effect
12
Aggregate demand: The IS equation
13
Aggregate demand: The IS equation
The IS curve:
• Shows demand & production for each interest rate level
• Has a negative slope because a higher rate of interest
leads to lower consumption and investments
• The slope is determined by how much the interest rate
affects C and I and the size of the multiplier
• Changes in interest and production lead to movements
along the IS curve
• Changes in exogenous variables ( ) lead to shifts
of the IS curveY e ,p e etc.
14
Aggregate demand: The IS equation
The IS curve and long-term equilibrium production
(note that )i = r+p e
If
production will be
on the natural
level
If
production will be
below the natural
level
i = rn +p e
i > rn +p e
15
Aggregate demand: The IS equation
mathematically
Consumption function:
Investment function:
Goods’ market equilibrium:
C = a0+a
1Y +a
2Y e -a
3r+a
4A
I = b0-b
1r+b
2Y e -b
3K
Y = a0+a
1Y +a
2Y e -a
3r+a
4A+b
0-b
1r+b
2Y e -b
3K
Y 1-a1( ) = a0
+b0- a
3+b
1( )r+ a2+b
2( )Y e +a4A-b
3K
Y =a
0+b
0
1-a1
-a
3+b
1
1-a1
r+a
2+b
2
1-a1
Y e +a
4
1-a1
A-b
3
1-a1
K
16
Aggregate demand: The IS equation - example
Effect of an increase in interest rate:
The size of the effect depends on:
• The interest rate sensitivity of consumption and
investments (a3+b1)
• The multiplier that depends on the marginal propensity
to consume (a1)
Y =a
0+b
0
1-a1
-a
3+b
1
1-a1
r+a
2+b
2
1-a1
Y e +a
4
1-a1
A-b
3
1-a1
K
DY = -a
3+b
1
1-a1
Dr = -1
1-a1
a3+b
1( )Dr
17
Aggregate demand: The LM equation
Household assets:
• Money
• Loans to companies
• Shares in the companies, which we assume they retain
The interest rate adjusts so that
supply = demand on loans, which is the same as
supply = demand on money:M
P=Y
V (i)
18
Aggregate demand: The LM equation
19
Aggregate demand: The LM equation
An increase in the money supply leads to a drop in the
interest rate
The central
bank can
influence the
interest rate by
changing the
money supply
20
Aggregate demand: The LM equation
With a given money supply, an increase in production
causes the interest rate to rise
21
Aggregate demand: The LM equation
22
Aggregate demand: The LM equation
The LM curve:
• Shows what the interest rate will be for each level ofproduction
• Slopes upwards since higher production leads to moretransactions and an increased demand on money
• The slope is determined by how production andinterest rate affect the demand on money
• Changes in production and interest rate lead tomovements along the LM curve
• Changes in exogenous variables (like M) lead to shifts ofthe LM curve
23
Aggregate demand: Equilibrium in the IS-LM
model
Goods’ market equilibrium
Consumption function
Investment function
Money market equilibrium
Four endogenous variables: Y, C, I, and i
Y =C+ I
M
P=Y
V (i)
C =C Y,Y e, i-p e,A( )
I = I i-p e,Y e,K( )
24
Aggregate demand: Equilibrium in the IS-LM
model
25
Aggregate demand: Equilibrium in the IS-LM
model
(IS)
(LM)
A: Both markets in equilibrium
B: Goods’ market not in
equilibrium (Y must go down)
C: Money market not in
equilibrium (i must go up)
Y =C Y,Y e, i-p e,A( )+ I i-p e,Y e,K( )
M
P=Y
V (i)
26
Aggregate demand: Equilibrium in the IS-LM
model
How to use the IS-LM model to analyse the effects of a
change in some exogenous variable:
• Determine whether disturbance shifts IS and/or LMcurve(s) and draw new curves in the diagram
• From the diagram, read what is the effect on interestrate and production (if they are going up or down)
• Present an economic explanation for what is happeningin the goods’ and money markets (direct and indirecteffects)
• Investigate and explain the effects on other variables(employment, consumption, investments, etc.)
27
Aggregate demand: Equilibrium in the IS-LM
model
What happens if the money supply increases ( )?0M
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Aggregate demand: Equilibrium in the IS-LM
model
What happens if consumers and investors become more
optimistic about the future ( )?DY e > 0
29
Aggregate demand: How do we know if the
model is right?
There are many studies of microdata that show that prices
are sluggish.
It is harder to use macroeconomic data to test the model.
30
Aggregate demand: How do we know if the
model is right?
How can we test if monetary policy has any effects on the
real economy?
• Study the correlation between changes in interest rateand changes in production?
• Carry out experiments with monetary policy?
• Use statistical methods (VAR) to identify effects of‘exogenous’ shocks to the interest rate. Studies usingthis method suggest that monetary policy hassubstantial effects on GDP
31
Aggregate demand: Effects of an unexpected
change in the interest rate in the USA
32