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Principles of Macroeconomics Professor Jeffrey Nilsen

Principles of Macroeconomics Professor Jeffrey Nilsen. The Economy in the Short Run Chapters 20 - 24. Chapter 20 Short-term Economic Fluctuations. If you’ve lost your job in recession, you won’t care that living standards will improve in long-run from gdp growth

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Principles of Macroeconomics Professor Jeffrey Nilsen

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  1. Principles of MacroeconomicsProfessor Jeffrey Nilsen The Economy in the Short Run Chapters 20 - 24

  2. Chapter 20Short-term Economic Fluctuations • If you’ve lost your job in recession, you won’t care that living standards will improve in long-run from gdp growth • Ch. 21’s basic Keynesian Model explains business cycle caused by spending • Ignores inflation • Ignores economy’s longer term self-correction mechanisms

  3. Expansion (boom): when Y grows significantly faster than normal • Recession (contraction): when Y grows significantly slower than normal • Depression: very long & severe recession • Solving simultaneous equations? Trough Peak Trough Peak

  4. Business Cycle is mis-named • “Cycle” doesn’t actually occur at regular intervals but has irregular length & strength • Difficult to know exactly when peak & trough occurs • A single business cycle affects nearly all industries & may affect all nations

  5. USA Real GDP (a long run view of the data)

  6. Potential (or “full-employment”)Output Y* • The maximum sustainablereal GDP an economy can produce • “Sustainable”: economy may be able to utilize its inputs above this rate for short time • Y* grows over time due to growth in labor, capital and/or technological change

  7. Causes of Recessions • I. Slow Y growth, normal Y* growth(economy doesn’t fully use K & L available) • Output gap (Y – Y*) arises: Y below Y* recession & high unemployment • If Y above Y* gap positive, tendency for higher inflation • Policy makers may want to “stabilize” economy (i.e. close output gap) • II. Slow Y* growth due to slower growth in technology (or reduced K & L): • If use K & L at normal rates, Y slows too • ZERO Output gap • Policy goal: promote saving, human capital & other investment to speed up Y* growth

  8. Recession Features: • High unemployment • High U rate signals poor utilization of resources (labor willing but unable to work) • Slow real wage growth • Durable goods industries slow down more than nondurable goods industries • Durable = “long-lasting” e.g. cars, houses

  9. Unemployment Concepts • Natural rate U* = frictional U + structural U • U* changes over time; difficult to measure • Cyclical U = U – U* (actual – natural U ) • Recessionary output gap Y < Y* so (U – U*) > 0, i.e. positive cyclical U • Expansionary output gap Y > Y* so (U – U*) < 0, i.e. negative cyclical U • When U = U* (natural rate), cyclical U = 0. No output gap exists

  10. Reasons for U* Changes over time • Internet job matching reduces frictional U • Baby boom aging reduces both frictional & structural U: • Older workers make fewer job changes • Young more likely to change jobs, to not have requisite skills

  11. Okun’s Law: Recessionary Output Gap brings Cyclical U • Empirical estimate of relation between output gap & cyclical U: • 1% cyclical U rise brings 2% fall in output gap • (Y – Y*)/Y* = -2 (U – U*) • If actual U = 7% & U* = 5% (high unemployment) • Then output gap = – 4% • Okun’s law specifies loss of GDP due to high U

  12. Some GDP Fluctuations due to Output Gaps: • Output gap due to fall in C or I or NX can be “closed” by rise in G • Over time, output gap causes P changes • Deflation from recessionary gap (workers willing to work for lower wages if out of work) • Inflation from expansionary gap (workers want higher wages due to more jobs than workers) • Firms’ P changes will eventually eliminate output gap (actual Y = Y*) • Output then fixed by economy’s productive capacity, not spending

  13. Preview: How Output Gaps Develop & Possible Policy Responses • In short run, firm’s capacity (Y*) fixed by K & L in place • Most sales changes due to fluctuating spending (not Y* changes) • Evidence shows P adjusts slowly: Y ≠ Y* • Firms estimate sales & pre-set appropriate P to “meet demand” (keeping P fixed in short run) • In short run, spending (C + I + G + NX) determines Y • In long run, firms change their Y* & also their P to be more appropriate to future expected demand

  14. Chapter 21: Spending & Output in the Short Run • Vicious cycles & the Keynesian Cross

  15. Economic Model • Implements theory’s explanation of an economic phenomenon • Like a road map, it abstracts from details like mountains, buildings to give clear & simple info on the desired route • Simplifying assumptions eliminate inessential details • Express Keynesian Model’s ideas in: • Precise words • Tabular form • Graphs • Equations

  16. Keynes’ ModelKey P Assumptions • Short-run: firms meet demand using earlier-set P set (data shows realistic!!) • Firms delay changing prices due to menu costs including: • Market survey, managerial time to find “best” P • Informing & perhaps angering customers with P changes • Firm chooses to raise P if Benefits (additional revenues) > Menu costs

  17. Keynes’ (Short run) Model • Aggregate spending changes cause business cycles • Story: planned aggregate expenditure PAE determines (actual) Y • ActualYmay differ from (potential) Y* • Fall in PAE leads to recessionary output gap • Rise in PAE leads to expansionary output gap • Policy goal to eliminate output gaps (“stabilization” policy)

  18. PAE determines Y in short run • PAEcomponents: • C = consumption by households • G = gov’t spending (no transfer payments) • NX = net exports (EX – IM) • Recall, imports subtracted, since counted in C, I, G • PAE = C + IP + G + NX • Assume actual C, G, NX = planned C, G, NX

  19. Consumer Spending, CLargest part of PAEinfluenced by: • Higher disposable income (Y – T) induces people to consume more • Autonomous consumption (C unrelated to disposable income): rises when • Confident: consume more, save less • Greater wealth: stock boom increases wealth, consume more at each level of disposable income • Lower interest rates: cuts borrowing cost so can buy cars and other consumer durables

  20. Keynes Consumption Function • Summarizes consumer spending motives • : autonomous consumption • mpc : “marginal propensity to consume” (rise in consumption due to next $1 of disposable income) • With next dollar income, save part & spend part => mpc between 0 & 1

  21. Planned & Actual Investment May Differ • If Actualsales < Expected sales(sales disappointing) => (unsold) inventories rise • I > IP(actual inventory investment greater than planned) • If Actualsales > Expected sales (sales are good) firm’s inventories shrink • IP > I (planned inventory investment greater than actual)

  22. Keynesian Model’sVicious Cycle • Production cut => lower income => spending cut => further production cut … • If firms cut production, workers’ & owners’ incomes fall • So workers & owners cut spending & production falls further • Consumption function shows link from production& income to spending C= 100 + ¾ (Y – T) spending income

  23. Consumption Function, Graphed Consumption function mpc 1 C = 100 + ¾ (Y – T)

  24. From the Consumption Function to PAE • LetC = 100 + ¾ (Y – T) • Let G = 120, T = 100, IP = 200, NX = - 20 • Then PAE = C + IP + G + NX • PAE = 100 + ¾ (Y – 100) + 200 + 120 + (- 20) • PAE = 100 + ¾ Y – 75 + 200 + 120 – 20 • PAE = 325 + ¾ Y • $1 higher income increases PAE by 0.75 (through the consumption function mpc again) Induced Expenditure (depends on income) Autonomous (independent of income)

  25. PAE or Expenditure Line PAE = 325 + ¾ Y Slope: mpc (same as in consumption function) Rise in autonomous expenditure shifts expenditure line up Autonomous Expenditure

  26. Short-Run Eqbm OutputUsing Table • Eqbm when firms produce Y equalling PAE Output or income too small for PAE (not enough inventories) so firms raise output Output or income too large for PAE (too many inventories) so firms cut output When Y rises by 100, PAE rises only by (mpc * 100) or 75

  27. Short run Eqbm OutputUsing Algebra • PAE = 325 + ¾ Y • Short run Eqbm requires PAE = Y, so • Y = 325 + ¾Y • ¼Y = 325 => Y = 1300 income PAE

  28. PAE Y = 1500 Short run Equilibrium OutputCalculating by Graph PAE =1450 mpc 325 Keynesian Cross 1500 At Y = 1500: Y > PAE C+I+G+NX > C+IP+G+NX I > IP Firms building up inventory so cut Y YSR.EQBM Y output

  29. PAE falls: a Recession is Born(worsened by Vicious Cycle) • PAE = 325 + ¾ Y: • Initial SR eqbm for Y* = 1300 and • Output Gap (Y– Y*) = 0 • Shock: share prices fall, people feel poorer so • Autonomous expenditure falls (assume to 300) • => PAE line shifts down 25 (lower planned spending at each level of income) • (Y* = 1300 still) • Find new SR eqbm Y by algebra • Y= 300 + ¾ Y => Y= 1200 • Y < Y*, now 100 recessionary gap 300 1200 1300

  30. The Vicious Cycle (Income-Expenditure Multiplier) • PAE’s Drop 25 caused Y to fall by 100 • «New» output gap since Y* constant • Initial spending cut reduces output & income in all sectors. The drop in Y leads to further spending cuts • Vicious Cycle: Initial spending cut reduces spending & income by multiple • Size ofmultiplierrelatedtompc • For given fall in spending, larger mpc => greater reduction in eqbm spending

  31. Stabilization policy: adjust PAE to try to close output gap • Fiscal (gov’t) or Monetary (ch 22) (central bank) Policy • Expansionary Policy: goal to raise Y to close recessionary gap • Contractionary Policy: to cut Y to close expansionary gap • NO WAY to use stabilization policy to fight slow Y* growth recessions

  32. Fiscal Policy: Change G • Stock crash cuts spending by 25 and shifts down PAE line • Gov’t raises spending by 25 to restore expenditure (PAE line shifts up to initial location)

  33. Difficulties with Fiscal Policy • 1. May not only affect PAE but also Y* (new highways may increase Y*) • 2. Higher deficits raise interest rates to «crowd out» investment spending • 3. INflexible • Legislation time-consuming • Gov’t may have conflicting goals (e.g. want economic expansion but to cut defense spending) • Automatic stabilizers more flexible: in recession lower income cuts T while U payments rise

  34. Problem 21.1 • Assume for Acme Corp: • It produces 4,000,000 in goods and expects to sell all its output • It plans to buy 1,500,000 in new equipment • It has 500,000 in inventory at the beginning of the year • What is actual & planned investment if: • It actually sells 3,850,000 of goods • It actually sells 4,000,000 of goods • It actually sells 4,200,000 of goods

  35. Problem 21.2Benjelloun Family • Graph the family consumption functionand find their marginal propensity to consume • How much would the family consume if their income was 32,000 and they paid taxes of 5,000 • Family wins a lottery so consumes more at each level of after-tax income (excluding prize). How does it affect the graph of their consumption function? Their mpc?

  36. Problem 21.3, 21.4 & 21.5 • Economy described by equations: • C = 1,800 + 0.6(Y-T) • IP = 900 • G = 1,500 • NX = 100 • T = 1,500 • Y* = 9,000 • A. Find numerical equation linking PAE to output. Identify autonomous expenditure & induced expenditure • B. Construct table to find short-run eqbm output (try from 8,200 to 9,000) • C. Show short-run eqbm using Keynesian Cross • D. Solve for short-run eqbm using algebra • E. What is output gap%? If U* = 4%, use Okun’s Law to find actual U. • F. Find effect on short-run eqbm Y of rise in gov’t purchases to 1,600

  37. Chapter 22Stabilization: Monetary Policy & The Central Bank • Central Bank policy decisions (changes in target interest rates) strongly influence financial markets & the macroeconomy • Goal: to eliminate output gaps • Monetary policy is more responsive than fiscal policy

  38. The Central Bankin the Banking System • Bank runs are chronic problem in fractional reserve banking system • When many depositors try to withdraw at same time, bank reserves may go to zero (bank fails) • If run, even profitable bank can fail • Institutions set up to limit bank runs after great depression: • Regulate banking system so banks sound • Require banks to hold level of reserves • Central bank ready to lend reserves to banks • Deposits insured by gov’t so public should not fear loss

  39. Policy Influences on PAEHigher rates cut: • Consumption Spending(autonomous part): raises saving at any Y so cuts consumption at any Y • PlannedInvestment: discourages firms from buying new capital (and public from building new homes)

  40. Central Bank’s Influence on Interest Rates • Influences nominal & also real interest rate (i – π = r) since inflation changes slowly • Affects r only in short run (savings & investment determines r in the long run) • BNB target rate: interbank rate (rate on very short-term loans of reserves from one bank to another) • Open market operations strongly influence interbank rates (banks’ lending rates often follow interbank rate) • Less influence over other market interest rates

  41. IntroducingInterest Sensitive PAE • Previously: • C = 100 + ¾ (Y – T) • G = 120, T = 100, IP = 200, NX = - 20 • PAE= C + IP + G + NX = 325 + ¾ Y • Interest sensitive PAE by hh & firms: • C = 100 + ¾ (Y – T) – 200 r • IP = 200 – 200 r • Unchanged:G = 120, T = 100, NX = - 20 • PAE = 100 + ¾ Y – 75 – 200 r + 200 – 200 r + 120 – 20 • PAE = [325 – 400 r] + ¾ Y • Term in brackets is autonomous expenditure

  42. PAE negatively related to interest rates • PAE = [325 – 400 r] + ¾ Y • If r = .05 (i.e. 5%), PAE= [305] + ¾ Y • Short-run eqbm: Y = PAE so • Y = [305] + ¾ Y • If r = .10 PAE= [285] + ¾ Y • Short-run eqbm: Y = 285 + ¾ Y • ¼ Y = 305 Y = 1220 ¼ Y = 285 Y = 1140

  43. Recessionary Output Gap • Assume r = 10% and Y < Y* (so high U) • BNB cuts interest rate from 10% to 5%. • Households & firms increase spending so PAE rises to close output gap

  44. PAE Expenditure Line shifts up with fall in interest rates mpc PAE =1300 285 Y = 1140 1500 305 Y = 1220 Y*

  45. Expansionary Output Gap • Persistent high demand induces firms to raise prices => inflation • Central bank can raise real interest rate to slow economy and shrink (Y – Y*)

  46. PAE Expenditure Line shifts down with rise in interest rates mpc PAE =1300 325 If i = 0 => PAE = 325 + ¾ Y Y > Y* Then BNB raises rates to 5% Y = 1300 1500 305 Y = 1220 Y*

  47. A Monetary Policy Rule (MPR) • Graph reflects systematic policy: • To cut inflation, Fed raises r, PAE fall & Y falls via multiplier • When low inflation (i.e. U high), Fed cuts r, PAE rises => Y rises via multiplier • MPR summarizes relation of π changes to Fed policy r rate changes • π*: target inflation rate • When π = π*, Fed sets r = r*

  48. Long run Targets of MPR • Fed sets r* target at level where SNAT = Investment • Fed chooses π*that brings best long-run Y* performance • In short-run, π ≠ π*, so r ≠ r*

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