LR Classical/Monetarist Model
Full employment Output in LR-Say's Law
Self-adjusting economy Vertical agg S curve at natural rate of unemployment/ natural rate level of output
Fiscal Policy no (and probably bad)
Complete crowding out G up I down no stimulus
Just composition C versus I (and growth)
Not needed self-regulating - full emp.
Monetary Policy P only
M->P only thru Quantity Theory of Money Classical Dichotomy/ Neutrality of money
Real factors determine real variables
K,L->y,Unemp (natural rate of unemployment,y) Loanable Funds Theory
S&I-> real interest rate=nominal i exp. inflation
Classical Dichotomy Neutrality of Money
M->P and nominal int rate, nom W NOT real vars
Krugman gt / friedman inflation causes/ de long p curve
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In the News?
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Course Issues
Midterm Weds EC-Greg Ip Little Book of Economics
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Quick Keynesian Review
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Keynes versus the Classics
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.
- John Maynard Keynes, A Tract on Monetary Reform (1923) Ch. 3 [2
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What Determines The Level Of Output In The Long-run?
A. Aggregate D&S B. Prices C. Fiscal and monetary policy D. Capital and Labor given technology E. Money supply
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Why?
Say's Law S->D
What about S not = I?
Loanable Funds Theory S & D for LF
->ireal and thus S=I at full employment
Flexible Wages and Prices
price rather than output adjustment
Quantity Theory of Money MV=Py
M->P only since V const and y at fe
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Say What?
Economy tends to full employment
potential gdp=natural rate level of output LR
No `general glut'if you produce it they will buy it
Can't have too little agg demand desired I=S always loanable funds theory
Real forces of productivity, amount of capital, labor force determine output
Business Cycle Fluctuations temporary
automatic adjustment thru price
No need for policy, and of no use
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Loanable Funds Theory real int
Supply and Demand for loanable funds
Savings and Investment determine the real interest rate Hence desired S= desired I always (at full employment) More next week
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SR and LR Aggregate Supply Curves
Short-Run - Keynesian Assume costs/wages constant Agg D increases to AD1 a->b P up -> profits up Qs up to b
Move along SR S Y up, P up If wages/costs not changed
Why Wages not changed?
Sticky Wages or Money Illusion
Long-Run-Classical As P up, W up SR S shifts SAS1 b->c Back to orig Y, P higher, W higher, W/P unchanged
Flexible wages and prices Output NAIRU output level, or potential output level or NAIRU
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ShortRun to LongRun Agg Supply
SR & LR Equilib at 1 Output at Yn U at Un Agg D increases to AD2 LRA P SR equilib at 2 S 3 P up, nom W unchanged sticky, Y up, U down, *below* Un (note 2 P* real Wage down too) Not LR equilib (W fixed, U<Un) 1 Nominal Wages increase- SRAS2 Y Y1 New SR & LR equilib 3 U=Un, Y=Yn n SRAS will keep shifting up until U=Un at Yn
SRAS2
AD 2 AD
Y
SRA S
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Keynesian vs Classical
Keynesian
Output and P Ms and P, Y Monetary transmission Interest rate determinants Unemployment Inflation Agg D&S below full emp Ms->i->I->D->p,y " Ms&Md->i nom Low agg D or S D or S shocks
Classical
L,Ky=f(K,L,tech) full emp Ms->P Ms-Spending/D ->P (y fixed) S & I -> i real i nom=i real+ infl Natural rate Ms growth
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Keynesian vs Classical 2
Keynesian Fiscal Policy Needed G->D->y, P Partial G up->I down Classical Not needed G crowds out I No change in D complete
Crowding Out
Monetary Policy
Useful Ms->i->I->D>p,y
Only P Ms->nom spending->P
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Keynes General Theory
Why did Keynes call his theory General? And why was it so hard for him to come up with it? See annotated chapters
1965
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Inflation in the Short-Run Keynesian
Demand Pull p,y up Cost Push p up, y down Stagflation Supply Shocks Wage-Price Spiral Self-Limiting Prices rise inflation Stops higher P
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Inflation in the Long-Run-Classical
D,S shocks self-limiting
Prices up but then stop Unless D continues to increase Only increases in Ms
"Inflation is everywhere and always a monetary phenomena" Friedman
Why would M increase continuously?
Too low a U target Validation of fiscal Policy
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Long-Run Phillips Curve
Short-Run Phillips Curve
Rate of Inflation & (%) Level of Unemployment (%) from Aggregate D & S downward sloping tradeoff between U and inflation
Long-Run Vertical Phillips Curve
Expectations Augmented Inflation = f(-U, +Exp Infl,+adverse Supply Shocks) SR P curve shifts LR No Tradeoff
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The NAIRU is
A. Inflation rate at which unemployment is 0 and only structural unemployment B. Unemployment rate at which inflation isn't increasing and no cyclical unemployment C. GDP at which unemployment is minimized D. 4%
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What's Natural about the Natural Rate? And Why NAIRU?
Labor market clearing rate of unemployment
Structural and frictional unemployment only Rate at which inflation = 0
Inflation=f(-U, Expectations) Below it, inflation increases
At NAIRU, inflation constant
(no acceleration)
NAIRU changes
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Real Interest Rate-What Is It
i real = i nominal expected inflation
i nominal = i real + expected inflation Real interest is the amount you receive for lending or pay for borrowing in terms of what you can buy with it Nominal interest is the $ you receive for lending or pay for borrowing Real interest rate is the key variable in determining investment and savings in the LR
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Fiscal Policy in the LR
Ineffectual in stabilization
Self-adjusting economy, fiscal policy not needed
Crowding out
If G up -> borrow more -> i up ->I down hence no affect on agg D just composition
Ricardian equivalence
If G up -> S up/C down to save for paying it back
Composition of output and growth
With G up and I down, less growth
Taxation and dead-weight losses
Inefficiency of taxes
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National Debt and foreign lenders
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Monetary Policy in the LR
Inflation focus (only) Expectations
Inflation=+exp Inflation, - Unemp, + adverse Supply Shocks credibility
Nominal anchors and and expectations
Rules
Time inconsistency Problem
Taylor Rule fed funds target=+inflation gap, + output gap
Inflation targeting
Constant Growth Rule (k% rule) Friedman
MV=Py -> to keep P constant, M grows at rate of Y
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Very Key Points
LRAS curve is vertical due to flexible wages and prices
SRAS upward sloping due to wage/price rigidities Vertical LRAS means full employment in LR price adjusts to shocks, not output
LR Inflation is a monetary phenomena Ms only (very) LR cause LR Phillips Curve Vertical no tradeoff between inflation and unemp
In LR, more inflation without less unemployment
Inflation=+exp Inflation, - Unemp, + adverse Supply Shocks
Inflationary Expectations quite important in Monetary Policy Credibility, Nominal anchors Rules Time inconsistency Problem Taylor Rule fed funds target=+inflation gap, + output gap Inflation targeting Constant Growth Rule (k% rule) Friedman MV=Py -> to keep P constant, M grows at rate of Y
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Quick Keynesian Review
Why did Keynes call his theory General? And why was it so hard for him to come up with it? How do the Keynesian and Classical Models relate to the current situation and policy disagreements?
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Classical, Keynesian, Monetarist/Neo-Classical, Rational Expectations, Supply Side, Real Business Cycle
Classical Macroeconomics: - pre 1930's Long-Run
Says Law "supply creates its own demand" hence no general glut (no unemployment) Loanable Funds Theory real interest rate determined by saving and investment
nominal interest rate = real rate + expected inflation
Flexible Wages and Prices vertical aggregate S curve Quantity Theory of Money
MV=Py (or PQ) Velocity=Py/M (nomGDP/Money) Money Supply ONLY affects Price level, not output or other real variables neutrality of money Classical Dichotomy
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Keynesian Revolution
1936-70's 'overthrew' classical model for Short-Run
Sticky or ridgities in wages -> upward sloping short-run -aggregate supply curve
Hence, equilibrium below full employment possible recession/depression long-lasting
Economy unstable and needs government intervention fiscal policy
Monetary policy can't push on a string
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Monetarists,Neo-Classical, Rational Expectations, Supply-Side, Real Bus.Cycle
Monetarists / Neo- Classical
Milton Friedman 1960; reformulated Classical more rigorously M changes P and y in SR, only P in LR. Monetarists versus fiscalists (Keynesians)
Rational Expectations
Optimal forecasts (but not necc. correct) Only anticipated policy has impact
Real Business Cycle Theorists
Shifts in aggregate supply drive economy
Supply-Side Economics
SR incentives to shift agg S P down, Y up Laffer curve No empirical support
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