Macro 1
Intro Assignment 9 NOTES The Long-Run/Classical Model and another look at Keynesian Macro Investment Game Round 3 and Career advisement
N. Sheflin
ONLINE MIDTERM Wednesday 10/26 4pm through Friday 10/28 8pm Must be taken in 1 hour window during this period. COVERS weeks 1-8 in 50 multiple choice questions covering material from these weeks. You might wish to study as follows: - review the OUTLINE OF KEY POINTS TO DATE below -look up any of the topics you don't understand -look at the textbooks' end of chapter summaries -look at the big questions and notes in each assignment -review the `answered' hw I posted -review the general hw questions you got wrong You must ASK YOURSELF QUESTIONS and TEST YOURSELF looking up material that you get wrong.
READING Rittenberg Chapter 7, focusing on the material on long-run aggregate demand and supply. Chapter 11, just section 3. MONETARY POLICY AND THE EQUATION OF EXCHANGE Chapter 12, just section 3 ISSUES IN FISCAL POLICY focusing on crowding out. Chapter 16, just section 3 `INFLATION AND UNEMPLOYMENT IN THE LONG RUN And: also http://www.bized.co.uk/virtual/economy/library/theory/ -read the material on classical/neo-classical economics and monetarism and Keynesianism and Keynes (bio, work, theories) and Friedman (bio, work, theories And the master at http://www.marxists.org/reference/subject/economics/keynes/general-theory/ Read the Preface, Chapter 1 and maybe, Chapter 3 (tougher) KEY POINTS note THE key is that the aggregate supply curve is VERTICAL in the LR Classical model explains long-run tendencies in the economy, and behavior if at full employment Output determined by K, L (and technology and raw material costs) o Output is at full employment/potential GDP producing all we can with given amount of labor and capital o Output is insensitive to P (i.e. vertical aggregate supply curve) since increases in price I nthe long-run increase both the demand for labor but reduce the supply and these cancel out. With no additional labor, output doesn't change with changes in price o Output grows with increases in K, L, technology (later) o Unemployment is at the natural rate with only frictional and structural unemployment Interest rates determined by Supply and Demand for loanable funds = Savings and Investment (NOT Ms) o Focus on REAL interest rates (what the interest can buy) Price level determined by Money Supply ONLY o Classical Dichotomy says M affects price level and NOMINAL Variables only Real variables determined by real factors Policy
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o Not needed since self-regulating economy tending to full employment o Fiscal Policy not needed, no effect due to complete crowding out o Monetary Policy not needed and affects only P and inflation Monetarism o Friedman money important determinant of SR fluctuations also; otherwise, classical lr view.
4 elements of the Classical Macro: 1) Says Law - "supply creates its own demand" hence no unemployment (other than structural and frictional). Production generates income which leads to consumption so there can't be a general glut of output and there can't be widespread sustained unemployment. If business produces and sells $100 of toasters, then they create $100 in income which creates $100 in spending (consumption) and everything is bought per the circular flow. a. Of course we know about leakages and injections (Saving and Investment), so that some of the $100 in incomes will `leak-out' of the spending stream as saving. Unless these are equalized, the economy will slow down (recession) b. In the Classical model, there will automatically be the same amount of investment injection through the loanable funds model. 2) Loanable Funds Theory explains why Saving equals Investment in the long-run and thus why Says law always holds. The supply and demand for `loanable funds' i.e., funds that can be loaned or borrowed (= saving and investment) determines the real interest rate and in equilibrium makes sure that S=I and hence the economy tends towards full employment equilibrium. The Supply of loanable funds is saving (Y-C) and is assumed to depend positively on the real interest rate higher real interest rate, more people wish to save. The Demand for loanable funds is inversely related to the real interest rate the higher the real rate, the less business wishes to borrow and invest. Normal market forces tend towards an equilibrium in which S=I (leakages = injections) and the economy is at full employment, purchasing all it produces.
2. Flexible Wages and Prices vertical Long-run aggregate Supply curve (LRAS). Meaning that changes the in aggregate price level does not change the level of output because price level changes also increase wages which offset any tendency to expand output. a. In the short-run, an increase in prices with wages constant, leads to an increase in the aggregate quantity supplied (move along the current SRAS curve) as business finds it profitable to expand output and thus we get the upward sloping SRAS curve (short-run aggregate supply curve) - movement from C to B with an increase in aggregate Demand. b. In the long-run, as workers see prices rising, they begin to ask for higher wages and the SRAS shifts up from SRAS1 to SRAS2 and we wind up back in equilibrium at A with higher prices but no change in output, which remains unchanged at the natural rate level of output
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4. Quantity Theory of Money explains the role of money in the long-run Classical model which is ONLY to determine the price level and nominal values. Start with the equation of exchange: MxV=Pxy (or PQ) where M=money supply, V=velocity, P=price level and y=real gdp. Note that Velocity=Py/M (nomGDP/Money) i.e. , how many times the stock of money changes hands each year Assume that velocity is roughly constant and that output is at full employment level according to Say's law and flexible wages and prices and loanable funds theory. Then, the quantity theory implies that changes in the Money Supply ONLY affects the level of Price, not output or other real variables. i.e. M x V = P x y and with V and y `fixed' (unchanging) then changes in M can only change P. This is referred to as the neutrality of money or Classical Dichotomy The Classical Model putting the above together in the aggregate D & S framework, we get the following results A vertical long-run supply curve at the level of potential GDP or natural rate level of output since flexible wages will increase whenever prices do, causing the SRAS curve to shift up and offset any increase in output caused by an increase in aggregate demand. Fiscal Policy leads to complete crowding out of investment (bad) and thus has no impact on Aggregate demand or anything else (other than I) and is not needed and not effective in the LONG RUN. Monetary Policy - only changes Prices (and other nominal variables like the nominal interest rate, nominal wage rate, etc) and thus not useful or effective for stabilization in the LONG RUN. Real Interest rates determined by Saving &Investment (real forces of thrift and productivity of capital) Summary: o o o Full employment in LR Self-adjusting economy M->P only Classical Dichotomy/ Neutrality of money No Fiscal Policy needed or useful Crowding out - G up I down Not needed economy tends to full emp. If left alone Monetary Policy M->P only
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MULTIPLE CHOICE QUESTIONS Sakai Tests & Quizzes INVESTMENT GAME Investment Game Round 3 posted under Resources/Investment Game NEWS , find examples of two of the following: Say's law
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velocity quantity theory natural rate of unemployment sticky wages classical dichotomy loanable funds theory real versus nominal interest rates DEFINITIONS you should define each of the following out loud to your cat. If nothing comes out of your mouth for (or if your cat laughs), look it up and try again Classical Macro Model Say's law Velocity of money Quantity theory Natural rate of unemployment sticky wages classical dichotomy loanable funds theory real versus nominal interest rates
APPLICATIONS 1. Find a good online, short, video or slide show biography of Keynes (prize for the best one). 2. Try the Presidential Game at: http://bcs.worthpublishers.com/mankiw7/#t_517719____ - and then scroll down to click on the Presidential Game link.. Note this is primarily short-run (Keynesian) policy making. a) What are the `goals' of the game? Why? Why is it hard to `win'? b) What are the policy tools? c) What are the short-run, and long-run impacts of a. an increase in money supply growth rate? b. an increase in tax rate? c. an increase in government spending share? SOME BIG QUESTIONS 1. 2. 3. 4. 5. 6. 7. How does the Classical Model explain output, interest rates, unemployment, prices and inflation What does the classical dichotomy imply about the role of monetary and fiscal policy? Which is correct, the Keynesian or the Classical Model? What makes the Classical model so different from the Keynesian model? Why did Keynes feel Say's law would not hold in the short-run? 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?