Macro08topic4HT08

Macro08topic4HT08 - Topic 4 The economy in the short run...

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1 Prof John Vickers David Williams Department of Economics Topic 4 The economy in the short run
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2 Prof John Vickers David Williams Department of Economics Does the ‘classical’ model work in the short run? If prices clear markets − which may be reasonable to assume in the long run − we have the ‘classical dichotomy’ between real variables – output, employment, real wages, real interest rate, etc – determined by real forces, and nominal variables – wages, prices, exchange rates, etc – determined by monetary policy But in the short run many prices and wage rates appear ‘sticky’ and unresponsive Then, quite unlike the classical model, quantities rather than prices may do the adjusting to economic shocks
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3 Prof John Vickers David Williams Department of Economics UK unemployment Source: Mankiw & Taylor, figure 1-3
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4 Prof John Vickers David Williams Department of Economics If quantities, not just prices, adjust in the short run… Greater output and (un)employment volatility Possible role for stabilization policy in response to demand and supply shocks monetary policy? fiscal policy – ‘Keynesian’ demand management? Policy discretion rather than rules? But might policy discretion have costs? And why might prices be sticky in the short run? Should policy aim instead at removal of price rigidity?
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5 Prof John Vickers David Williams Department of Economics Short-run analysis: a map Keynesian Cross Loanable Funds Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve: short/long run Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations
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6 Prof John Vickers David Williams Department of Economics Lecture plan The IS curve − goods market equilibrium between investment and saving The LM curve − money market equilibrium between money supply and demand for liquidity Hence the IS-LM model of aggregate demand AD Combining aggregate supply AS with AD Open economy issues
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7 Prof John Vickers David Williams Department of Economics A very basic ‘Keynesian’ model Simple closed economy model Planned expenditure is E = C + I + G Actual expenditure/output is Y = real GDP Over-production = unplanned inventory investment = Y – E = - ( ) C C Y T I I = , G G T T = = ( ) E C Y T I G = - + + = Y E Consumption function: Investment is (initially) exogenous: Planned expenditure: Equilibrium: Govt policy variables:
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8 Prof John Vickers David Williams Department of Economics The Keynesian cross model income, output, Y E planned expenditure E  = Y E  = + + G Equilibrium income 45 º MPC 1
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9 Prof John Vickers David Williams Department of Economics Effect of fiscal policy: Δ G Y C I G = + + Y C I G = ∆ + ∆ + ∆ MPC = × ∆ + ∆ Y G C G = + ∆ (1 MPC) - ×∆ = ∆ Y G 1 1 MPC = × ∆ - Y G equilibrium condition in changes because I   exogenous because C   = MPC   Collect terms with Y    on the left side of the equals sign: Solve for Y  :
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Macro08topic4HT08 - Topic 4 The economy in the short run...

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