ISCurve - 10/27/2010 Economic Fluctuations Fluctuations A...

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10/27/2010 1 Economic Fluctuations A Solow-ISLM model Juan Carlos Cordoba ISU A Solow-ISLM Model Potential Output versus Aggregate Demand Keynsians distinguish between potential output, ( ) ( ) 1 , t t t t N K F z Y = … and desired output or aggregate demand: Here G t stands for government purchases at time t . In the Solow model .. but economies may not always produce at their potential. For example, excessive unemployment suggests that () 2 d t Y = d t t Y Y = t d t Y Y < t d t d t G I C + + (aggregate demand is weak). In those cases actual (observed) production is determined by the short side of the market: In what follows, we focus in the case . Therefore, so that production = aggregate demand<potential output. ( ) d t t t Y Y Y , min = t d t Y Y < d t t Y Y =
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10/27/2010 2 Solow-IS-LM Model Price stickiness and price adjustments A reason for this problem ( ) could be price stickiness. • prices do not adjust quickly to guarantee at all times. t d t Y Y < d t t Y Y = •L e t p t be the nominal price (in dollars) of a unit of output at time t . Suppose p t is predetermined (i.e., given or unresponsive) at time t . • For example, if G t increases it affects but does not affect p t . Prices do respond to "clear" the market but with lag : d t Y 0 , 1 > = + μ t t d t t t t Y Y Y p p p Thus, excessive aggregate demand (over potential output), , leads to price increases. As we will see, higher prices reduce the gap between and . Once prices stop changing ( p t = p t+1 ). t d t Y Y > d t Y d t t Y Y = t Y IS-LM Model Short term "quasi-equilibrium" The ISLM model serves to study the short run performance of the economy when , or more generally, when the aggregate production is t t Y Y < determined by the aggregate demand. Developed by Sir John Hicks (Nobel Laureate) in 1937, it was initially intended as a graphical representation of Keynes ideas. The ISLM model continues to dominate policy. It has gained new strength during the current economic crisis. The ISLM is commonly ignored by serious academicians because it relies on i ti l b h i d i i i t t ith i i l id irrational behavior and is inconsistent with empirical evidence. Modern versions of the ISLM model introduce some rational behavior and better quantitative predictions.
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ISCurve - 10/27/2010 Economic Fluctuations Fluctuations A...

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