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Unformatted text preview: 5/19/2011 Economics 1B UC Davis UC D i Professor Siegler Spring 2011 No quiz this week No quiz this week Exams back in section next week The last part of Question 1 on the exam asked you to discuss the impact of a move from a revenueneutral income tax to a consumption on economic growth and economic inequality. This part of the question was worth 8 of 20 points, and the TA's tell me that many people did not address this part of the question. 2 1 5/19/2011 I. Introduction
The economic fluctuations model is a dynamic y aggregate demand and aggregate supply model.
Static models describe the economy at a point in time, while dynamic models describe how the economy evolves over time. The economic fluctuations model combines both the short run and the long run. The economic fluctuations model is similar in structure to the models that the Federal Reserve uses. The economic fluctuations model is also closely related to the models you will most likely use in intermediate macro.
3 I. Introduction
The economic fluctuations model allows us to examine interactions across markets, instead of just examining interactions across markets, instead of just examining each market in isolation. It consists of three relationships:
The IS curve, which represents the relationship between aggregate spending (= real GDP) and the real interest rate. The MP curve, which represents how monetary policymakers react to inflation by changing real interest rates. The IS and MP curves together yield the aggregate rates The IS and MP curves together yield the aggregate demand (AD) curve. The AS curves (short run and long run), which represent how inflation changes as real GDP deviates from its long run trend (potential output). Taylor calls the shortrun aggregate supply curve the inflationadjustment (IA) curve.
4 2 5/19/2011 I. Introduction
Please note that I m going to graphically display the Please note that I'm going to graphically display the economic fluctuations model using two diagrams (IS/MP and AD/AS) instead of the three diagrams that Taylor uses, but the model is exactly the same. There is a supplementary chapter available in SmartSite, under "Modules," which complements the lecture tonight and next Tuesday. th l t t i ht d tT d 5 II. Short Run vs. Long Run
Thus far, we have only examined long run models, Thus far, we have only examined longrun models, which assumed completely flexible prices and market clearing, so that the economy was at always at potential output. These longrun models exhibited the following properties:
Classical dichotomy: The theoretical separation of real and nominal variables, which implies that nominal variables do not affect real variables. Money neutrality: The property that a change in the money supply does not influence real variables.
6 3 5/19/2011 II. Short Run vs. Long Run
Key Difference Between Short Run and Long Run Key Difference Between Short Run and Long Run
In the short run, wages and prices do not fully adjust (sticky inflation assumption) so that nominal variables, like the money supply and nominal interest rates can affect real variables, like real interest rates and real GDP. In the short run, the classical i o o y ea o a o ey i o eu a dichotomy breaks down and money is not neutral. 7 II. Short Run vs. Long Run
Why is inflation sticky in the short run? Why is inflation sticky in the short run?
Expectations of continuing inflation. Many individuals and firms have adaptive expectations in that they use past history as a guide to predict the future. If, for example, inflation has been about 3 percent per year, then it is reasonable to expect i a io o o i ue a pe e pe yea inflation to continue at 3 percent per year. If actual inflation exceeds expected inflation, for example, it will take some time for inflation expectations to be revised upwards.
8 4 5/19/2011 II. Short Run vs. Long Run
Why is inflation sticky in the short run? Why is inflation sticky in the short run?
Staggered wage and price setting. Not all wages and prices are changed at the same time throughout the economy. Workers often negotiate annual or multi year contracts. Firms are also reluctant to continually change prices for many reasons. Because of the i eque a ju infrequent adjustment of wages and price, inflation is e o age a p i e, i a io i slow to adjust. That is, inflation is sticky. 9 II. Short Run vs. Long Run
In the economic fluctuations model, we will make In the economic fluctuations model, we will make the simplifying assumption that inflation is constant in the short run, absent any shocks to input prices, like a dramatic increase in the price of oil. If inflation is constant, then any change in the nominal interest rate will translate into a change in the real interest rate. Over time, inflation will adjust interest rate Over time inflation will adjust eventually, so the Federal Reserve can only influence the real interest rate, real GDP, and unemployment in the short run, but not in the long run.
10 5 5/19/2011 III. The IS Curve
The IS curve represents equilibrium in the market for p q goods and services. Equilibrium occurs where real GDP (Y) equals planned aggregate spending (also called planned aggregate expenditures). It can be represented mathematically as: The difference between the expression above and the national income and product account identity from Chapter 6 is that investment is now planned investment.
11 III. The IS Curve
Let's examine each of the expenditure components, p p starting with consumption (C). The economic fluctuations model assumes that consumption spending depends on two variables:
Disposable income (YT). The amount of income households have at their disposal after paying taxes and receiving any transfers from the government, like u e p oy e t be e its o Socia Secu ity. is et ta es. unemployment benefits or Social Security. T is net taxes. As disposable income increases so does consumption spending. The real interest rate (r). As the real interest rate increases, consumer spending falls since the cost of borrowing is higher.
12 6 5/19/2011 III. The IS Curve
We can express the consumption function mathematically as: h i ll Note that the "C" in front of the parentheses on the righthand side should be read "as a function of." We are not multiplying C by (YT, r), but just saying We are not multiplying C by (Y T r) but just saying consumption depends on disposable income and the real interest rate. We could have just as easily written this as:
13 III. The IS Curve
The "bar" over net taxes means that it is an exogenous variable. Total GDP (Y) and the real interest rate (r) is determined endogenously in the model. There are also other exogenous variables that can increase consumption at any given real interest rate or level of real GDP, including:
Wealth (more wealth, more consumption) Expectations of the future (more optimistic, more consumption) Availability of credit (more credit, more consumption) Uncertainty (more uncertainty, less consumption)
14 7 5/19/2011 III. The IS Curve
The second expenditure is planned investment (I). p p () Recall that investment consists of business fixed investment (businesses' purchases of capital, new equipment and construction of structures), residential fixed investment (household purchases of new homes), and inventory investment. Actual investment may deviate (very temporarily) from planned investment as a result of unplanned planned investment as a result of unplanned (unexpected) inventory accumulation or inventory depletion. In equilibrium (the point of spending balance): actual investment = planned investment.
15 III. The IS Curve
Planned investment depends endogenously on the Planned investment depends endogenously on the real interest rate. When the real interest rate increases, the cost of borrowing is higher, so firms will purchase less capital, and households will purchase fewer new homes. We can show the investment function mathematically as: th ti ll 16 8 5/19/2011 III. The IS Curve
There can also be exogenous factors that shift the There can also be exogenous factors that shift the investment function, so there is more (or less) investment at any given real interest rate. A profit maximizing firm will follow the investment decision rule:
If the expected real rate of return > real interest rate, buy the capital If th td l t f t li t t t b th it l If the expected real rate of return<real interest rate, don't buy capital 17 III. The IS Curve
Anything that changes the expected real rate of return affects investment spending at any given real return affects investment spending at any given real interest rate, including:
Expected revenue from selling the product made with the capital. More expected revenue, higher expected rate of return, more investment at any given real interest rate. Price of capital. The higher the price of capital, the Price of capital. The higher the price of capital, the lower the expected rate of return, and the less investment at any given real interest rate. The cost of using the capital. The more costly it is to use the capital, the lower the expected real rate of return, and the less investment at any given real interest rate. 18 9 5/19/2011 III. The IS Curve
The third component is government spending (G). The third component is government spending (G).
We will assume that government spending is exogenously determined and bears no systematic relationship to the other variables in the model. We will assume the same thing about net taxes (T). If G and/or T changes, then the IS curve shifts since spending has changed at any given real interest rate. spending has changed at any given real interest rate Government sometimes responds to recessions or expansions, but we will look at this on a casebycase basis.
19 III. The IS Curve
The fourth component of aggregate spending is net p gg g p g exports (X).
As we highlighted in Chapter 7, net exports is negatively related to the real interest rate. As the real interest rate rises, the dollar appreciates (the exchange rate rises), making our exports more expensive to foreigners and imports cheaper to Americans, thereby decreasing net exports. decreasing net exports Net exports is also assumed to depend endogenously on real GDP in the U.S. As our GDP increases, so does consumer incomes. The higher incomes mean Americans buy more imports, thereby, causing net exports to fall.
20 10 5/19/2011 III. The IS Curve
We can summarize the IS curve relationship p mathematically as: The variables in parentheses without a bar over them are the endogenous variables. Thus far, we have only introduced one of three parts of the economic fluctuations model.
21 III. The IS Curve
If Y PAE, then inventories unexpectedly rise, which If Y>PAE, then inventories unexpectedly rise, which signals firms to produce less until Y=PAE If Y<PAE, then inventories unexpectedly fall, which signals firms to produce more until Y=PAE The IS curve traces out all of the combinations of the real interest rate and spending balance (where Y=PAE).
22 11 5/19/2011 IncomeExpenditure (or Keynesian Cross) Diagram
Planned Spending IS Curve
As the real interest falls, planned spending and real GDP increases. The IS curve displays these points of spending balance. B C IS C(YT, r2)+I(r2)+G+X(r2,Y) r r0 r1
A C
C(YT, r1)+I(r1)+G+X(r1,Y) C(YT, r0)+I(r0)+G+X(r0,Y) B A r2
450 Y0 Y1 Y2 Y Y0 Y1 Y2 Y
23 III. The IS Curve 24 12 5/19/2011 III. The IS Curve
The IS curve shifts right if spending (and output) spending (and output) increase at any given real interest rate IS shifts right if: decrease in T increase in G exogenous increase in C, I, and/or X i C I d/ X 25 Question 14.1
The proposition that changes in money have no real The proposition that changes in money have no real effect on the economy in the longrun and only affect other nominal variables is called A) inflation. B) the classical dichotomy. ) q y y y C) the quantity theory of money. D) money neutrality. E) the quantity equation. Answer: D
26 13 5/19/2011 Question 14.2
Suppose that an economy is currently not in shortrun pp y y equilibrium (spending balance) and production is greater than planned aggregate expenditures (Y>PAE). In this case, there would be an unexpected _________ in inventories, which would provide a signal to firms to _________ production. A) decrease; decrease B) increase; increase increase; increase C) increase; decrease D) decrease; increase Answer: C
27 Question 14.3
The IS curve describes the __________ relationship The IS curve describes the relationship between __________ and __________. A) negative; tax rate; investment B) positive; real interest rate; real GDP. C) negative; real interest rate; real GDP. D) negative; real interest rate; money supply negative; real interest rate; money supply E) positive; planned aggregate expenditures; real GDP. Answer: C
28 14 5/19/2011 Question 14.4
If the real interest rate rises, then: If the real interest rate rises, then: A) the IS curve shifts right. B) the IS curve shifts left. C) there is an upward movement along the IS curve. D) there is a downward movement along the IS there is a downward movement along the IS curve. Answer: C 29 Question 14.5
If net taxes decrease ( ) then If net taxes decrease ( ) then A) the IS curve shifts right. B) the IS curve shifts left. C) there is an upward movement along the IS curve. D) there is a downward movement along the IS there is a downward movement along the IS curve. Answer: A 30 15 ...
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This note was uploaded on 02/07/2012 for the course ECON 1b taught by Professor Sheffrin during the Spring '07 term at UC Davis.
 Spring '07
 Sheffrin
 Economics

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