ShortRunA - Part V The Economy in the Short Run I Overview We will now develop a model that captures the short-run fluctuations in the economy I

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1 Part V. The Economy in the Short Run I. Overview We will now develop a model that captures the short-run fluctuations in the economy. I will depart significantly from the book. Skip Ch. 11. The material we will talk about first is in Ch. 12. Neoclassical economists believe that all fluctuations in output are fluctuations in potential GDP. Thus, they don’t think you need a separate model for the short-run. (Builds on Classical view of Adam Smith, David Ricardo, etc.) Keynesian economists believe that output often deviates from potential GDP because of market imperfections such as sticky prices . The model we will study is a Keynesian model. The Keynesian model is the one that most policy makers and Wall Street professionals have in their heads.
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2 John Maynard Keynes “In the long run we are all dead.” Explain how bad things were in the UK during the 1920s and 1930s
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3 Stylized Facts about Economic Fluctuations 2. Felt throughout the economy 3. Most are felt globally 4. Unemployment rises sharply 5. Durable goods industries are hit the hardest; services and nondurables less 6. Recessions are often preceded by an increase in inflation and followed by a decrease in inflation.
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5 II. Key Assumptions of Keynesian Model of Aggregate Expenditure 1. Firms preset prices (sticky prices). Prices are not going to adjust immediately to make S=D (Keynes’ original version – he focuses on sticky wages) 2. Firms meet demand at those preset prices These 2 key assumptions imply that output in the SR is determined by planned aggregate expenditures (PAE) If PAE < Y*(potential GDP), unemployment rte will be above natural PAE = C + I^P + G + NX , I^P = planned investment PAE differs from actual aggregate expenditures by unplanned inventory investment 1. Firms preset prices 2. Firms meet demand at those prices Note: original version was sticky wages and price is a markup on wages. These 2 key assumptions imply that output in the SR is determined by planned aggregate expenditures (PAE). If PAE < Y*, then U > U* PAE = C + IP + G + NX PAE differs from actual AE by unplanned inventory investment
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6 III. Components of Planned Aggregate Expenditures We will talk about each component of PAE: Consumption: 2/3 of all expenditures in the economy Investment: About 16% of expenditures, but very volatile Government purchases : About 20% of expenditures Net Exports: Varies a lot, now negative. In this simple model, only C and NX vary with Y. Thus, for now we take planned investment and G as given.
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7 A. The Consumption Function and Disposable Income Keynes’ Theory of Consumption The Consumption Function C = a + b x Y^D where Y^D = Y-T C = consumption Y^D = disposable income Y = total income T = net taxes a: intercept “autonomous consumption” part of cous that is independent of current disposable income. a can capture effects of current wealth and
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This note was uploaded on 04/07/2008 for the course GENERAL ED MMW 1,2; E taught by Professor Vandehey during the Spring '08 term at UCSD.

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ShortRunA - Part V The Economy in the Short Run I Overview We will now develop a model that captures the short-run fluctuations in the economy I

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