1

Great divide of macroeconomics

Aggregate demandand business cycles

Aggregate supplyand “economic growth”

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The Great DivideClassical macro:

- Full employment- Flexible wages and prices- Perfect competition and rational expectations- Only “real” business cycles, and all unemployment is voluntary and efficient

Keynesian macro:- Underutilized resources- Inflexible (or fixed) wages and prices- Imperfect competition and behavioral expectations- Yes, business cycles, with persistent slumps, involuntary unemployment, and macro waste.

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Understanding business cyclesMajor elements of cycles

– short-period (1-3 yr) erratic fluctuations in output– pro-cyclical movements of employment, profits, prices– counter-cyclical movements in unemployment– appearance of “involuntary” unemployment in

recessions

Historical trends– lower volatility of output, inflation over time (until 2008)– movement from stable prices to rising prices since WW

II

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The incomplete recovery

Shaded areas are NBER recessions.

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1950 1960 1970 1980 1990 2000 2010

Full employment

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Output gaps and the business cycle5

13,500

14,000

14,500

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16,000

16,500

17,000

2005 2006 2007 2008 2009 2010 2011 2012 2013

Potential GDPActual GDP

Large GDP “gap”

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“The Great Moderation on Output”

Definition of volatility (often used in finance): the standard deviation of returns or rates of growth, usually at an annual rate.

.00

.02

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00 10 20 30 40 50 60 70 80 90 00 10

Volatility of Real GDP Growth

GOLD STANDARD

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Volatility of inflation

“The Great Moderation on Inflation”

GOLD STANDARD

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IS-MP modelThe major tool for showing the impact of monetary

and fiscal polices, along with the effect of various shocks, in a short-run Keynesian situation.

The “MP” function replaces the “LM” function, which is obsolete. Check the reading list very carefully!

Key assumptions in short-run macro model:• Fixed prices (P=1 and π = 0); or can have fixed inflation.• Unemployed resources (Y < potential Y = Mankiw’s natural

Y)• Closed economy (inessential and considered later)• Goods markets (IS) and financial markets (MP)

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IS curve (expenditures)

Basic idea: describes equilibrium in goods market.Finds Y where planned I = planned S or planned

expenditure = planned output.Basic set of equations:

1. Y = C + I + G2. C = a + b(Y-T)3. T = T0 + τ Y [note assume income tax, τ =

marginal tax rate]4. I = I0 – dr [note i = r because zero inflation]5. G = G0

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which gives the IS curve:

(IS) Y = a - bT0 + G0 + I0 - dr 1 - b(1- τ)(IS) Y = μ [A0 - dr]

whereA0 = autonomous spending = a - bT0 + G0 +

I0

μ = simple Keynesian multiplier = 1/[(1 - b(1- τ)]which we graph as the IS curve.

Note that changes in fiscal policy, investment “animal spirits,” consumption wealth effect SHIFT IS CURVE HORIZONTALLY.

r = realinterest rate

Y = real output (GDP)

IS(G, T0, …)

re

Ye

IS diagram

E

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r = real interest rate

Y = real output (GDP)

IS(G, T0, …)

IS curve

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r = real interest rate

Y = real output (GDP)

IS curve

IS(G, T0, …)IS(G’, T0, …)

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MP curve (monetary policy/financial markets)

The simplest MP curve says that the Fed sets the short term interest rate (i). With given inflation, this gives real interest rate:

So with Fed setting the interest rate, this is simple MP curve:

(MP) r = i - π

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r = real interest rate

Y = real output (GDP)

IS(G, T0, …)

re

Ye

MP(π*)

IS-MP diagram

E

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… to the real stuff• In reality, the Fed has a “dual mandate”(see

below).• This is usually represented by the Taylor rule, so

let’s go there.

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The Dual MandateFed’s dual mandate (Federal Reserve Act as amended): “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

In practice (FOMC statement January 2012):“The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.”“The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market…In the most recent projections, FOMC participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 6.0 percent”

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MP curve with the dual mandate

The Taylor RuleBegin with a monetary policy equation in the form of a “Taylor

rule”: (TR) i = π + r* + b(π-π*) + cyr* is the equilibrium real interest rate, π inflation rate, π* is

inflation target, y is log output gap [log(Y/Yp)], b and c are parameters.

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88 90 92 94 96 98 00 02 04 06 08 10

ActualTaylor rule

Actual and Taylor rule federal funds rate

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MP curve with the dual mandate

The Taylor RuleBegin with a monetary policy equation in the form of a “Taylor

rule”: (TR) i = π + r* + b(π-π*) + cyr* is the equilibrium real interest rate, π inflation rate, π* is

inflation target, y is log output gap [log(Y/Yp)], b and c are parameters.

2. Assume for now that inflation is at target.So π = π* and we have financial market:

(MP) r = r* + cy

Later on, we will introduce inflation.

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MP curve with inflation

Now add inflation to the MP curve.Assume that inflation is a function of output (this will be done

later):

(PC) π = π*+φ y + η (η =inflation shock)

(TR) i = π + r* + b(π-π*) + cySo new MP curve is:

i = π + r* + b(φ y + η ) + cy

or(MP) i = π + r* + (bφ+c) y + bη

So adding inflation makes the MP curve steeper, but does not change the basic structure..

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Algebra of IS-MP Analysis• The analysis looks at simultaneous equilibrium in goods

market and financial markets (Main St and Wall St).• The algebraic solution for equilibrium Ye is:

Ye = μ*A0 – μ* d r*

where μ* = μ/(1 + μdc) = multiplier with monetary policy. μ = simple multiplier > μ* ; A0 = autonomous spending

= a - bT0 + G0 + I0 ,Note impacts on output:

Positive: G, I0, NXNegative: risk premium (and later inflation shock)

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r = real interest rate

Y = real output (GDP)

IS(G, T0, …)

re

Ye

MP(r*)

IS-MP diagram

E

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1. What are the effects of fiscal policy?

• A fiscal policy is change in purchases (G) or in taxes (T0, τ), holding monetary policy constant.

• In normal times, because MP curve slopes upward, expenditure multiplier is reduced due to crowding out.

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IS shock (as in fiscal expansion)

i

Y = real output (GDP)

IS(G)

MP

IS(G’)

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Multiplier Estimates by the CBO

Congressional Budget Office, Estimated Impact of the ARRA, April 2010

0.0

0.5

1.0

1.5

2.0

2.5

3.0

G: Fed G: S&L Trans: indiv Tax: Mid/Low Income

Tax: High Income

Bus Tax

Mul

tiplie

r fro

m G

,T o

n GD

P

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Inflationary shock

i

Y = real output (GDP)

IS

MP(ηt = 0)

Yt**

it**

MP(ηt > 0)