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Short Term Keynesian Economics: IS-LM-FE FIN 30220: Macroeconomic Analysis

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Classical economics and the “Long Run” Optimal behavior by individuals Competitive Markets All prices are fully flexible Labor markets determine total production/income Capital markets determine expenditures Money markets determine prices

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In a “classical world”, monetary policy is very simple… Or, in percentages Inflation Based off money demand. Determined in capital markets The Fed takes the “real economy” as a given and chooses money supply to set the inflation rate

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In a classical world, the Federal Reserve chairman would not be a very newsworthy job…however try to do a LexisNexis search Chairman of the Federal Reserve from 1987 to ,045 articles in the last year Chairman of the Federal Reserve from 2006 to ,596 articles in the last month Current Chairman of the Federal Reserve 2,741 articles in the last 6 months They must be a littler more important that the classical world would suggest!

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% Deviation from Trend Correlation = -.20 Real Interest Rate vs. M2 It seems that increasing the money supply lowers the interest rate

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Correlation =.25 M2 Money Supply vs. GDP % Deviation from Trend It seems that increasing the money supply has a positive effect on GDP

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Keynesian economics and the “Short Run” Capital markets determine output (employment) via expenditures Money Markets determine the interest rate (price level is fixed) Optimal behavior by (most) individuals Not necessarily competitive markets The price level is fixed Labor markets determine real wages

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Why are prices fixed in the short run? For some companies, it is costly to continually change prices For other companies there are strategic reasons for not changing prices continuously

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Product GroupAverage time between price changes (months) Cement13.2 Steel13.0 Chemicals12.8 Glass10.2 Paper8.7 Rubber Tires8.1 Petroleum5.9 Truck Motors5.4 Plywood4.7 Non-Ferrous Metals4.3 Household Appliances3.6 * Source: Dennis W. Carlton, “The Rigidity of Prices, American Economic Review, September 1986, pp

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Imagine that we have an initial equilibrium. Now, suppose that the Fed increases the money supply. In a classical world, the price level would increase. However, if prices are fixed…

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If the interest rate falls to bring the money market into equilibrium, the capital market is out of equilibrium. In a Keynesian world, the economy is demand determined. That is, the economy supplies whatever is demanded. In this case higher demand raises production <

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Higher production has two effects Higher production (which means higher income) raises savings Higher production (which means higher income) raises money demand In a Keynesian world, the economy is demand determined. That is, the economy supplies whatever is demanded. In this case higher demand raises production =

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Note that the current level of output is higher than it would be at the initial equilibrium (i.e. the labor market is out of equilibrium). = This would be an economy that is overemployed

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Again, imagine that we have an initial equilibrium. Now, suppose that we get a random decline in investment (Keynes call this “animal spirits”)

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The interest rate needs to decline to bring demand back in line with supply In a Classical world, the economy is supply determined. In this case a decline in prices increases the real value of money which lowers the interest rate Price level falls

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In a Keynesian world, the price level can’t adjust. Because output is greater than expenditures, output drops <

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Lower output decreases savings and lowers money demand Because output is greater than expenditures, output drops

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Note that the current level of output is lower than it would be at the initial equilibrium (i.e. the labor market is out of equilibrium). = This would be an economy that is underemployed We need a more compact way of representing this…

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We need to identify an equilibrium relationship between current GDP and the interest rate in the capital market. All else equal, a rise in current GDP will raise savings which lowers the interest rate. We call this equilibrium relationship the IS curve

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We need to identify an equilibrium relationship between current GDP and the interest rate in the money market. All else equal, a rise in current GDP will raise money demand which raises the interest rate. We call this equilibrium relationship the LM curve

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= Now, we can repeat the previous analysis. Suppose that the Fed increases the money supply. In a classical world, the price level would increase. However, of prices are fixed… An increase in the money supply would push down the interest rate for any level of GDP. This moves the LM curve down

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= Now, we can repeat the previous analysis. Suppose that the Fed increases the money supply. In a classical world, the price level would increase. However, of prices are fixed… The new equilibrium has a higher level of GDP (which results in higher savings and higher money demand)

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> Or, as in the “Animal Spirits” example…a drop in investment demand changes the GDP/interest rate relationship in the capital market This drop in investment demand lowers the capital market interest rate…IS shifts down

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= The new equilibrium has a lower level of GDP (which results in lower savings and lower money demand) Or, as in the “Animal Spirits” example…a drop in investment demand changes the GDP/interest rate relationship in the capital market

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What about labor markets? We can represent labor markets as the FE (Full Employment) curve. Note that interest rates have no effect on labor supply or demand.

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Now, lets put it all together….suppose that the Federal reserve increases the money supply = With prices fixed, the rise in money supply lowers the interest rate (LM shifts down)

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Now, lets put it all together….suppose that the Federal reserve increases the money supply = The new short term (Keynesian) equilibrium has higher GDP and lower interest rates (above equilibrium employment)

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Now, lets put it all together….suppose that the Federal reserve increases the money supply = The long term (Classical) equilibrium has higher prices (equilibrium employment)

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Now, lets put it all together….suppose we get a drop in investment demand = With prices fixed, the drop in investment lowers the interest rate (IS shifts down)

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Now, lets put it all together….suppose we get a drop in investment demand = The new short term (Keynesian) equilibrium has lower GDP and lower interest rates (below equilibrium employment)

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Now, lets put it all together….suppose we get a drop in investment demand = The long term (Classical) equilibrium has lower prices and lower interest rates (equilibrium employment)

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What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. = The drop in productivity creates a decline in full employment output

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What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. = The drop in GDP (lowering current income raises the interest rate through lower savings– the IS relationship)

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What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. = The drop in GDP (lowering current income lowers the interest rate through lower money demand– the LM relationship)

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What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. = The new short term (Keynesian) equilibrium has GDP and interest rates unaffected (above equilibrium employment) I know…this is weird!

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What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. = The long term (Classical) equilibrium has higher prices and higher interest rates (equilibrium employment)

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What about the supply shocks from real business cycle theory. Suppose we have a permanent drop in productivity. = The drop in productivity creates a decline in full employment output (FE) and lowers investment (IS) Its possible for the Classical and Keynesian solutions to coincide with no price change necessary

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We can also do IS-LM-FE analysis numerically…

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First, we need to find the long run equilibrium for this economy. For this, we can temporarily ignore the LM sector… The FE curve represents long run output…plug this into the IS curve

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Now that we know the interest rate and output, we can add the money market Plug in values for output and the interest rate Now, solve for real money Now, any value for money supply implies a unique price level

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So, we have the economy’s long run equilibrium…now, lets give the economy a shock! Let’s increase the money supply by $10B

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On impact, this shock only effects the money market…initially, the price level is fixed But, at an interest rate of 2.75%, demand for goods and services would be $8,725!! Assuming that output remained at 5,000, the interest rate would need to drop to 2.75% to get people willing to hold the extra cash

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In the short run, we find a compromise…an interest rate where both money demand = money supply and where demand = supply (for goods & services) Plug one into the other to solve for r Now, find Y This would be the short term equilibrium…

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Eventually, we need to return to the long run production level given by the FE sector…to accomplish this, a price increase will lower the real value of money and bring interest rates back up This would be the short term equilibrium… To return demand back to 5,000, r = 4% Long run output is 5,000

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Let’s try another one….a temporary productivity shock Suppose we have a temporary productivity shock…output temporarily increases by 10%

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Let’s try another one….again, prices are initially fixed The interest rate would need to rise to 14% to clear the money market The interest rate would need to fall to 3.5% to clear the goods market Now what???

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Let’s try another one….again, prices are initially fixed An increase in the real value of money will bring the interest rate down A price level of 1.98 will lower the interest rate to 3.5%

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Let’s try one more…how about a demand shock. Consider a shock that (at the initial interest rate, increases investment demand by 10%)

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Let’s try one more…how about a demand shock (i.e. a rise in investment demand). Given the demand shock, the interest rate would need to rise to 4.5% to keep demand at 5,000 At an interest rate of 4.5 (and output equal to 5,000), real money demand is 384, but real money supply is 386

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Again, in the short run, we need a compromise… Plug one into the other to solve for r Now, find Y

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Again, it will be a change in the price level that returns us to capacity An decrease in the real value of money will bring the interest rate up to 4.5% A price level of 2.21 will raise the interest rate to 4.5%

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