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Summary The long-run model determines potential output and the long-run rate of inflation. The short-run model determines current output and current inflation.

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Presentation on theme: "Summary The long-run model determines potential output and the long-run rate of inflation. The short-run model determines current output and current inflation."— Presentation transcript:

1 Summary The long-run model determines potential output and the long-run rate of inflation. The short-run model determines current output and current inflation. In any given year, output consists of two components: –The long-run potential output –Short-run output

2 Short run output –Is the percentage difference between actual and potential output. –Is positive when the economy is booming. –Is negative when the economy is slumping. Recession: –Our Definition: A period when actual output falls below potential Short-run output becomes negative (Ỹ < 0) –Usual Definition (Roughly) 2 Quarters of negative GDP. Declared by the NBER Business Cycle Dating Committee. (ΔY < 0)

3 Short-run fluctuation –The difference in actual and potential output, expressed as a percentage of potential output –Referred to as “detrended output” or short-run output:


5 Ỹ < 0 Recession Ends ΔY <0 ΔY >0 ΔY 0 ΔY>0 but Ỹ < 0




9 A recession: –Begins when actual output falls below potential, and short-run output becomes negative. –Ends when short-run output starts to rise and become less negative. During a recession: –Output is usually below potential for approximately two years, which results in a loss of about $2,400 per person. –Between 1.5 million and 3 million jobs are lost.

10 Measuring Potential Output There is no directly observable measure of potential output in an economy. Ways to measure potential output: –Assume a perfectly smooth trend passes through quarterly movements of real GDP. –Take averages of the surrounding actual GDP numbers.



13 9.3 The Short-Run Model Short-run model features: –Open economy exists where global booms and recessions impact the local economy. –The economy will exhibit long-run growth and fluctuations. –Central Bank manages monetary policy to smooth fluctuations.

14 The short-run model is based on three premises: 1. The economy is constantly being hit by shocks: Shocks: factors that cause fluctuations in output or inflation. 2. Monetary and fiscal policies affect output: Policymakers may be able to neutralize shocks to the economy.

15 3. There is a dynamic trade-off between output and inflation: The Phillips curve is the dynamic trade-off between output and inflation.

16 Philips curve

17 The Empirical Fit of the Phillips Curve Empirically, the slope is approximately one-half. –Meaning: if output exceeds potential by 2 percent, the inflation rate increases one percentage point.


19 How the Short-Run Model Works Assume policymakers can select short- run output through monetary policy Example: –1979: inflation was increasing because of oil prices –Monetary Policy: raise interest rates –What happens? –Recession!



22 Important thing about the Philip Curve This is about accelerating and decelerating inflation. This is a change in the change of the price level Is the Philips Curve fixed? –Supply Shocks. –Expectations.

23 Okun’s law


25 Okun’s Law Natural rate of unemployment Current rate of unemployment Short-run output Cyclical unemployment

26 Okun’s Law 1960 Recession

27 Okun’s Law 1969 Recession

28 Okun’s Law 1980/1981 Recession

29 Okun’s Law 1990 Recession

30 Okun’s Law Great Recession

31 11.1 Introduction In this chapter, we learn –The first building block of our short-run model: the IS curve describes the effect of changes in the real interest rate on output in the short run. –How shocks to consumption, investment, government purchases, or net exports— “aggregate demand shocks”—can shift the IS curve.

32 –A theory of consumption called the life- cycle/permanent-income hypothesis. –That investment is the key channel through which changes in real interest rates affect GDP in the short run.

33 The Federal Reserve exerts a substantial influence on the level of economic activity in the short run. –Sets the rate at which people borrow and lend in financial markets The basic story is this:

34 The IS curve –The IS curve captures the relationship between interest rates and output in the short run. –There is a negative relationship between the interest rate and short-run output. –An increase in the interest rate will decrease investment, which will decrease output.


36 11.2 Setting Up the Economy The national income accounting identity –Implies that the total resources available to the economy equal total uses –One equation with six unknowns Production Imports Consumption Investment Government purchases Exports

37 We need five additional equations to solve the model:

38 Consumption and Friends Level of potential output is given exogenously. –Consumption C, government purchases G, exports EX, and imports IM depend on the economy’s potential output. –Each of these components of GDP is a constant fraction of potential output. the fraction is a parameter


40 Potential output is smoother than actual GDP. –A shock to actual GDP will leave potential output unchanged The equation depends on potential output. –Shocks to income are “smoothed” to keep consumption steady.

41 The Investment Equation The share of potential output that goes to investment A term weighting the difference between the real interest rate and the MPK Real interest rate Marginal Product of Capital (MPK)

42 The MPK –Is an exogenous parameter –Is time invariant If the MPK is low relative to the real interest rate –Firms should save money and not invest in capital

43 If the MPK is high relative to the real interest rate –Firms should borrow and invest in capital In the short run, the MPK and the real interest rate can be different. –Installing capital to equate the two takes time.


45 1. Divide the national income accounting identity by potential output. 2. Substitute the five equations into this equation Deriving the IS Curve

46 3. Recall the definition of short-run output. Simplifies the equation for the IS curve:

47 The gap between the real interest rate and the MPK is what matters for output fluctuations. –Firms can always earn the MPK on new investments. The parameter –Is –Is called the aggregate demand shock –Will equal zero when potential output is equal to actual output

48 Case Study: Why is it called the “IS Curve”? IS stands for “investment = savings” See this again in Chapters 17 and 18.

49 11.4 Using the IS Curve The Basic IS Curve When the demand shock parameter equals zero, the IS curve has a short- run output of 0 where the real interest rate is equal to the long-run value of the MPK.


51 The Effect of a Change in the Interest Rate When the real interest rate changes, the economy will move along the IS curve. –An increase in the interest rate causes the economy to move up the IS curve Causes short-run output to decline

52 When the real interest rate changes, the economy will move along the IS curve: –The higher interest rate raises borrowing costs reduces demand for investment reduces output below potential


54 If the sensitivity to the interest rate were higher –The IS curve would be flatter –Any change in the interest rate would be associated with larger changes in output –Draw horizontal and vertical IS curves.

55 An Aggregate Demand Shock Suppose that information technology improvements create an investment boom. –The aggregate demand shock parameter will increase. –Output is higher at every interest rate and the IS curve shifts right. –For any given real interest rate R t, output is higher when Demand shock parameter


57 Case Study: Move Along or Shift? A Guide to the IS Curve A change in R shows up as a movement along the IS curve. –The IS curve is a graph of R versus short-run output. Any other change in the parameters of the short-run model causes the IS curve to shift.

58 A Shock to Potential Output Shocks to potential output –Change actual output by the same amount in our setup –Do not change short-run output Some shocks to potential output may change other parameters. Earthquake, for example: –Reduces actual and potential output by the same amount –Leads to an increase in short-run output because it also increases the MPK

59 Other Experiments Imagine that Japan enters into a recession. –The aggregate demand parameter for exports declines. the IS curve shifts to the left –thus the Japanese recession has an international effect. –We could shock any of the other aggregate demand parameters.

60 11.5 Microfoundations of the IS Curve Microfoundations –The underlying microeconomic behavior that establishes the demands for C, I, G, EX, and IM.

61 Consumption People prefer a smooth path for consumption compared to a path that involves large movements.

62 The permanent-income hypothesis –People will base their consumption on an average of their income over time rather than on their current income. The life-cycle model of consumption –Suggests that consumption is based on average lifetime income rather than on income at any given age.

63 The life-cycle model of consumption: –Young people borrow to consume more than their income. –As income rises over a person’s life consumption rises more slowly individuals save more –During retirement, individuals live off their accumulated savings.

64 The life-cycle/permanent-income (LC/PI) hypothesis –Implies that people smooth their consumption relative to their income –This is why we set consumption proportional to potential output rather than actual output.


66 Alaska: –Residents receive a refund based on state oil revenues. –A separate refund from federal tax revenues –A study shows that: consumption does not change when residents receive the oil revenue refund. the same individuals increase consumption when federal tax refunds are received.

67 Multiplier Effects We can modify the consumption equation to include a term that is proportional to short-run output.

68 Solving for the IS curve –Will yield a similar result –Now includes a multiplier on the aggregate demand shock and interest rate terms: the multiplier is larger than one

69 With a multiplier: –Aggregate demand shocks will increase short-run output by more than one-for-one. –A shock will “multiply” through the economy and will result in a larger effect. If short-run output falls with a multiplier –Consumption falls –Which leads to short-run output falling –Consumption falls again –“Virtuous circle” or “vicious circle”

70 Investment At the firm level, investment is determined by the gap between the real interest rate and MPK. In a simple model –The return on capital is the MPK minus depreciation. The richer framework includes: –Corporate income taxes –Investment tax credits –Depreciation allowances

71 A second determinant of investment –The firm’s cash flow the amount of internal resources the company has on hand after paying its expenses

72 What is wonky about this model? What does it mean to say R > r? Can we explain this with cash flow? Financing out of firm’s savings? –Why finance a project at r when you can save with paper assets at R?

73 Government Purchases Government purchases can be –A source of short-run fluctuation –An instrument to reduce fluctuations Discretionary fiscal policy –Includes purchases of additional goods in addition to the use of tax rates –For example, the government can use the investment tax credit to encourage investment

74 Transfer spending often increases when an economy enters into a recession. Automatic stabilizers –Programs where additional spending occurs automatically to help stabilize the economy –Welfare programs and Medicaid are two such stabilizer programs. receive additional funding when the economy weakens

75 Fiscal policy’s impact depends on two things: 1.The problem of timing discretionary changes are often put into place with significant delay. 2. The no-free-lunch principle implies that higher spending today must be paid for today or some point in the future. such taxes may offset the impact of the discretionary spending adjustment.

76 Case Study: The Macroeconomic Effects of the American Recovery and Reinvestment Act of 2009 Economists had a wide range of opinions about the effectiveness and costs of the stimulus. Congressional Budget Office (CBO) gave estimates of unemployment with and without a stimulus. –Estimated 9 percent peak without a stimulus –Actual unemployment rate with stimulus was above this.


78 Net Exports If Americans demand more imports –The IS curve shifts left and reduces short- run output If foreigners demand more American exports –The IS curve shifts right

79 11.6 Conclusion Higher interest rates –Raise the cost of borrowing to firms and households –Reduce the demand for investment spending –Decrease short-run output

80 Summary The IS curve –Describes how output in the short run depends on the real interest rate and on shocks to the aggregate economy –Shows a negative relationship between output and the real interest rate When the real interest rate rises, the cost of borrowing increases, leading to delayed purchases of capital. These delays reduce the level of investment, which in turn lowers output below potential.

81 Shocks to aggregate demand can shift the IS curve. These shocks include: –Changes in consumption relative to potential output –Technological improvements that stimulate investment demand given the current interest rate –Changes in government purchases relative to potential output –Interactions between the domestic and foreign economies that affect exports and imports

82 The life-cycle/permanent-income hypothesis –Individual consumption depends on average income over time rather than current income –Serves as the underlying justification for why we assume consumption depends on potential output

83 The permanent-income theory –Does not seem to hold exactly –Consumption responds to temporary movements in income as well. When we include this effect in our IS curve, a multiplier term appears. –That is, a shock that reduces the aggregate demand parameter may have an even larger effect on short-run output.

84 A consideration of the microfoundations of the equations that underlie the IS curve reveals important subtleties. The most important are associated with the no-free-lunch principle imposed by the government’s budget constraint. Depending on how government purchases are financed, they can also affect consumption and investment. –partially mitigating the effects of fiscal policy on short-run output

85 Additional Figures for Worked Exercises




89 12.1 Introduction In this chapter, we learn: –How the central bank effectively sets the real interest rate in the short run, and how this rate shows up as the MP curve in our short-run model. –That the Phillips curve describes how firms set their prices over time, pinning down the inflation rate. –How the IS curve, the MP curve, and the Phillips curve make up our short-run model. –How to analyze the evolution of the macroeconomy in response to changes in policy or economic shocks.

90 The federal funds rate –The interest rate paid from one bank to another for overnight loans The monetary policy (MP) curve –Describes how the central bank sets the nominal interest rate

91 The short-run model summary: –Through the MP curve the nominal interest rate determines the real interest rate –Through the IS curve the real interest rate influences GDP in the short run –The Phillips curve describes how booms and recessions affect the evolution of inflation


93 12.2 The MP Curve: Monetary Policy and the Interest Rates Large banks and financial institutions borrow from each other. Central banks set the nominal interest rate by stating what they are willing to lend or borrow at the specified rate.

94 Banks cannot charge a higher rate. –everyone would use the central bank. Banks cannot charge a lower rate. –They would borrow at the lower rate and lend it back to the central bank at a higher rate. –This is called the arbitrage opportunity. Thus, banks must exactly match the rate the central bank is willing to lend at.


96 From Nominal to Real Interest Rates The relationship between the interest rates is given by the Fisher equation. Nominal interest rate Real interest rate Rate of inflation

97 The sticky inflation assumption –The rate of inflation displays inertia, or stickiness, so that it adjusts slowly over time. –In the very short run the rate of inflation does not respond directly to monetary policy. –Central banks have the ability to set the real interest rate in the short run.

98 Why is there sticky inflation? Imperfect information Costs of setting prices Contracts also set prices and wages in nominal rather than real terms. There are bargaining costs to negotiating prices and wages. Social norms and money illusions –Cause concerns about whether the nominal wage should decline as a matter of fairness Money illusion –The idea that people sometimes focus on nominal rather than real magnitudes

99 The IS-MP Diagram The MP curve –Illustrates the central bank’s ability to set the real interest rate Central banks set the real interest rate at a particular value. –The MP curve is a horizontal line.


101 The nominal interest rate –Is the opportunity cost of holding money –Is the amount you give up by holding money instead of keeping it in a savings account –Is pinned down by equilibrium in the money market If the nominal interest rate is higher than its equilibrium level –Households hold their wealth in savings rather than currency. –The nominal interest rate falls.

102 The demand for money –Is a decreasing function of the nominal interest rate –Is downward sloping –Higher interest rates reduce the demand for money. The supply of money –Is a vertical line for the level of money the central bank provides

103 Changing the Interest Rate To raise the interest rate –The central bank reduces the money supply –Creates an excess of demand over supply –A higher interest rate on savings accounts reduces excess demand. –The markets adjust to a new equilibrium.


105 Why i t instead of M t ? The interest rate is crucial even when central banks focus on the money supply. The money demand curve is subject to many shocks, which shift the curve. –Changes in price level –Changes in output If the money supply is constant –The nominal interest rate fluctuates –Resulting in changes in output

106 The money supply schedule is effectively horizontal at a targeted interest rate. An expansionary (loosening) monetary policy –Increases the money supply –Lowers the nominal interest rate A contractionary (tightening) monetary policy –Reduces the money supply –Increases the nominal interest rate



109 The economy is at potential when –The real interest rate equals the MPK. –There are no aggregate demand shocks. – Short-run output = 0. If the central bank raises the interest rate above the MPK –Inflation is slow to adjust. –The real interest rate rises. –Investment falls.


111 Example: The End of a Housing Bubble Suppose housing prices had been rising, but then they fall sharply. –The aggregate demand parameter declines. –The IS curve shifts left. If the central bank lowers the nominal interest rate in response: –The real interest rate falls as well because inflation is sticky. –If judged correctly and without lag, the economy would not have a decline in output.


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