1. Short Run Fluctuations Chapter 5

2. Neoclassical Dichotomy Theory of macroeconomy where output is given by labor, capital, and TFP. TFP is given by R & D (and possibly allocative efficiency) Capital investment is given by real interest rates which is given by savings which is in turn given by demographic factors and the dynamics of future income. Labor is given by labor-leisure trade-off, real labor productivity and turnover in job market. No relationship between output between money, prices or inflation.

3. Long run output, Y Y π Y

4. Business Cycles

5. Link HK GDP In chained (2009) dollars

6. Pattern of production. GDP is growing over time. GDP growth is not smooth. Sometimes GDP is above and sometimes below the long term growth path. GDP has seasonal pattern with production consistently concentrated in 4 th quarter. Christmas given as an explanation. These movements are so large they hide less predictable short-term movements in the economy. Solution: Seasonal adjustment. Smooth out the average changes associated with the season.

8. Output Gap Study of long-term growth focuses on explaining the secular upward movement in GDP. Business cycles examine fluctuations around that trend. Object of interest is the output gap, the % deviation of GDP from its long-term trend path.

9. Measuring Trend Simplest way to measure trend is to assume that it grows at a constant rate over time. Ln(TREND t ) = α 0 + α 1 ∙t → ΔLn(TREND t )= Ln(TREND t )- Ln(TREND t-1 ) = α 1 In theory, corresponds with BGP of neoclassical growth model where α 1 is the growth rate of technology.

10. Estimating Trend Construct Data LHS: The natural log of GDP RHS: Index of Time Source: FRED DatabaseFRED Database Note: USA Annual Data used here for convenience. Can easily be applied to quarterly data.

11. Estimate Regression Model Estimate Regression: ln(Y t ) = α 0 + α 1 ∙t +ε t Regression coefficient is α 1 =.03068

12. Output Gap The output gap is the % deviation from trend ln(Y t )- ln(TREND t ) which corresponds with ε t. Use the fitted residual as a measure of the output gap.

13. Deviations from Trend

15. Estimating Trend HK GDP Construct Data LHS: The natural log of GDP RHS: Index of Time Source: Note: Annual Data used here for convenience. Can easily be applied to quarterly data.

16. Estimate Regression Model Estimate Regression: ln(Y t ) = α 0 + α 1 ∙t +ε t Regression coefficient is α 1 =.0255

17. Output Gap The output gap is the % deviation from trend ln(Y t )- ln(TREND t ) which corresponds with ε t. Use the fitted residual as a measure of the output gap.

19. Business Cycles?

20. Stochastic Trends Trend line may change over time, if long- run technology also changes. We want to distinguish between short-run deviations from trend from long-lasting changes in the trend path. Allow for a smoothly changing trend, known as a Hodrick Prescott trend. Examine Data in Growth Rates

21. HP Trend and ln(GDP)

22. HP Filtered Output Gap

23. Expenditure Cycles in the Closed Economy Planned Expenditure is C + I + G. Investment is sensitive to the real interest rate. Consumer spending is sensitive to disposable income YD = Y – T. Draw a planned expenditure curve that shows response of demand to GDP

24. IS Curve When the real interest rate rises, investment will fall. This, along with knock-on multiplier effects, will lead to a contraction in demand. IS curve maps out the relationship between real interest rate and demand for goods (taking into account the multiplier effect) Q: What shifts the IS curve? A: Shifts in Fiscal Policy, optimism about future income, expectations about future MPK, wealth effects of asset prices.

25. Planned Expenditure IS r Y MP r(π) Y*Y*

26. Monetary Policy Reaction Function Central bank controls the money supply. Central bankers set money supply in response to economic conditions. When economy is booming or prices are rising to quickly, central banks raise real interest rates.

27. How does the central bank set real interest rates? The central bank participates in the money market to control the real interest rate. Central bank has control over the money supply M. If prices do not respond 1-for-1 with money (due to pricing stickiness), they can control the supply of real balances. From Baumol-Tobin, the demand for real balances is determined by nominal interest rates and output. Nominal interest rates are a function of real interest rates and expected inflation.

28. Money Demand Curve r(π,Y)

29. Money Market Equilibrium Equilibrium under fixed money supply: If real interest rate is higher than money market equilibrium, money supply will be higher than money demand. Households will not want to hold cash and will deposit it into banks. Banks with a surplus of liquidity will lower equilibrium rates. Equilibrium under interest target: Under interest rate targets, if money supply is higher than money demand at the desired real interest rate, the central bank must sell some of its holdings of interest paying assets (typically government bonds).

30. Increase in expected inflation r(π)

31. Increase in Inflation r(π,Y)

32. Increase in Output r(π,Y)

33. Planned Expenditure IS r Y MP r*(π) Y*(π)

34. Inflation Rises IS r Y MP r*(π) Y*(π) MP ʹ r**(π ʹ ) Y**(π ʹ )

35. Aggregate Demand Curve Negative relationship between inflation and output generated by monetary policy response to inflation. Q: What causes AD curve to shift? Answer Shifts in the IS curve Shifts in Monetary Policy

36. AD Curve Y π

37. Aggregate Supply Curve Keynesian model: Firms will increase output if the inflation rate is high. Positive relationship between inflation level and output is called AS curve. Fluctuations in output are caused by fluctuations in the AD curve which are in turn caused by fluctuations in the

38. Equilibrium Y π SRAS AD π*π* Y*

39. AD Curve Shifts Y π SRAS AD π*π* Y* AD’ π** Y**

40. Monetary Policy and the Demand Curve Y Sπ π*π* Y Strong Stance Weak Stance

41. Demand Curve/Supply Curve Y Sπ π*π* Strong Stance Weak Stance

42. Supply Curve The supply curve is based on the notion that wages are sticky. So far, we have thought of real wages as being determined in a competitive market with a supply curve and a demand curve for labor. In Keynesian theory, wages are set by contract. Workers choose a wage and firms hire as many workers as desired at that wage rate.

43. Inflation and Labor Demand Workers base wage demands on what they believe the price level will be. Workers are backward looking in their expectations W t = w×P t E = w×P t-1. Firms choose a quantity of workers so W t = P t ×MPL t =w×P t-1. In equilibrium,

44. Equilibrium Labor L MPL L*L*

45. Inflation Rises, Real Wages Fall L MPL L*L* L **

46. Inflation/Employment Tradeoff Keynesian economists perceived that the government faced a choice between high inflation on the one hand and unemployment on the other. If the government wanted to push up employment, they could (through expansionary monetary or fiscal policy) push out the demand curve if they were willing to bear the consequences in terms of inflation.

47. Tradeoff Inflation & Unemployment USA 1948-1969 Source: St. Louis Fed DatabaseSt. Louis Fed Database

48. Critics Critics of this business cycle theory pointed out that the ability of the government to increase employment was based on the notion that workers would expect zero employment. Phelps and Friedman suggested that it might be more realistic to imagine that workers would have some forecast of inflation π E t. Then they would demand wages that would maintain their standard of living in the face of this inflation. W t = w×P t E = w×(1+ π E t ) ×P t-1.

49. Inflation and inflation expectations Firms would hire workers up until that point where MPL = real wage. Inflation reduces real wages and increases employment only to the extent that it stays ahead of workers expectations. There is some level of employment (referred to as the natural level) and corresponding level of output (referred to as potential output) which prevails when output inflation equal expectation.

50. IA Curve YPYP π Y AD πEπE Y* SRAS

51. Supply Curve A more realistic supply curve rule, might say that output is above potential output only when inflation is above expected inflation. SRAS: π E t Expected Inflation Expectations Augmented Philips curve π t = π E t + θ∙[y t – y P ] Adaptive Expectations π t = π t-1 + θ∙[y t – y P ]

52. Short-run Inflation/Output Tradeoff But workers will demand wages that will support their real wages, which will require wage growth to keep up with expected inflation. Friedman says workers will base inflation expectations on inflation that has been observed in the past. π =π t-1

53. Adaptive Expectations Adaptive expectations generate some dynamics to inflation-output trade-off. In the short-run, an expansion in money growth will lead to an increase in inflation and output. But after a period, inflation expectations will increase, leading to more inflation. Eventually output will return to its long run level. –Only accelerating inflation can lead to long run output increases. –Once the government increases money supply growth, they cannot reduce inflation without incurring a recession.

54. Y π Y AD t πEπE AD t ’ μ ↑ SRAS t π t+1 SRAS t+1 SRAS t+2 π t+2 SRAS t+∞ π t+∞

55. Breakdown in Inflation and Unemployment Relationship

56. Final Exam Material including taxes, money demand, inflation, Keynesian model, rational expectations model 14/12/2011 12:30-15:00 LTF Semi-open book: 1 L4 paper w/ handwritten notes both sides, calculator, writing materials.