The most idiotic Keynesian model Y=I+C+G =I+G+aY Y

What do we get? Government expenditures are good: dY/dG>0 Animal spirits are good: dY/dI > 0 Thrift is bad: dY/da >0 « Keynesian multiplier » 1/(1-a)

What do we need? Y = C+I+G means that output is determined by demand To be so, it must be that demand < productive capacity Prices must not adjust to restore equilibrium  prices are held fixed « in the short run » Therefore, quantities adjust and output is demand-determined

The next less stupid model: IS-LM Y i IS LM

What do we get ? The model now simultaneously explains interest and output An increase in money supply now raises output: dY/dM >0, di/dM<0 Animal spirits, government expenditure, and dissavings now increase interest rates di/dG >0, dY/dg >0 Expected inflation is expansionary, because the real rate is reduced (Mundell-Tobin effect)

The monetary transmission mechanism i = interest rate on bonds = opportunity cost of holding money Demand for money is for « real money » M/p, but p is fixed M goes up, i must fall for people to hold the extra money (the price of bonds must go up) A lower i means a lower r boosts consumption and investment Output goes up in response

What do we need? The demand for money as a function of i is an important ingredient of the IS-LM model A motive for holding money is needed

Missing bits 1: the labor market Ouput fluctuations were mechanically transformed into employment fluctuations by « Okun’s law » Δu = Δ (y – y*) Summarizes « labor hoarding » as well as the production function

Missing bits 2: the Phillips curve Unemployment Inflation

The AS-AD model y p

Missing bits 3: The foreign sector CF(i – i*) + NX = 0 Balance of payments identity NX = NX(ep/p*) New IS: Y = I+C+G+NX Under capital mobility, i = i* Flexible rates: e adjusts Fixed rates: M adjusts

Output determination, flexible rates Y i LM i*

Exchange rate determination, flexible rates Y e Y e

The monetary transmission mechanism M goes up, incipient fall in i Capital flows abroad, people sell home assets The demand for the home currency falls Exchange rate depreciates Exports and output goes up In the end, i remains equal to i*

Fiscal policy is ineffective An increase in public expenditure incipiently boosts output and money demand Interest rates go up Capital inflow appreciates the exchange rate To restore equilibrium on the money market, output must return to its initial value The fall in next export equates the increase in public expenditure

Output determination, fixed rates IS i* Y

Fiscal policy is effective An increase in public expenditure incipiently boosts output and money demand Interest rates go up Capital inflow appreciates the exchange rate To prevent appreciation, the government prints money Equilibrium in the money market is restored when interest rates are back to their initial value Net exports are unchanged, so ouput must go up

The problems Nominal rigidities are unexplained and unspecified Real/Nominal dichotomy violated Permanent output/inflation trade-off The parameters are not structural => « Lucas critique » Expectations about the future are poorly specified

The rational expectations revolution In the 60s, policymakers in the US tried to exploit the Phillips curve to « fine-tune » the economy However, it then shifted up, leading to « stagflation » The trade-off appeared to be short-run not long-run

Why? We need to know why there is a trade-off in the first place. If people care about real things, should not be a trade-off Friedman/Lucas: misperceptions Or: wages set one period in advance In both cases, trade-off arises because actual inflation differs from expected inflation.

Adaptive expectations If gvt attempts to exploit trade-off systematically, Phillips curve gradually shifts as people’s expectations adjust Thus, fine-tuning only works because people are fooled But are adaptive expectations plausible if systematic policy is pre-announced?

Response to a jump in inflation t y

Rational expectations People use all their information to form expectations They compute future outcomes using the right model of the economy (or the equilibrium distribution for each variable)

A RE model

Solving the model