Lecture Seven: The macroeconomy: standard views

Lecture Seven: The macroeconomy: standard views
Managerial Economics Lecture Seven: The macroeconomy: standard views

Recap & Wrap-up on Microeconomics
Superficially, microeconomics a settled field Micro-economics = Neoclassical economics In depth, many possible approaches Empirical: data contradicts neoclassical assumptions Theoretical: Schumpeter & evolutionary views of behavior of firms Analytic: multi-agent modelling of behavior of firms & consumers A much more complex mosaic than “supply & demand” Next set of lectures: macroeconomics Still dominated by neoclassical views But more avowedly subject to debate

Macroeconomics: the context of business
Manager’s most immediate concern is own market & competition But macroeconomic performance sets context for own market Most markets rise & fall with general economic conditions Some exceptions—e.g., liquidators do well in slumps! “Boom” or “slump” conditions thus affect profitability Ability to foresee switch from one extreme to other also extremely important Hence economists being paid to “forecast” So can you rely upon economists to predict the behavior of the macroeconomy?

Macroeconomics … Acknowledged debate
Can’t even agree amongst themselves on how it works Opening sentence of Sloman & Morris “says it all” “There is no universal agreement among economists as to how the economy functions at a macroeconomic level. Instead there are various schools of thought.” (p. 382) Dominant areas of dispute: Whether economy tends towards full employment or unemployment equilibrium Role of government in economy “Ignored” area: whether economy inherently stable or cyclical

Sloman & Morris summary of debate: 3 issues Flexibility of wages & prices Flexibility of aggregate supply Role of expectations in working of market Debates shown in context of “aggregate demand & supply analysis” (AD & AS) Macro-economy summarised by intersection of AD curve & AS Diagram: prices on vertical axis; GDP on horizontal Two curves: Downward-sloping aggregate demand (AD) Upward-sloping aggregate supply (AS) Sound familiar?

AD: fixed money supply & real income Lower price level means higher real demand AS: aggregate production function with diminishing marginal productivity (DMP): If output increases, costs must rise Price level AS AD GDP AD: movement along requires fall in prices; shift up causes increase in price & increase in GDP AS: movement along causes rising price level; shift up causes increase in price & fall in GDP

Essentially “port” of micro framework to macro economy Micro: “intersecting demand & supply curves explain everything” Macro: “intersecting AD & AS curves explain everything” But as we’ve seen… Micro analysis has real flaws Macro… Similar problems BUT some debate over “elasticity” of curves… “Flexibility of wages & prices Flexibility of aggregate supply Role of expectations in working of market”

Flexibility of wages & prices “Some economists argue … Markets tend to clear … fairly quickly. Disequilibrium unemployment … fairly small… Any long-term unemployment, therefore, will be equilibrium (or `natural') unemployment. To cure this, they argue, encouragement must be given to the free play of market forces… Some argue, however, that in the short run wages may not be perfectly flexible… The solution … is to curb … unions so that wage flexibility can be restored and disequilibrium unemployment cured. Other economists reject the assumption of highly flexible wages and prices… unions will resist cuts in real wages and, certainly, cuts in money wages… The prices of goods may also be inflexible… firms use cost-plus methods of pricing. If wages are inflexible downwards, … prices will also be inflexible downwards.” (382)

Flexibility of wages & prices
High flexibility: quick adjustment from one equilibrium to another: P AS “Instantaneous” movement, system always in equilibrium P2 Low flexibility: slow adjustment from one equilibrium to another: P1 AD2 P,GDP AD1 Potential for out of equilibrium effects: “disequilibrium unemployment” Y1 Y2 GDP

Discussion “micro” in nature IF markets assumed flexible THEN no macro problems IF markets inflexible THEN problem is micro Unions if wages inflexible Monopolies if prices inflexible No discussion of empirics despite existence of research Blinder (1998) survey conclusive: prices inflexible; adjustments slow Therefore disequilibrium unemployment persists But “debate” continues…

Flexibility of aggregate supply “… flexible … aggregate supply does not respond … to changes in aggregate demand. Aggregate supply … depends on the quantity and productivity of factors of production, not on the level of aggregate demand. An expansion of aggregate demand will merely lead to (demand-pull) inflation… If the government, therefore, wants to expand aggregate supply and get more rapid economic growth… it should concentrate directly on supply by encouraging enterprise and competition, and generally by encouraging markets to operate more freely…. supply-side economics. Other … argue that rises in aggregate demand will cause aggregate supply to rise… However, these conditions will not be achieved, they argue, if the government pursues a non-interventionist, laissez-faire policy. The government instead must seek to control aggregate demand, to ensure that it continues to grow, and at a steady, nonfluctuating rate.” (383)

Debate shown in terms of slope of AS function Steep: “neoclassical” Demand influences only price level Horizontal: “extreme Keynesian” Demand influences GDP, price level constant

Again, empirical evidence clear but ignored Blinder finds downward sloping marginal cost the rule Only possible reason: excess capacity also the rule “Supply” therefore can expand to match demand “Aggregate supply” should be horizontal Main issue—cost pressures on inputs (wages, raw materials) Rising costs due to rising input prices rather than diminishing marginal productivity… But “debate” continues…

Role of expectations in working of market “Some economists argue that people's [price change expectations] adjust rapidly … If aggregate demand expands … people will expect higher prices… all firms will raise their prices in response to the demand increase… price rises will fully choke off the extra demand… no increase in sales, … output and employment. … increased aggregate demand merely fuels inflation… Others believe that the formation of expectations is more complex … If there is a lot of slack in the economy—if unemployment is very high and there are many idle resources…—then output and employment may quickly rise…” (384)

Blinder’s research again Very few firms anticipate inflation when setting prices Empirical research thus rejects “rational expectations” attitude to impact of demand increase But empirical evidence ignored and “debate” continues… IF evidence taken into account, then Disequilibrium output, employment & prices the rule Supply flexible—excess capacity—so “demand management” policies can affect employment Prices sluggish & don’t anticipate inflation: cost-push inflation the rule So in terms of the debate model:

Sloman & Morris diagram (c) the rule… BUT AS slope due to rising input costs, not DMP… AND… how to model disequilibrium prices? Can model cope? Let’s check derivation… Model an extension of Hicks’s “IS-LM” interpretation of Keynes…

Keynes “general theory”, according to Hicks
Deriving the LM curve: Fixed Money supply Exogenously set by Reserve Bank Money demand a negative function of interest rate Money held in case investment expectations not fulfilled Otherwise no need to hold money except for immediate transactions But money “barren” [no income from it] so increased interest rate increases opportunity cost of holding money a positive function of income “transactions demand for money” increased income level requires more money for transactions

The combination: an upward-sloping LM curve: The LM curve Exogenous Ms i i Md2 (Y2) Md1 (Y1) GDP=Y M Y1 Y2 LM curve thus shows all combinations of output and interest rate that give equilibrium in money market: demand for money equals supply…

Next, the IS curve: Investment demand a negative function of i [I=I(i)] Lower interest rate makes more projects NPV positive Investment rises as interest rate falls Savings supply a positive function of Income [S=S(Y)] Savings a residual after consumption Savings rise as income rise

IS curve thus shows all points where goods market is in equilibrium Investment = Savings So consumption = output of consumer goods Y (income) Y (income) S=S(Y) Savings a function of income S Y (income) i Investment a function of interest rate i The IS curve Multiplier I=I(i) Y(output) I (Investment)

The product: IS-LM analysis LM curve shows all points for money market equilibrium Money demand equals money supply IS curve shows all points for goods market equilibrium Investment=Savings Demand for goods equals supply Intersection shows overall economy equilibrium i LM IS Y (GDP)

Macroeconomics … The old debate
Original Keynesian-Neoclassical debate conducted in terms of IS-LM model with Arguments over whether “free market” IS-LM equilibrium coincided with full employment “Keynesian” “ Neoclassical” LM IS i Y LM IS i Y FE FE (Different views of labour market lie behind different positions for [& definitions of!] full employment)

Arguments over slope of LM curve & effectiveness of monetary & fiscal policy “Keynesian region” In “Keynesian” region, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts income In “Classical region”, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts interest rate “the General Theory of Employment is the Economics of Depression”, Classical is Economics of full employment i Monetary policy ineffective; Fiscal policy needed to shift IS curve “Classical region” Monetary policy effective; Fiscal policy just causes higher interest rates LM IS Yd Yf Y

IS-LM analysis dominant when price level relatively stable Legitimised fiscal policy to counter economic slumps “the General Theory of Employment is the Economics of Depression” (Hicks): increase output & employment by government spending when economy in a slump Increased price-level volatility led to next development: Aggregate Demand-Aggregate Supply Analysis Aggregate Demand curve derived from IS-LM analysis Assume fixed money supply Higher price level with fixed Ms means less purchases possible with given Ms level LM curve “shifts up” as price level rises:

Macroeconomics … The middle-aged debate
IS & LM curves subsumed into one (AD) mapping output against price level… LMP2 i P LMP1 LMP0 P2 P1 P0 IS AD Y2 Y1 Y0 Y (GDP) Y2 Y1 Y0 Y (GDP)

Aggregate supply graph derived from view of labour market Neoclassical: real wage is set in labour market Demand for labour is marginal product of labour curve Derived from production function with DMP… Supply of labour assumed upward-sloping Treated as any other commodity BUT Even under neoclassical theory labour is not a “commodity” not produced by factories subject to DMP but offered by workers as part of work-leisure choice Model can’t definitely derive any shape—upward or downward-sloping…

Individual worker decides how much labour to supply as trade-off between two “goods”: “income” & “leisure” Indifference curves show income/leisure combinations that give equal satisfaction “Budget line” is 24 hours leisure vs 24 hours x wage rate This worker supplies more labour as real wage rises Income Leisure Wage Work At low wage (say 1 banana/hour) has high leisure h1 (say 18 hours/day) w3 Labour supply w2 w2 Lower leisure (e.g., 16 hours) for higher wage (e.g., 2 bananas/hour… ) w1 w1 24-h3 h3 h2 h1 24 24-h2 24-h1

But analysis can easily derive upward sloping supply of labour curve: worker works less as wage rises: Wage Labour This worker supplies less labour as real wage rises At low wage (say 1 banana/hour) has low leisure h1 (say 12 hours/day) Time (24 hours) Income w3 Labour supply w3 w2 w2 w1 w1 Higher leisure (e.g., 16 hours) for higher wage (e.g., 2 bananas/hour… ) h1 h2 h3 24-h2 Leisure Work 24-h3 24-h1 So neoclassical theory can’t derive upward-sloping labour supply function: shape depends on individual preferences Nonetheless, assumes upward slope and continues on!

Neoclassical demand for labour derived from production function GDP produced under conditions of diminishing marginal productivity Labour market competitive so economy(!) can purchase as much labour as it likes at the going real wage… Product market competitive so economy(!) can sell as much as it likes without affecting the price level… Employers therefore hire workers until marginal benefit (increased profit) equals marginal cost (increased wage bill). Marginal benefit is increase in output Marginal cost is (constant???) going real wage Equilibrium wage is thus equal to marginal product of labour

GDP assumed produced under conditions of diminishing marginal productivity Higher output needs more labour (capital fixed) Additional labour less productive because of DMP GDP Labour Marginal Product/Real Wage Labour Employers willing to pay lower (real) wage to hire Marginal physical product curve thus traces out demand for labour Real wage thus equals the marginal product of labour Physical Marginal RW1 Product RW2 E1 E2

Sounds “meritocratic”: “you get what you contribute” “the real wage equals the marginal product of labour” BUT… Absurd to apply “firm level” micro assumptions at economy level Firm might have little impact on employment but “Economy” must have large impact Firm might not depress its price too much by increasing output but “Economy” has to reduce price to increase sales… When these factors added, outcome not so meritocratic: neoclassical theory shows workers ‘ripped off’…

With acknowledgement of Wage rises as function of aggregate employment Price falls as function of aggregate output… Two factors mean real wage much less than marginal product of labour… But ignoring this and assuming perfect competition everywhere, neoclassical aggregate supply function is…

A vertical line! Intersection of labour supply & demand determines real wage and equilibrium (“full employment”) supply of labour Equilibrium labour supply determines output via production function [Source: Levacic & Rebmann Macroeconomics: an Introduction to Keynesian-Neoclassical Controversies (1982); still probably best advanced macro text around] Equilibrium output & employment independent of prices Fiscal policy ineffective; Economy tends to full employment anyway…

Neoclassical AD/AS: Manipulating aggregate demand (fiscal policy) simply causes inflation… Any impact of AD on employment a “temporary disequilibrium effect”… Increase in price level causes apparent drop in real wage Drop in real wage encourages greater demand for labour Increased demand absorbed by rise in wages AS P AD2 AD1 Y

Keynesian AS/AD demand differs only in model of labour market. Argues: workers bargain over money wage, not real Can employ any number of workers at going money wage up to full employment; From that point on, wage must rise to employ more people “Full employment” defined not as equilibrium condition (as in neoclassical version) but as percentage of workforce (e.g., “3% unemployment=full employment”) Position attacked by neoclassicals as presuming “non-rational behavior” by workers Bargaining in money rather than real terms Suffering from “money illusion”

But Keynesian position easily derivable from neoclassical analysis of labour supply Since individual labour supply curves can have any shape, no aggregate relation can be presumed between (real or nominal) wages and labour supply Keynes’s “hire as many workers as wish at the going wage” at least as valid as Neoclassicals unjustified assumption of upward-sloping aggregate labour supply Given Keynesian money-wage supply function: Increasing price level lowers real wage Lower real wage encourages employers to hire more workers Aggregate supply therefore slopes upwards…

Fiscal policy (shifting AD) can increase output & employment at expense of increased price level… Price level AS Subsequent theoretical developments dominated by neoclassicals Effectively application of micro to macro: Economy modelled as either single rational agent or general equilibrium system… AD GDP

So two perspectives: Neoclassical: Economy tends to full employment equilibrium on its own Fiscal policy just causes inflation Keynesian: Economy can fall into unemployment equilibrium Fiscal policy causes inflation which can move economy to full employment… Reality check time! (A) Which perspective is closer to the empirical truth? (B) What about what both perspectives ignore: disequilibrium dynamics (Schumpeter again…)

“IS-LM: An Explanation”
In 1979/80, Hicks commented that “The IS-LM diagram, which is widely, though not universally, accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.” saw two key problems with IS-LM as an interpretation of Keynes 2nd problem was time-period of model: Hicks’s used a week, Keynes used “a ‘short-period’, a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year” (Hicks 1980).

Not unreasonable to hold expectations constant for a week–and therefore ignore them. But keeping expectations constant over a year in an IS-LM model does not make sense, because “for the purpose of generating an LM curve, which is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.” (Hicks OREF) I.e., why hold money for precautions/speculation, if expectations were constant? Can’t validly derive LM curve, because transactions are only reason for holding money when expectations constant

If expectations constant, then can’t be out of equilibrium if out of equilibrium, expectations must change!: “I accordingly conclude that the only way in which IS-LM analysis usefully survives–as anything more than a classroom gadget, to be superseded, later on, by something better–is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate…” “When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected–if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium.” (Hicks 1980)

Macroeconomics … Some empirical data
“Rational Expectations” version of Neoclassical theory eventually developed the “Policy Ineffectiveness Proposition” (PIP): Expressed in terms of “Phillips curve” trade-off between unemployment and inflation… “by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips curve even for one period.” (Thomas J. Sargent & Neil Wallace 1976, “Rational Expectations and the Theory of Economic Policy”, Journal of Monetary Economics Vol. 2, pp )

Macroeconomics … Some empirical data
PIP asserts economic policy could never have been effective Keynesians dominated economic policy Neoclassicals dominated 1973-now By PIP, should be no difference between two except: Inflation & money supply growth higher under Keynesian Budget deficit greater under Keynesian Interest rates higher under Keynesian All real variables (unemployment, growth) the same… Some causal empiricism: compare economic growth, unemployment, inflation, money growth, interest rates, government deficit (USA Data)

GDP Growth Keynesian Period Monetarist/Neoclassical

Unemployment Monetarist/Neoclassical Keynesian Period

Inflation Keynesian Period Monetarist/Neoclassical

Money Supply Keynesian Period Monetarist/Neoclassical

Interest Rates Keynesian Period Monetarist/Neoclassical

Government Budget Keynesian Period Monetarist/Neoclassical

Balance of Trade Keynesian Period Monetarist/Neoclassical

Income distribution Keynesian Period Monetarist/Neoclassical

The Keynesian/Neoclassical Scorecard
Outcomes contradict RE Hypothesis: Keynesian period has Lower Money Growth, Inflation, Interest Rates, Unemployment; Higher Growth How could this be if policy was “ineffective”? Did the economy suddenly deteriorate? (possibly true…)

Macroeconomics: what the debate ignores
Empirical record hardly indicates “equilibrium”: There is a “disequilibrium” interpretation too: Schumpeter and cycles Minsky’s “Financial Instability Hypothesis” But first, empirical investigation of cycles in USA data… next week

Lecture Seven: The macroeconomy: standard views

Similar presentations

Presentation on theme: "Lecture Seven: The macroeconomy: standard views"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Lecture Seven: The macroeconomy: standard views

Similar presentations

Presentation on theme: "Lecture Seven: The macroeconomy: standard views"— Presentation transcript:

Similar presentations

About project

Feedback