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Midterm info

• Wed Oct 12, 11:35-12:50• Place: TBA• Covers: everything to next Monday• Review sessions: M and T, 5 – 9, LC 211• Last year’s exam as an example (no answers)

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Business cycles and short run macro

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Let’s review our voyage to date:

We have analyzed:• Measuring economic activity• Aggregate production functions and distribution• Classical AS and AD (flexible w and p)• Financial macro (including money)• Open-economy macro

We now move on to • Business cycles, Keynesian economics, and the IS-

MP model

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The Great DivideClassical macro:

- full employment- flexible wages and prices- Perfect competition and rational expectations- No business cycles (or “real” business cycles), and all unemployment is voluntary and efficient

Keynesian macro:- Underutilized resources- Inflexible (or fixed) wages and prices- Imperfect competition and behavioral expectations- Yes, business cycles, with persistent slumps, involuntary unemployment, and macro waste.

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Understanding business cyclesMajor elements of cycles

– short-period (1-3 yr) erratic fluctuations in output– pro-cyclical movements of employment, profits, prices– counter-cyclical movements in unemployment– appearance of “involuntary” unemployment in

recessions

Historical trends– lower volatility of output, inflation over time (until 2008)– movement from stable prices to rising prices since WW

II

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Output gaps and business cycles

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12,000

12,500

13,000

13,500

14,000

14,500

15,000

2004 2005 2006 2007 2008 2009 2010 2011

Potential (full employment) real GDPActual real GDP

Large GDP “gap”

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Unemployment and recessions

3

4

5

6

7

8

9

10

11

70 75 80 85 90 95 00 05 10

Unemployment rates and recessionsU

nem

ploy

men

t rat

e (%

of l

abor

forc

e)

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Unemployment and vacancies (2000-2011)

1.6

2.0

2.4

2.8

3.2

3.6

4.0

2 3 4 5 6 7 8 9 10 11

Unemployment rate (%)

Vaca

ncy r

ate (%

)

2011

2000

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Major approaches to business cycles• “Keynesian cross” (Econ 116): useful for intuition

• AS-AD with p and Y (Econ 116): needs updating and will not use

• IS-LM: from earlier era

• IS-MP (Econ 122)

• Mankiw’s dynamic model: mainstream modern Keynesian macro

• Open-economy in short run: Mundell-Fleming: Very important approach to open economy

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IS-MP modelThe major tool for showing the impact of monetary

and fiscal polices, along with the effect of various shocks, in a short-run Keynesian situation.

Key assumptions• Fixed prices (P=1 and π = 0)• Unemployed resources (Y < potential Y = Mankiw’s natural

Y)• Closed economy (not essential and will be considered later)• Goods markets (IS) and financial markets (MP)

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IS curve (expenditures)

Basic idea: describes equilibrium in goods marketFinds Y where planned I = planned S or planned

expenditure = planned outputBasic set of equations:

1. Y = C + I + G2. C = a + b(Y-T)3. T = T0 + τ Y [note assume income tax, τ =

marginal tax rate]4. I = I0 –dr [note i = r because fixed P]5. G = G0

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which gives the IS curve:

Y = a - bT0 + G0 + I0 - dr 1 - b(1- τ)

Y = μ [A0 - dr]whereA0 = autonomous spending = a - bT0 + G0 + I0

μ = simple Keynesian multiplier = 1/[(1 - b(1- τ)]or in terms of solving for the interest rate:r = (A0 - Y/μ ) / d

which we graph as the IS curve.

r = realinterest rate

Y = real output (GDP)

IS(G, T0, …)

re

Ye

IS diagram

E

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MP curve (monetary policy/financial markets)

The MP curve represents equilibrium in financial markets. 1. Monetary Policy: Taylor Rule

Begin with a monetary policy equation in the form of a “Taylor rule”:

(TR) i = π + r* + b(π-π*) + cyr* is the equilibrium real interest rate, π inflation rate, π* is

inflation target, y is log output gap [log(Y/Yp)], b and c are parameters.

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Taylor rule and actual

-4

-2

0

2

4

6

8

10

90 92 94 96 98 00 02 04 06 08 10

Actual fed funds rateTaylor rule prediction

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MP curve (monetary policy/financial markets)

The MP curve represents equilibrium in financial markets. 1. Monetary Policy: Taylor Rule

Begin with a monetary policy equation in the form of a “Taylor rule”: (TR) i = π + r* + b(π-π*) + cyr* is the equilibrium real interest rate, π inflation rate, π* is inflation

target, y is log output gap [log(Y/Yp)], b and c are parameters.

2. We will ignore inflation for now to simplify. Add that after have studied. So π = π* = 0 and we have financial market:

(MP) r = r* + cy

Later on, we will introduce inflation in the TR and MP.

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Algebra of IS-MP Analysis• The analysis looks at simultaneous equilibrium in goods market and financial markets (Main St and Wall St).

• The algebraic solution for equilibrium Ye is:***Ye = μ*A0 – μ* d r*

where μ* = μ/(1 + μdc’) = multiplier with monetary policy. μ = simple multiplier > μ* ; A0 = autonomous spending

= a - bT0 + G0 + I0 ,Note impacts on output:

Positive: G, I0, NXNegative: risk premium (and later inflation shock)

*** There is a small technical issue in the algebra here. The Taylor rule has r as a function of y = ln(Y/Yp), whereas the IS is Y = f(r). We want to keep the Y in the equation because mulitpliers are dY/dG (see CBO figure below). And Taylor rule is in y (or sometimes u). So we need a change of variable. The best way is to use Taylor approximation (different Taylor), that ln(1+x)= x +o(x2) for x close to zero. So ln (1+Y/Yp-1) ≈ Y/Yp-1, so we substitute that into the MP. This will give new c’ = cYp. Analysis is identical.

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r = real interest rate

Y = real output (GDP)

IS(G, T0, …)

re

Ye

MP(r*)

IS-MP diagram

E

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1. What are the effects of fiscal policy?

• A fiscal policy is change in purchases (G) or in taxes (T0, t), holding monetary policy constant.

• In normal times, because MP curve slopes upward, expenditure multiplier is reduced due to crowding out.

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Fiscal policy in normal times

r = real interest rate

Y = real output (GDP)

IS

re

MP

IS’

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Multiplier Estimates by the CBO

Congressional Budget Office, Estimated Impact of the ARRA, April 2010

0.0

0.5

1.0

1.5

2.0

2.5

3.0

G: Fed G: S&L Trans: indiv Tax: Mid/Low Income

Tax: High Income

Bus Tax

Mul

tiplie

r fro

m G

,T o

n GD

P

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What about the abnormal times?

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Liquidity trap in US in Great Depression

0

1

2

3

4

5

6

1930 1932 1934 1936 1938 1940 1942 1944

US short-term interest rates, 1929-45 (% per year)

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US in current recession

0

4

8

12

16

20

1975 1980 1985 1990 1995 2000 2005 2010

Federal funds rate (% per year)

Policy has hit the “zero lower bound” three years ago.

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Japan short-term interest rates, 1994-2010

Liquidity trap from 1996 to today: 15 years and counting.

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Fiscal policy in liquidity trap r = real interest rate

Y = real output (GDP)

IS

re

IS’ MP

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Can you see why macroeconomists emphasize the importance of fiscal policy in the current environment?

“Our policy approach started with a major commitment to fiscal stimulus. Economists in recent years have become skeptical about discretionary fiscal policy and have regarded monetary policy as a better tool for short-term stabilization. Our judgment, however, was that in a liquidity trap-type scenario of zero interest rates, a dysfunctional financial system, and expectations of protracted contraction, the results of monetary policy were highly uncertain whereas fiscal policy was likely to be potent.”

Lawrence Summers, July 19, 2009

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The MP curve represents monetary policy.

That is, the central bank responds by lowering (raising) interest rates when output declines (rises).- somewhat confusing because Fed actually has discretion, so in a sense the Taylor rule is a forecast of how Fed will act given the economy and its objectives

Note that cannot follow Taylor rule in liquidity trap (when nominal short risk-free rates are near zero).

Case 2. Monetary policy

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Older approach that emphasized the supply of money.

Very important tradition, particularly Friedman and Schwartz, A Monetary History of the United States.

Deemphasized in Econ 122, but still important in many other views of macro (warning about dissensus)

Case 3. Monetarism

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Summary on IS-MP ModelThis is the workhorse model for analyzing short-run

impacts of monetary and fiscal policy Key assumptions:

- Fixed or rigid prices- Unemployed resources

Now on to analysis of Great Depression in IS-MP framework.