Appunti in Inglese Macroeconomics, Appunti di Macroeconomia

Scarica Appunti in Inglese Macroeconomics e più Appunti in PDF di Macroeconomia solo su Docsity! MACROECONOMICS 2 CH 8: ECONOMIC GROWTH 1: CAPITAL ACCUMULATION AND POPULATION GROWTH WHY GROWTH MATTERS Data on infant mortality rates 20% in the poorest 1/5 of all countries o.4% in the richest 1/5 In Pakistan, 85% op people live on less than 2$/ day. One fourth of the poorest countries have has famines during the past 3 decades. Poverty is associated with oppression of women and minorities. Economic growth raises living standards and reduces poverty Before you teach this chapter, please check out the links I’ve included to Gapminder. This amazing website creates dynamic cross-country scatter-type graphs using data from reputable sources (such as the World Bank’s World Development Indicators). The graphs are really quite amazing and will surely spark student interest in the topic and, if you wish, class discussion. I prepared some introductory slides on economic growths a few editions ago, and they remain. But the Gapminder graphs are better; please check them out and consider using one or more of them in class. This slide provides links to some dynamic graphs at Gapminder.org. I strongly encourage you to invest 10-15 minutes exploring this site, and then to share it with your students. You can start by checking out some or all of the five graphs I’ve linked to here. For class, I suggest you show the life expectancy graph and one or two of the other ones. Disclaimers/warnings: Gapminder is an external site not under the control of Worth Publishers. It could be taken down at any time (though this is very unlikely). I had to use “TinyURL” to create links small enough for PowerPoint to recognize; TinyURL is an external service not under the control of Worth Publishers, and it is possible that the TinyURL service could be interrupted or discontinued (though this is unlikely. WHY GROWTH MATTERS Anything that effects the long-run rate of economic growth- even by a tiny amount- will have huge effects on living standards in the long run If the annual growth rate of U.S. real GDP per capita had been just one-tenth of one percent higher from 2000–2010, the average person would have earned $2,782 more during the The $2,782 figure is in 2005 prices. In current prices, the figure would be a bit higher. Also, the result would have been a little higher if we divided GDP by working aged adults rather than the entire population. For these reasons, we can consider $2,782 to be a lower bound on the extra income someone would have earned if the growth rate were just 0.1% higher. How I did this calculation: 1. Created an annual real GDP per capita series with data on real GDP (in 2005 dollars) and population from FRED. 2. Computed the annual growth rate of real GDP per capita from 2000 to 2010. 3. Added 0.1% to each of these growth rates. 4. Computed what real GDP per capita would have been each year using these 0.1% higher growth rates. 5. Computed the difference between these hypothetical income per capita values and the actual ones. 6. Added up these differences for the decade and got the total: $2,782. THE SOLOW MODEL due to Robert Solow who won Nobel Prize for contributions to the study of economic growth a major paradigm:  widely used in policy making  benchmark against which most recent growth theories are compared looks at the determinants of economic growth and the standard of living in the long run HOW SOLOW MODEL IS DIFFERENT FROM CHAPTER 3’MODEL No G or T ( only to simplify presentation; we can still di fiscal policy experiments) Cosmetic differences [include things like the notation (lowercase letters for per- worker magnitudes instead of uppercase letters for aggregate magnitudes) and the variables that are measured on the axes of the main graph.] As in chapter £, closed economy (NX=0). Start with fixed L and then consider pop growth THE PORODUCTION FUNCTION In aggregate terms: Y = F (K, L) A NUMERICAL EXAMPLE Production function( aggregate) To derive the per-worker production function, divide through by L: Then substitute y = Y/L and k = K/L to get Assume:  S= 0,3  = 0.1 initial value of k = 4.0 As each assumption appears on the screen, explain its interpretation. I.e., “The economy saves three-tenths of income,” “every year, 10% of the capital stock wears out,” and “suppose the economy starts out with four units of capital for every worker.” Summary: As long as k < k*, investment will exceed depreciation, and k will continue to grow toward k*. PREDICTION:  Higher s  higher k*.  And since y = f(k) , higher k*  higher y* .  Thus, the Solow model predicts that countries with higher rates of saving and investment will have higher levels of capital and income per worker in the long run. After showing this slide, you might also note that the converse is true, as well: a fall in s (caused, for example, by tax cuts or government spending increases) leads ultimately to a lower standard of living. In the static model of Chapter 3, we learned that a fiscal expansion crowds out investment. The Solow model allows us to see the long-run dynamic effects: the fiscal expansion, by reducing the saving rate, reduces investment. If we were initially in a steady state (in which investment just covers depreciation), then the fall in investment will cause capital per worker, labor productivity, and income per capita to fall toward a new, lower steady state. (If we were initially below a steady state, then the fiscal expansion causes capital per worker and productivity to grow more slowly, and reduces their steady-state values.) This, of course, is relevant because actual U.S. public saving has fallen sharply since 2001. Before revealing the numbers in the first row, ask your students to determine them and write them in their notes. Give them a moment, then reveal the first row and make sure everyone understands where each number comes from. Then, ask them to determine the numbers for the second row and write them in their notes. After the second round of this, it’s Next, we see what the model says about the relationship between a country’s saving rate and its standard of living (income per capita) in the long run (or steady state). An earlier slide said that the model’s omission of G and T was only to simplify the presentation. We can still do policy analysis. We know from Chapter 3 that changes in G and/or T affect national saving. In the Solow model as presented here, we can simply THE GOLDEN RULE: INTRODUCTION Different values of s lead to different steady states. How do we know which is the “best” steady state? The “best” steady state has the highest possible consumption per person: c* = (1–s) f(k*).  An increase in s  leads to higher k* and y*, which raises c*  reduces consumption’s share of income (1–s), which lowers c*. So, how do we find the s and k* that maximize c*? THE GOLDEN RULE: THE MATH The Golden Rule level of capital, the steady state value of k, that maximize consumption. To find it, first express c* in terms of k* Since c*(k*) is concave, its maximum is determined by c*’(k*) = 0, that is, f’(k*) = , or MPK = . THE GOLDEN RULE: THE GRAPH Figure 8.12, p.230. International Evidence on the Solow Model This scatterplot shows the experience of about 160 countries, each represented by a single point. The vertical axis shows a country’s income per person, and the horizontal axis shows its effective investment rate s over (delta plus n). These two variables are positively associated, as the Solow model predicts. The correlation between these two variables is 0.71. Students sometimes confuse this graph with the other Solow model diagram, as the curves look similar. Be sure to clarify the differences: 1. On this graph, the horizontal axis measures k*, not k. Thus, once we have found k* using the other graph, we plot that k* on this graph to see where the economy’s steady state is in relation to the golden rule capital stock. 2. On this graph, the curve measures f(k*), not sf(k). 3. On the other diagram, the intersection of the two curves determines k*. On this graph, the only thing determined by the intersection of the two curves is the level of capital where c*=0, and we certainly wouldn’t want to be there.   k to replace capital as it wears out  n k to equip new workers with capital (Otherwise, k would fall as the existing capital stock is spread more thinly over a larger population of workers.) THE EQUATION OF MOTION FOR K With population growth the equation of motion for k is: THE SOLOW MODEL DIAGRAM PREDICTION Higher n  lower k* Since y= f(k), lower k*lower y* Thus the Solow model predicts that countries with higher population growth rates will have lower level of capital and income per worker in the long run THE GOLDEN RULE WITH POPULATION GROWTH: THE IMPACT OF POPULATION GROWTH Figure 8-13, p.235. This figure is a scatterplot of data from 100 countries. It shows that countries with high rates of population growth tend to have low levels of income per person, as the Solow model predicts. So far, we’ve now learned two things a poor country can do to raise its standard of living: increase national saving (perhaps by reducing its budget deficit) and reduce population growth. Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 7.1, Center for International Comparisons of Production, Income and Prices at the To find the Golden Rule capital stock, express c* in terms of k*: c* = y*  i* = f (k* )  ( + n) k* c* is maximized when MPK =  + n or equivalently, MPK   = n ALTERNTIVE PERSPECTIVE ON PRODUCTION GROWTH The Malthusian Model (1798)  Predicts population growth will outstrip the Earth’s ability to produce food, leading to the impoverishment of humanity.  Since Malthus, world population has increased sixfold, yet living standards are higher than ever.  Malthus neglected the effects of technological progress. The Kremerian Model (1993) Michael Kremer (Nobel prize 2019) posits that population growth contributes to economic growth. o More people = more geniuses, scientists & engineers, so faster technological progress. o Evidence, from very long historical periods:  As world pop. growth rate increased, so did rate of growth in living standards  Historically, regions with larger populations have enjoyed faster growth. ECONOMIC GROWTH 2: TECHNOLOGY, EMPIRICS AND POLICY Chapter 8 had a single focus: the in-depth development of the Solow model with population growth. In contrast, Chapter 9 is a survey of many growth topics. First, the Solow model is extended to incorporate labor-augmenting technological progress at an exogenous rate. This is followed by a discussion of growth empirics, including balanced growth, convergence, and growth from factor accumulation vs. increases in efficiency. Next, policy implications are discussed. Finally, the chapter presents two very simple endogenous growth models. In the Golden Rule steady state, the marginal product of capital net of depreciation equals the population growth rate. The models in this chapter are presented very concisely. If you want your students to master these models, have them do exercises and policy experiments with the models. In the book, the Problems and Applications at the end of the chapter are excellent for this; consider assigning them as homework or use in class to break up your lecture. If you are pressed for time and are considering skipping this chapter, I encourage you to at least cover section 9-1, so that your students will learn the full Solow model with technological progress. One class period should be enough time to cover it, allowing for one or two in-class exercises if you wish. If you can spare a few more minutes, also consider section 9-3: it discusses policy implications, it’s not difficult or time-consuming, and students find it very interesting - it gives additional real-world relevance to the material in Chapter 8 and in Section 9-1. INTRODUCTION In the Solow model of chapter 8 :  the production technology is held costant  Income pro capita is constant in the steady state . Neither point is true in the real world:  1900-213; U.S real GDP per person grew by a factor of 8.3 or 1,9% per year  Examples of technological progress abound: wheel, plough, mill, combustion engine, railroad, car, airplane, telephone, telegraph computer, internet, Al… TECHNOLOGICAL PROGRESS IN THE SOLOW MODEL A new variable: E = labor efficiency Assume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g:  Now we write the production function as: ( , )Y F K L E   Where L x E= the number of effective workers. Increases in labor efficiency have the same effect on output as increases in the labor force. Notation: Y=Y/(LE)= output per effective workers K= K/(LE)= capital per effective workers Production function per effective worker: y = f(k) Saving and investment per effective worker: s y = s f(k) TECHNOLOGICAL PROGRESS IN THE SOLOW MODEL E g E   from part (c), we know that total labor income grows at rate n + g. We, therefore, conclude that the real wage grows at rate g. GROWTH EMPIRICS: BALANCED GROWTH Solow model predicts constant capital and labor shares of income  Capital’s share of income = MPK  (K/Y).  In ss both MPK = f’(k) and K/Y are constant.  Labor’s share of income is 1 – MPK  (K/Y). Also true in the real world. But L’s share is declining in several countries since the 80s, possibly due to superstar firms.  Karabarbounis & Neiman 2014 QJE; Autor et al. 2017 IZA DP & AER Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant.  Real rental price of capital R = MPK.  Real wage income wL = [1 – MPK (K/Y)] Y.  Hence Δw/w + n = n + g, so Δw/w = g. Also true in the real world. GROWTH EMPIRICS: CONVERGENCE Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones. If true, then the income gap between rich & poor countries would shrink over time, causing living standards to converge. In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails? Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones.  No, because “other things” aren’t equal:  In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year.  In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year. What the Solow model really predicts is conditional convergence—countries converge to their own steady states, which are determined by saving, population growth, and education. This prediction comes true in the real world. POLICY ISSUE  Are we saving enough? Too much?  What policies might change the saving rate?  How should we allocate our investment between privately owned physical capital, public infrastructure, and human capital?  How do a country’s institutions affect production efficiency and capital accumulation?  What policies might encourage faster technological progress? POLICY ISSUE: EVALUATING THE RATE OF SAVING Use the Golden Rule to determine whether the U.S. saving rate and capital stock are too high, too low, or about right.  If (MPK   ) > (n + g ), U.S. economy is below the Golden Rule steady state and should increase s.  If (MPK   ) < (n + g ), U.S. economy is above the Golden Rule steady state and should reduce s. This section (this and the next couple of slides) presents a very clever and fairly simple analysis of the U.S. economy. When asked, students often have reasonable ideas of how to estimate MPK (e.g., look at stock market returns), n and g, but very few offer suggestions on how to estimate the depreciation rate: there are lots of different kinds of capital out there. Here, Mankiw presents a simple and elegant way to estimate the aggregate depreciation rate (which appears a couple of slides below). First, though, you should make sure your students know why the inequalities in the last two lines tell us whether our current steady state is above or below the Golden Rule steady state. To see this, remember that the steady-state value of capital is inversely related to the steady state value of MPK. If we’re above the Golden Rule capital stock, then we have “too much” capital, so MPK will be smaller than in the Golden Rule steady state. If we’re below the GR capital stock, then MPK is higher than in the Golden Rule. To estimate (MPK   ), use three facts about the U.S. economy: 1. k = 2.5 y The capital stock is about 2.5 times one year’s GDP. 2.  k = 0.1 y About 10% of GDP is used to replace depreciating capital. 3. MPK  k = 0.3 y Capital income is about 30% of GDP. 1. k = 2.5 y 2.  k = 0.1 y 3. MPK  k = 0.3 y To determine  , divide 2 by 1: The actual U.S. economy has tens of thousands of different types of capital goods, all with different depreciation rates. Estimating the aggregate depreciation rate therefore might seem impossible. But on this slide, we see Mankiw’s simple, clever, and elegant method of estimating the aggregate depreciation rate. Pretty neat! To determine MPK, divide 3 by 1: Similarly, the method of estimating the aggregate MPK shown on this slide is far simpler and more elegant than somehow measuring and aggregating the returns on all different kinds of capital.  From the last slide: MPK   = 0.08  U.S. real GDP grows an average of 3% per year, so n + g = 0.03  Industrial policy: encourages specific industries that are key for rapid tech. progress (subject to the preceding concerns). ENDOGENOUS GROWTH THEORY Solow model:  sustained growth in living standards is due to tech progress.  the rate of tech progress is exogenous. Endogenous growth theory:  a set of models in which the growth rate of productivity and living standards is endogenous. 2018 Nobel Prize in Economics to Paul Romer:  for endogenizing tech progress. In the Solow model, the long-run economic growth rate equals the rate of technological progress, which is exogenous in the model. Hence, the Solow model is basically saying “all I can tell you is that growth in living standards depends on technological progress. I have no idea what drives technological progress.” Endogenous growth theory tries to explain the behavior of the rates of technological progress and/or productivity growth, rather than merely taking these rates as given. THE BASIC MODEL  Production function: Y = A Kwhere A is the amount of output for each unit of capital (A is exogenous & constant)  Key difference between this model & Solow: MPK is constant here, diminishes in Solow  Investment: s Y  Depreciation:  K  Equation of motion for total capital:  Divide through by K and use Y = A K to get: Y K sA Y K        If s A > , then income will grow forever, and investment is the “engine of growth.”  Here, the permanent growth rate depends on s. In Solow model, it does not. Y and K grow at the same rate because A is constant. Discussion: The return to capital is the incentive to invest. If capital exhibits diminishing returns, then the incentive to invest decreases as the economy grows. Hence, investment cannot be a source of sustained growth. However, in this model, MPK does not fall as K rises, so the incentive to invest never declines, people will always find it worthwhile to save and invest over and above depreciation, so investment becomes an engine of growth. The $64,000 question: Does capital exhibit diminishing or constant marginal returns? The answer is critical, for it determines whether investment explains sustained (i.e. steady-state) growth in productivity and living standards. See the next slide for discussion. A TWO-SECTOR MODEL Two sectors:  manufacturing firms produce goods.  research universities produce knowledge that increases labor efficiency in manufacturing. u = fraction of labor in research (u is exogenous) Mfg prod func: Y = F [K, (1  u )E L] Res prod func: DE = g (u )E Cap accumulation: DK = s Y   K Before presenting this model, it might be helpful to tell students that it is an extension of something they already know - the Solow model with tech progress. There are two differences: • First, a fraction of the labor force does not produce goods & services, but rather produces “knowledge” by doing research in universities. • Second, the rate of tech progress is not exogenous, but rather depends on how fast the stock of knowledge grows, which in turn depends on how much labor the economy has allocated to research. If you have a few minutes of class time after presenting the model, you should consider having your students work problem #6 on p.261. Otherwise, assign it as a homework exercise. In regards to the specific elements of the model, • Manufacturing production function: Just like in the Solow model with exogenous technological progress, output of manufactures depends on capital and the effective labor force employed in the mfg sector, (1-u)EL. • Research production function: The “output” is increases in knowledge and labor efficiency. The “inputs” are labor and current knowledge. The function g( ) shows how changes in the amount of labor devoted to research affect the creation of new knowledge. All we need is for g( ) to be an increasing function. It does not matter whether a doubling of scientists causes the creation of knowledge to double, more than double, or less than double. • Capital accumulation: Same as in the previous model -- net investment equals gross investment (sY) minus depreciation.  In the steady state, mfg output per worker and the standard of living grow at rate E / E = g (u ).  Key variables: s: affects the level of income, but not its growth rate (same as in Solow model) u: affects level and growth rate of income In this model, the steady state growth rate of the standard of living equals the growth rate of labor efficiency, just like in the Solow model with tech progress, covered at the beginning of this chapter. The difference here is that the rate of tech progress, g, is not exogenous: it depends on how much labor the economy has allocated to research. INTRODUCTION TO ECONOMIC FLACTUATIONS This chapter has two main objectives: motivating the study of short-run fluctuations, and introducing (a simple version of) the model of aggregate demand and aggregate supply. Regarding the first objective, the chapter provides lots of data and discussion of the macroeconomy’s behavior in the short run. Regarding the second, the presentation here is best seen as providing the overall context or outline, which will be considerably fleshed out over the next few chapters. This chapter is less difficult than most other chapters in the book, and all of the concepts it introduces are all developed in more detail in the following chapters of Part IV. Therefore, you might consider spending a little less class time on this chapter than on other chapters. Please note that the AD curve in this chapter is based on the quantity theory of money. This simple theory, familiar to students from earlier chapters, yields a simple AD curve, which is adequate for the purposes of this chapter’s basic introduction to AD/AS. The shaded vertical bars denote recessions. Over the long run, real GDP grows about 3 percent per year. Over the short run, though, there are substantial fluctuations in GDP, as this graph clearly shows. This graph also shows the growth rate of consumption. It’s easy to see that consumption is usually less volatile than income. Consumers prefer smooth consumption, so they use saving as a buffer against income shocks. (An exception occurs in the late 1990s, when consumption growth exceeded The unemployment rate rises during recessions and falls during expansions. Since the 1991 recession, the unemployment rate lags GDP growth, particularly in recoveries. In each of the three recessions since 1990, the unemployment rate continues rising for a few months after the recession ends before it begins to fall AGGREGATE SUPPLY IN THE LONG RUN  Recall from Chap. 3: In the long run, output is determined by factor supplies and technology Y =Is the full employment or natural level of output, at which the economy’s resources are fully employed “Full employment” means that unemployment equals its natural rate (not zero). For future reference (a bunch of slides later in this chapter), it will be useful to see how a change in M shifts the AD curve. Page 287 discusses the shift. Here’s the idea: With velocity fixed, the quantity equation implies that PY is determined by M. An increase in M causes an increase in PY, which means higher Y for each value of P, or higher P for each value of Y. Or: for a given value of P, an increase in M implies higher real money balances. In the simple money demand function associated with the quantity theory, the demand for real balances is proportional to the demand for output, so output must rise at each P in order for real money demand to rise and equal the new, higher supply of real balances M/P. Or, if you prefer, just have your students take on faith that an increase in the money supply shifts the Sometimes it takes students a little while to understand why the LRAS curve is vertical, when the supply curves they learned in their micro principles class were mostly upward-sloping. Here’s an explanation they might find helpful: “P” on the vertical axis is the economy’s overall price level – the average price of EVERYTHING. A 10% increase in the price level means that, on average, EVERYTHING costs 10% more. Thus, a firm can get 10% more revenue for each unit it sells. But the firm also pays an average of 10% more in wages, prices of intermediate goods, advertising, and so on. Thus, the firm has no incentive to increase output. Another thought: We learn from microeconomics that a firm’s supply depends on the RELATIVE price of its output. [The textbook does a fall in AD (Figure 10-8 on p.289); this slide does an increase.] Notice that the results in this graph are exactly as we learned in Chapter 5: a change in the money supply affects the price level, but not the quantity of output. Here, we are seeing these results on a graph with different variables on the axes (P and Y), but it’s the same model. AGGREGTE SUPPLY IN THE SHORT RUN Many prices are sticky in the short run.  For now( and through out chapter 12) ), we assume  all prices are stuck at a predetermined level in the short run.  firms are willing to sell as much at that price level as their customers are willing to buy.  Therefore, the short-run aggregate supply (SRAS) curve is horizontal: The assumption that all prices are fixed in the short run is extreme. Chapter 14 derives the SRAS curve under more realistic assumptions. Yet, the extreme assumption here is worth making. The short-run response of output & employment to policies and shocks is the same (qualitatively) whether the SRAS curve is upward-sloping or horizontal. But the horizontal SRAS curve makes the analysis much simpler: a shift in AD leaves P unchanged in the short run. This greatly simplifies analysis in the IS-LM-AD model (Chapters 11 and 12). (With an upward- sloping SRAS curve, a shock to the IS and AD curves would change prices in the short run in addition to changing output. The change in prices would change the real money supply, which would shift the LM curve.) [The textbook (Figure 10-10 on p.291) does a decrease in AD, this slide does an increase.] What about the unemployment rate? Remember from chapter 2: Okun’s law says that unemployment and output are negatively related. In the graph here, in order for firms to increase output, they require more workers. Employment rises, and the unemployment rate falls. FROM THE SHORT RUN TO THE LONG RUN Over time, prices gradually become “unstuck” When they do , will they rise or fall? The adjustment of prices is what moves the economy to its long-run equilibrium. You might want to discuss the intuition for the price adjustment in each case. First, suppose aggregate demand is higher than the full-employment level of output in the economy’s initial short-run equilibrium. Then, there is upward pressure on prices: In order for firms to produce this above-average level of output, they must pay their workers overtime and make their capital work at a high intensity, which causes more maintenance, repairs, and depreciation. For all these reasons, firms would like to raise their prices. In the short run, they cannot. But over time, prices gradually become “unstuck,” and firms can increase prices in response to these cost pressures. Instead, suppose that output is below its natural rate. Then, there is downward pressure on prices: Firms can’t sell as much output as they’d like at their current prices, so they would like to reduce prices. With lower than normal output, firms won’t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the natural rate of unemployment. The high unemployment rate puts downward pressure on wages. Wages and prices are stuck in the short run, but over time, they fall in response to these pressures. Finally: if output equals its normal (or natural) level, then there is no pressure for prices to rise or fall. Over time, as prices become “unstuck,” they will simply remain constant. [The textbook does a decrease in aggregate demand, Figure 10-12 on p.292. This slide presents an increase in aggregate demand.]This slide puts together the pieces that have been developed over the previous slides: the short-run and long-run effects, as well as the adjustment of prices over time that causes the economy to move from the short-run equilibrium at point B to the long-run equilibrium at C. The economy starts at point A; output and unemployment are at their natural rates. The Fed increases the money supply, shifting AD to the right. In the short run, prices are sticky, so output rises. The new short-run equilibrium is at point B in the graph. In order for firms to increase output, they hire more workers, so unemployment falls below the natural rate of unemployment, putting upward pressure on wages. The high level of demand for goods & services at point B puts upward pressure on prices. Over time, as prices become unstuck, they begin to rise in response to these pressures. The price level rises and the economy moves up its (new) AD curve, from point B toward point C. This process stops when the economy gets to point C: output again equals the natural rate of output, and unemployment again equals the natural rate of unemployment, so there is no further pressure on prices to change. HOW SHOCKING!!  shocks: exogenous changes in agg. supply or demand  Shocks temporarily push the economy away from full employment.  Example: exogenous decrease in velocity If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services. Source: http://www.eia.gov/forecasts/steo/realprices/ November 2020 http://www.eia.gov/forecasts/steo/realprices/ STABILIZATION POLICY  def: policy actions aimed at reducing the severity of short-run economic fluctuations. Data source: See p.299 of the textbook. This second shock was associated with the revolution in Iran. The Shah, who maintained cordial relations with the West, was deposed. The new leader, Ayatollah Khomeini, was considerably less friendly toward the West. (He even forbade his citizens from listening to A few slides back, we analyzed the effects of an adverse supply shock. It might be worth noting that the predicted effects of a favorable supply shock are just the opposite: in the short run, the price level (or inflation rate) falls, output rises, and unemployment falls. Looking at the graph: at first glance, it may seem that the fall in oil prices doesn’t occur until 1986. But remind students to look at the left-hand scale, on which 0 is in the middle, not at the bottom. Oil prices fell about 10% in  Example: Using monetary policy to combat the effects of adverse supply shocks… STABILIZING OUTPUT WITH MONETARY POLICY Note: If the Fed correctly anticipates the sign and magnitude of the shock, then the Fed can respond as the shock occurs rather than after, and the economy never would go to point B—it would go immediately to point C. AGGREGATE DEMAND BUILDING THE IS-LM MODEL This chapter builds the IS-LM model, which Chapter 12 will use extensively to analyze the effects of policies and economic shocks. This chapter also introduces students to the Keynesian cross and liquidity preference models, which underlie the IS curve and LM curve, respectively. CONTEXT Chapter 10 introduced the model of aggregate demand and aggregate supply. Long run:  prices flexible  output determined by factors of production & technology  unemployment equals its natural rate Short run:  prices fixed  output determined by aggregate demand  unemployment negatively related to output This chapter develops the IS-LM model, the basis of the aggregate demand curve. We focus on the short run and assume the price level is fixed (so the SRAS curve is horizontal). Chapters 11 and 12 focus on the closed-economy case. Chapter 13 presents the open-economy case. THE KEYNESIAN CROSS A simple closed-economy model in which income is determined by expenditure. Notation: I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure Difference between actual & planned expenditure = unplanned inventory investment ELEMENTS OF THE KEYNESIAN CROSS Consumption function: Govt policy variables: For now, planned investment is exogenous: Planned expenditure Equilibrium condition ; actual expenditure= planned expenditure Stress that much of this model is very familiar to students: same consumption function as in previous chapters, same treatment of fiscal policy variables. In equilibrium, there is no unplanned inventory investment: Firms are selling everything they had intended to sell. GRAPHING PLANNED EXPENDITURE GRAPHING THE EQUILIBRIUM CONDITION The equilibrium point is the value of income at which the curves cross. Be sure your students understand why the equilibrium income appears on both the horizontal and vertical axes. Answer: In equilibrium, PE (which is measured on the vertical) equals Y (which is measured on the horizontal). Why slope of PE line equals the MPC: With I and G exogenous, the only component of (C+I+G) that changes when income changes is consumption. A one-unit increase in income causes consumption---and therefore PE---to increase by the MPC. Recall from Chapter 3: the marginal propensity to consume, MPC, equals the increase in consumption resulting from a one-unit increase in disposable income. Since T is exogenous here, a one-unit THE EQUILIBRIUM VALUE OF INCOME negative: C =  MPC  TC is part of planned expenditure. The fall in C causes the PE line to shift down by the size of the initial drop in C. At the initial value of output, there is now unplanned inventory investment: Sales have fallen below output, so the unsold output adds to inventory. In this situation, firms will reduce production, causing total output, income, and expenditure to fall. The new equilibrium is at Y2, where planned expenditure once again equals actual expenditure/output, and unplanned inventory investment is again equal to zero. THE TAX MULTIPLIER the change in income resulting from a $1 increase in T If MPC =0.8, then the tax multiplier equals THE TAX MULTIPLIER …Is negative; A tax increase reduces C which reduces income …Is greater than one (in absolute value) A change in taxes has a multiplier effect on income …is smaller than the govt spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. THE IS CURVE Def. a graph of all combinations of r and Y that results in goods market equilibrium i.e. actual expenditure (output)= planned expenditure. The equation for the IS curve is: DERIVING THE IS CURVE WHY THE IS CURVE IS NEGATIVELY SLOPED A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ). To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase. This slide simply states the intuition behind the graphs on the preceding slide. Suggestion: Omit this slide from your presentation, and just give the students this information orally as you present the preceding slide. THE IS CURVE AND THE LOANABLE FUNDS MODEL This material was covered in previous editions of the textbook but was deleted to help make room for newer material in other chapters. I have “hidden” this slide rather than deleted it, since many professors still may wish to show their students how the IS curve is just another expression of the familiar loanable funds model from Chapter 3. The IS curve can also be derived from the (hopefully now familiar) loanable funds model from chapter 3. A decrease in income from Y1 to Y2 causes a fall in national saving. (Recall, S = Y-C-G) The fall in saving causes a reduction in the supply of loanable funds. The interest rate must rise to restore equilibrium to the loanable funds market. Now we can see where the IS curve gets its name: When the loanable funds market is in equilibrium, investment = saving. The IS curve shows all combinations of r and Y such that investment (I) equals saving (S). Hence, IS curve. FISCAL POLICY AND THE IS CURVE We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output. Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve… SHIFTING THE IS CURVE: G This slide has two purposes. First, to show which way the IS curve shifts when G changes. Second, to actually measure the distance of the shift. We can measure either the horizontal or vertical distance of the shift. The horizontal distance of the IS curve shift is the change in Y required to restore goods market equilibrium AT THE INITIAL INTEREST RATE when G is raised. Since the interest rate is unchanged at r1, investment will also be unchanged. This is why, in the upper THE THEORY OF LIQUIDITY PREFERENCE Due to John Maynard Keynes. A simple theory in which the interest rate is determined by money supply and money demand. For the IS we started from given I (Keynesian cross) and then let I depend on r. For the LM we start with L(r) and then let it depend on Y MONEY SUPPLY MONEY DEMAND EQUILIBRIUM We are assuming a fixed supply of real money balances because P is fixed by assumption (short-run), and M is an exogenous policy HOW THE CB RAISES THE INTEREST RATE As we learned in Chapter 5, the nominal interest rate is the opportunity cost of holding money (instead of bonds), so money demand depends negatively on the nominal AGGREGATE DEMAND II: APPLYING THE IS-LM MODEL EQUILIBRIUM IN THE IS- LM MODEL The IS curve represents equilibrium in the goods market. The LM curve represents money market equilibrium The intersection determines the unique combination of Y and r that satisfies equilibrium in both markets. POLICY ANALYSIS WITH THE IS-LM MODEL We can use the IS-LM model to analyze the effects of: • fiscal policy: G and/or T • monetary policy: M AN INCREASE IN GOVERNMENT PURCHASES 1. IS curve shifts right by causing output and income to rise 2. This raises money demand, causing the interest rate to rise… 3. ..which reduces investment. So the final increase in Y is smaller than A TAX CUT Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G… and the IS curve shifts by Chapter 11 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPCT)/(1- MPC). If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that T < 0 for a tax cut, so the expression actually is positive. The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the MONETARY POLICY: AN INCREASE IN M 1. M > 0 shifts the LM curve down (or to the right) 2.…causing the interest rate to fall 3. which increases investment, causing output & income to rise. Chapter 11 showed that an increase in M shifts the LM curve to the right. Here is a richer explanation for the LM shift: The increase in M causes the interest rate to fall. [People like to keep optimal proportions of money and bonds in their portfolios; if money is increased, then people try to re-attain their optimal proportions by “exchanging” some of the money for bonds: they use some of the extra money to buy bonds. This increase in the demand for bonds drives up the price of bonds -- and causes interest rates to fall (since interest rates are inversely related to bond prices). The fall in the interest rate induces an increase in investment demand, which causes output and income to increase. The increase in income causes money demand to increase, which increases the interest rate (though doesn’t increase it all the way back to its initial value; instead, this effect simply reduces the total decrease in the interest rate). INTERACTION BETWEEN MONETARY &FISCAL POLICY Model: Monetary & fiscal policy variables (M, G, and T) are exogenous Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa. Such interactions may alter the impact of the original policy change. THE CB’S RESPONSE TO G > 0 Suppose Congress increases G Possible responses by the central bank 1. hold M constant 2. hold r constant 3. hold Y constant In each case, the effects of the G are different… RESPONSE 1: HOLD M CONSTANT If government raises G, the IS curve shifts right. If the CB holds M constant, then LM curve doesn’t shift. Results: RESPONSE 2: HOLD r CONSTANT To keep r constant, the CB increases M to shift LM curve right. Results: RESPONSE 3: HOLDING Y CONSTANT To keep Y constant, the CB reduces M to shift LM curve left. Results: ESTIMATES OF FISCAL POLICY MULTIPLIERS The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides. First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated. Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides. Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC). Much research since 2008  Country-level time series or panel estimates  Structural estimation of NK-DSGE models  Identification: SVAR, natural experiments, narrative method (historical documents) Ramey (2019 JEP): most estimated multipliers are  G: 0.6-1, but >1.5 when i=0 Causes: 2) 9/11  increased uncertainty  fall in consumer & business confidence  result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals  Enron, WorldCom, etc.  reduced stock prices, discouraged investment Fiscal policy response: shifted IS curve right  Tax cut in 2001 and 2003  Spending increases  airline industry bailout  NYC reconstruction  Afghanistan war  Iraq war WHAT IS THE CB POLICY INSTRUMENT? Why do CB target interest rates instead of the money supply? 1) They are easier to measure than the money supply 2) The CB might believe that LM shocks are more prevalent than IS shocks: if so, then targeting the interest rate stabilizes income better than targeting the money supply? IS-LM AND AGGREGATE DEMAND So far, we’ve been using the IS-LM model to analyse the short run, when the price level is assumed fixed, however, a change in P would shift LM and Starting in mid-2000, the S&P 500 begins a downward trend. The fall in stock prices eroded the wealth of millions of U.S. consumers. They responded by reducing consumption The war was a response to the 9/11 attacks, not to the recession. But wars involve significant fiscal policy expansion, which increases aggregate demand and alleviates or ends recessions. Easier monetary policy shifted the LM curve to the right, causing interest rates to fall, as shown in this graph. therefore affect Y. The aggregate demand curve captures this relationship between P and Y DERIVING THE AD CURVE Intuition for slope of AD curve: P  (M/P )  LM shifts left  r  I  Y It might be useful to explain to students the reason why we draw P1 before drawing the LM curve: The position of the LM curve depends on the value of M/P. M is an exogenous policy variable. So, if P is low (like P1 in the lower panel of the diagram), then M/P is relatively high, so the LM curve is over toward the right in the upper diagram. If P is high, like P2, then M/P is relatively low, so the LM curve is more toward the left. Because the value of P affects the position of the LM curve, we label the LM curves in the upper panel as LM(P1) and LM(P2). MONETARY POLICY AND THE AD CURVE The CB can increase aggregate demand: M  LM shifts right  r  I  Y at each value of P FISCAL POLICY AND THE AD CURVE Expansionary fiscal policy (G and/or T ) increases agg. demand: T  C  IS shifts right  Y at each value of P IS-LM AND AD-AS IN THE SHORT RUN &LONG RUN Recall from Chapter 10: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. It’s worth taking a moment to explain why we are holding P fixed at P1: To find out whether the AD curve shifts to the left or right, we need to find out what happens to the value of Y associated with any given value of P. This is not to say that the equilibrium value of P will remain fixed after the policy change (though, in fact, we are assuming P is fixed in the short run). We just want to see what happens to the AD curve. Once we know how the AD curve shifts, we THE SR AND LR EFFECTS OF AN IS SHOCKS SR= Short run, LR= Long Run THE SR AND LR EFFECTS OF AN IS SHOCK THE OPEN ECONOMY REVISITED: THE MUNDELL FLEMING MODEL AND THE EXCHANGE RATE REGIME Chapter 13 covers a lot of material. First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal, monetary, and trade policy under floating and flexible exchange rates. Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The 1994-95 Mexican Peso Crisis is an important real- world example of this. The next few slides put our IS-LM-AD in the context of the bigger picture—the AD-AS model in the short run and long A negative IS shock shifts IS and AD left, causing Y to fall. In the new short run equilibrium FLOATING & FIXED EXCHANGE RATES In a system of floating and fixed exchange rates, e is allowed to fluctuate in response to changing economic conditions In contrast, under fixed exchange rate s the central bank trades domestic for foreign currency at a permitted price Next , policy analysis:  in a floating exchange rate system  in a fixed exchange rate system FISCAL POLICY UNDER THE FLOATING EXCHANGE RATES Intuition for the shift in IS*:At a given value of e (and hence NX), an increase in G causes an increase in the value of Y that equates planned expenditure with actual expenditure. Intuition for the results:As we learned in earlier chapters, a fiscal expansion puts upward pressure on the country’s interest rate. In a small open economy with perfect capital mobility, as soon as the domestic interest rate rises even the tiniest bit about the world rate, tons of foreign (financial) capital will flow in to take advantage of the rate difference. But in order for foreigners to buy these U.S. bonds, they must first acquire U.S. dollars. Hence, the capital inflows cause an increase in foreign demand for dollars in the foreign exchange market, causing the dollar to appreciate. This appreciation makes exports more expensive to foreigners, and imports cheaper to people at home, and thus causes NX to fall. The fall in NX offsets the effect of the fiscal expansion. How do we know that Y = 0? Because maintaining equilibrium in the money market requires that Y be unchanged: the fiscal expansion does not affect either the real money supply (M/P) or the world interest rate (because this economy is “small”). Hence, any change in income would throw the money market out of whack. So, the exchange rate has to rise until NX has fallen enough to perfectly offset the expansionary impact of the fiscal policy on output. LESSONS ABOUT FISCAL POLICY In a small open economy with perfect capital mobility, fiscal policy cannot affect real GDP. Crowding out  closed economy: Fiscal policy crowds out investment by causing the interest rate to rise.  small open economy: Fiscal policy crowds out net exports by causing the exchange rate to appreciate. MONETARY POLICY UNDER FLOATING EXCHANGE RATES Suggestion: Treat this experiment as an in-class exercise. Display the graph with the initial equilibrium. Then give students 2-3 minutes to use the model to determine the effects of an increase in M on e and Y. Intuition for the rightward LM* shift: At the initial (r*,Y), an increase in M throws the money market out of equilibrium. To restore equilibrium, either Y must rise or the interest rate must fall, or some combination of the two. In a small open economy, though, the interest rate cannot fall. So Y must rise to restore equilibrium in the money market. Intuition for the results: Initially, the increase in the money supply puts downward pressure on the interest rate. (In a closed economy, the interest rate would fall.) Because the economy is small and open, when the interest rate tries to fall below r*, savers send their loanable funds to the world financial market. This capital outflow causes the exchange rate to fall, which causes NX—and hence Y—to increase. LESSONS ABOUT MONOETARY OLICY Monetary policy affects output by affecting the components of aggregate demand: Expansionary mon. policy does not raise world agg. demand, it merely shifts demand from foreign to domestic products. So, the increases in domestic income and employment are at the expense of losses abroad. TRADE POLICY UNDER FLOATING EXCHANGE RATES Intuition for results: At the initial exchange rate, the tariff or quota shifts domestic residents’ demand from foreign to domestic goods. The reduction in their demand for foreign goods causes a corresponding reduction in the supply of the country’s currency in the foreign exchange market. This causes the exchange rate to rise. The appreciation reduces NX, offsetting the import restriction’s initial expansion of NX. How do we know that the effect of the appreciation on NX exactly cancels out the effect of the import restriction on NX? There is only one value of Y that allows the money market to clear; since Y, C, I, and G are all unchanged, NX = Y-(C+I+G) must also be unchanged. Or looking at it differently: As we learned in chapter 5, the accounting identities say that NX = S - I. The import restriction does not affect S or I, so it cannot affect the equilibrium value of NX. LESSONS ABOUT TRADE POLICY  Import restrictions cannot reduce a trade deficit.  Even though NX is unchanged, there is less trade:  The trade restriction reduces imports.  The exchange rate appreciation reduces exports.  Less trade means fewer “gains from trade.”  Import restrictions on specific products save jobs in the domestic industries that produce those products but destroy jobs in export- producing sectors.  Hence, import restrictions fail to increase total employment.  Also, import restrictions create sectoral shifts, which cause frictional unemployment. Import restrictions cause a sectoral shift, a shift in demand from export-producing sectors to import-competing sectors. As we learned in Chapter 7, sectoral shifts contribute to the natural rate of unemployment, because displaced workers in declining sectors take time to be matched with appropriate jobs in other sectors. FIXED EXCHANGE RATES M-F model to analyze the effects of a change in the risk premium. The next few slides present this analysis, then discuss an important real-world example (the Mexican peso crisis). THE EFFECTS OF AN INCREASE IN  The fall in e is intuitive: An increase in country risk or an expected depreciation makes holding the country’s currency less attractive. Note: An expected depreciation is a self-fulfilling prophecy. The increase in Y occurs because the boost in NX (from the depreciation) is greater than the fall in I (from the rise in r ). WHY INCOME MAY NOT RISE • The central bank may try to prevent the depreciation by reducing the money supply. • The depreciation might boost the price of imports enough to increase the price level (which would reduce the real money supply). • Consumers might respond to the increased risk by holding more money.Each of the above would shift LM* leftward. The result that income rises when the risk premium rises seems counterintuitive and inaccurate. This slide explains why the increase in the risk premium may cause other things to occur that prevent income from rising, and may even cause income to fall. Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per pesos In the early 1990s, Mexico was an attractive place for foreign investment. During 1994, political developments caused an increase in Mexico’s risk premium ( ):  peasant uprising in Chiapas  assassination of leading presidential candidate Another factor: The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation. (Dr* > 0) These events put downward pressure on the peso. Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall,so it bought pesos and sold dollars to prop up the peso exchange rate. Doing this requires that Mexico’s central bank have adequate reserves of dollars. Did it?We have already seen why an increase in a country’s risk premium causes its exchange rate to fall. One could also use the M-F model to show that an increase in r* also causes the exchange rate to fall. The intuition is as follows: An increase in foreign interest rates causes capital outflows: investors shift some of their funds out of the country to take advantage of higher returns abroad. This capital outflow causes the exchange rate to fall as it implies an increase in the supply of the country’s currency in the foreign exchange market. THE DISASTER Dec. 20: Mexico devalues the peso by 13%(fixes e at 25 cents instead of 29 cents) In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to float. In just one week, the peso lost nearly 40% of its value, and fell further during the following months. Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank. (August 17, 1994 was the date of the pr sidential election.) Ask your students if they can figure out why Mexico’s central bank didn’t tell anybody it was running out of reserves. The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to defend the peso. Source (not only for the data on this slide, but some of the other information in Investors are SHOCKED! – they had no idea Mexico was running out of reserves. , investors dump their Mexican assets and pull their capital out of Mexico. Dec. 22: central bank’s reserves nearly gone. It abandons the fixed rate and lets e float.In a week, e falls another 30%. THE RESCUE PACKAGE 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt. This helped restore confidence in Mexico, reduced the risk premium. After a hard recession in 1995, Mexico began a strong recovery from the crisis. FLOATING VS. FIXED EXCHANGE RATES Argument for floating rates: • allow monetary policy to be used to pursue other goals (stable growth, low inflation). Arguments for fixed rates: • avoid uncertainty and volatility, making international transactions easier. • discipline monetary policy to prevent excessive money growth & hyperinflation. NOTE LESSON 23/11/21 Why is interest rate the ssme? Because of the actual arbitrage. Suppose I am a small economy and you are the rest of the world and suppose that my domestic interest rate is lower. I realize that there is arbitrage and I can start taking advantage of it, other people starts to realize it as well, and start borrowing money in my country In an open economy , as we know there is net export here we are looking at the world interest rate ad exogenously given. The LM curve is usually the position in the money market(?). there is only one level on income in which money is in equilibriuem Fiscal expension are ineffective, while monetary policy are effective. In a closed economy we have just fiscal and monetary policy but in an open economy we also have trade policy. For a given exchange rate NOTE LECTURE 29/11/21 What happens when you fix the exchange rate? Suppose central bank fix the exchange rate at e1 you cannot stimulate economy with a fiscal expansion. Assets differ for a big number of feature. In terms of riskiness and in terms of expected exchange change Suppose that the domestic interest rate is equal to the world’s interest rate plus some differential ARGENTINA whan came aout of a dictatorship, it was 2001 one of the problem they had was inflation. Formally they still had the pesos but it was woth one dollar so the exchange rate was one. Inflation rate was generally low but still higher than the us. So overtime Argentine progress lost competitiveness. Overtime they become more expensive and less competitive at some point they started to think that tais could not go on forever. One possible way out was devaluation. If they started to think obiut it the situation was bad Chapter 14 notes In the long run production depend on the production capacity of the economy. We’ll first evaluate an upward sloping relation and and then we’ll turn to a more dynamic model. There are many possible reason why prices are sticky over the short run. It is and old and still open debate. When prices go up then income goes up as well AGGREGATE SUPPLY AND THE SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT Chapter 14 has two parts. The first concerns aggregate supply. In the preceding chapters, we made the simple and extreme assumption that all prices were “stuck” in the short run. This assumption implied a horizontal short-run aggregate supply curve. More realistic models of aggregate supply imply an upward-sloping SRAS curve. This chapter presents two of the most prominent models. The second half of the chapter is devoted to the Phillips curve and related issues. The section uses a few lines of algebra to derive an expression for the Phillips curve from the SRAS equation. This is followed by a discussion of adaptive and rational expectations, and the sacrifice ratio. The chapter concludes by contrasting the notion of hysteresis to the natural rate hypothesis. INTORDUCTION In previous chapters, we assumed the price level P was stuck in the short run. This implies a horizontal SRAS curve. Now we consider two prominent models of aggregate supply in the short run: Sticky price model and imperfect information model Both models imply: Other thinhs equal , Y and P are positively related, so the SRAS curve is upward sloping THE STICKY- PRICE MODEL Reasoning for sticky prices:  Long term contracts between firms and customers with frequent price changes  Uncertainty about demand curve and industry prices Assumptions: Firrms set their own prices If you don’t like the appearance of the term “monopolistic competition” in this slide, just change the parenthetical comment to “(i.e., firms have some market power)” or something to that effect. THE STICKY PRICE MODEL An individual firms’s desired price is where a > 0. Suppose two types of firms:  firms with flexible prices, set prices as above  firms with sticky prices, must set their price before they know how P and Y will turn out: Interpretation of the first equation: If output is at its natural rate, then each firm’s optimal price is the same as the overall price level. When the economy is weak (output below its natural rate), firms set their prices lower, and in a boom when demand is high, firms set their prices higher. Remind your students that “E” is the expectation operator introduced in Chapter 5. Hence, EP is the expected price level and (EY – EYbar) is the expected deviation of output from its natural, full-employment level. Assume Sticky-price firms expect that output will equal its natural rate. Then, To derive the aggregate supply curve first fid an expression for the overall price level. S=fraction of firms with sticky prices. Then, we can write the overall price level as… Subtract (1-s)P from both sides: Divide both sides by s: INFLATION, UNEMPLOYMENT, AND THE PHILLIPS CURVE This graph has two lessons for students: First, changes in the expected price level shift the SRAS curve (this should be clear from the equation, as should the fact that a change in the natural rate of output will shift the SRAS curve). The second lesson concerns the adjustment of the economy back to full- employment output. where  > 0 is an exogenous constant. DERIVING THE PHILLIPS CURVE FORM SRAS COMPARING SRAS AND THE PHILLIPS CURVE  SRAS curve: Output is related to unexpected movements in the price level.  Phillips curve: Unemployment is related to unexpected movements in the inflation rate. ADAPRTIVE EXPECTATION Adaptive expectations: an approach that assumes people form their expectations of future inflation based on recently observed inflation. Equation (1) is the SRAS equation. Solve (1) for P to get (2). To get (3), add the supply shock term to (2). To get (4), subtract last year’s price level (P-1) from both sides. To get (5), write  in place of (P- P-1) and e in place of (Pe- P- 1). Note that the change in the price level is not exactly the inflation rate, unless we interpret P as the natural log of the price level. Equation (6) captures the relationship between output and unemployment from Okun’s law: the deviation of output from its natural rate is inversely related to cyclical unemployment. Note that in chapter 10 Okun’s law was presented as a relation between cyclical unemployment and the difference between the current and average growth rate rather than level of output. Substituting (6) into (5) gives (7), the Phillips curve equation A simple version: Expected inflation = last year’s actual inflation Then P.C. becomes INFLATION INERTIA In this form, the Phillips curve implies that inflation has inertia:  In the absence of supply shocks or cyclical unemployment, inflation will continue indefinitely at its current rate.  Past inflation influences expectations of current inflation, which in turn influences the wages & prices that people set. TWO CAUSES OF RISING& FALLING INFLATION  cost-push inflation: inflation resulting from supply shocks. Adverse supply shocks typically raise production costs and induce firms to raise prices, pushing inflation up.  demand-pull inflation: inflation resulting from demand shocks. Positive shocks to aggregate demand cause unemployment to fall below its natural rate, which pulls the inflation rate up. Of course, a favorable supply shock that lowers production costs will push inflation down, and a negative demand shock which raises cyclical unemployment will pull inflation down. GRAPHING THE PHILLIPS CURVE Here, the “short run” is the period until people adjust their expectations of inflation. SHIFTING THE PHILLIPS CURVE After displaying this slide, you might consider giving your students an exercise using the P.C. curve. One possibility would be to ask them to draw a graph of the PC curve, then show what happens to it in the face of an adverse supply shock or an increase in the natural rate of unemployment, giving intuition for each. The intuition for why an increase in the natural rate shifts the PC upward (or rightward) is as follows:At any given value of actual unemployment, an increase in the natural rate implies a decrease in cyclical unemployment, which increases inflation by increasing pressures for wages to rise. Thus, each value of unemployment has a higher value of inflation than before. CASE STUDY INFLATION AND UNEMPLOYMENT CASE STUDY INFLATION AND UNEMPLOYMETN IN ITALY THE SACRIFICE RATIO  To reduce inflation, policymakers can contract agg. demand, causing unemployment to rise above the natural rate.  The sacrifice ratio measures the percentage of a year’s real GDP that must be forgone to reduce inflation by 1 percentage point.  A typical estimate of the ratio is 5. Example: To reduce inflation from 6 to 2 percent, must sacrifice 20 percent of one year’s GDP: GDP loss = (inflation reduction) × (sacrifice ratio) = 4 × 5 remind them that the concepts behind the notation are familiar: the IS curve, the Phillips curve, the Fisher equation, and others. INTRODUCTION The dynamic model of aggregate demand and aggregate supply gives us more insight into how the economy works in the short run It is a simplified version of a DSGE model used in cutting-edge macroeconomic research (DSGE = Dynamic, Stochastic, General Equilibrium) The dynamic model of aggregate demand and aggregate supply is built from familiar concepts, such as:  the IS curve, which negatively relates the real interest rate and demand for goods & services  the Phillips curve, which relates inflation to the gap between output and its natural level, expected inflation, and supply shocks  adaptive expectations, a simple model of inflation expectations HOW THE DYNAMIC AD-AS MODEL IS DIFFERENT FORM THE STANDARD MODEL  Instead of fixing the money supply, the central bank follows a monetary policy rule that adjusts interest rates when output or inflation change.  The vertical axis of the DAD-DAS diagram measures the inflation rate, not the price level.  Subsequent time periods are linked together: Changes in inflation in one period alter expectations of future inflation, which changes aggregate supply in future periods, which further alters inflation and inflation expectations. KEEPING TRACK OF TIME The subscript “t ” denotes the time period, e.g.  Yt = real GDP in period t  Yt -1 = real GDP in period t – 1  Yt +1 = real GDP in period t + 1 We can think of time periods as years. E.g., if t = 2010, then  Yt = Y2010 = real GDP in 2010  Yt -1 = Y2009 = real GDP in 2009  Yt +1 = Y2011 = real GDP in 2011 THE MODEL’S ELEMENTS  The model has five equations and five endogenous variables: output, inflation, the real interest rate, the nominal interest rate, and expected inflation.  The equations may use different notation, but they are conceptually similar to things you’ve already learned.  The first equation is for output… OUTPUT: THE DEMAND FOR GOODS AND SERVICES Negative relation between output and interest rate, same intuition as IS curve. The demand for goods and services is negatively related to the real interest rate, just as with the IS curve: a higher interest rate reduces investment (and the interest-sensitive portion of consumption, if you’re modeling consumption and saving as functions of the interest rate), and therefore reduces income. This equation also shows that the demand for goods and services is higher when the natural rate of output is higher. The following slide explains the parameters (alpha and rho) and the demand shock. THE REAL INTEREST RATE: THE FISHER EQUATION The Fisher equation, familiar from Chapter 4, states that the nominal interest rate equals the real interest rate plus the inflation rate. You might explain the demand shock term as follows: When epsilon is zero, as it is on average, demand is determined by its “fundamentals,” the real interest rate and the natural rate of output. When epsilon > 0, demand is higher than the level implied by its fundamentals. This would occur, for example, if consumers or businesses were unusually optimistic. When epsilon < 0, demand is lower than implied by the fundamental determinants of demand. This might represent pessimistic consumers or business firms. (Caution: the preceding use of the term “fundamentals” is not in the textbook.) Alpha is a positive parameter that reflects the sensitivity of aggregate demand to changes in the interest rate. A given change in the real interest rate has a bigger effect on output if alpha is large than if it is small. Rho can be thought of as the “natural rate of The equation on this slide is obtained by solving the Fisher equation for the real interest rate, and using the expected (rather than actual/realized) inflation rate to determine the ex ante (rather than ex post) real interest rate. Thus, the real return savers expect to earn on their loans, and the real cost borrowers expect to pay on their debts, is the nominal interest rate minus the inflation rate people expect. INFLATION: THE PHILLIPS CURVE Current inflation is affected by three things: 1) the rate of inflation people expected in the previous period, because it figured into their previous wage and price-setting decisions 2) the output gap: when output is above its natural level, firms experience rising marginal costs, so they raise prices faster. When output is below its natural level, marginal costs fall, so firms slow the rate of their price increases. 3) a supply shock (e.g. sharp changes in the price of oil), as discussed in Chapter 14 EXPECTED INFLATION: ADOPTIVE EXPECTATIONS As the textbook mentions at this point and in Chapter 14, adaptive expectations is a crude simplification. Most people form their expectations rationally (at least when making important financial decisions, such as when a firm chooses prices for its catalog), taking into account all currently available relevant information. Suppose inflation has been 3% for a number of years, when an “unemployment hawk” is appointed Fed chairperson. Surely, most people would expect inflation to rise, yet adaptive expectations assumes that people would continue to expect 3% inflation until actual inflation started rising. We use adaptive expectations not because it’s perfect, but because it keeps the model from getting terribly complicated, yet doesn’t compromise the integrity of the results. THE NOMINAL INTEREST RATE: THE MONETARY-POLICY RULE  Exogenous variables:  Predetermined variable:  Parameters: THE MODEL ‘S LONG RUNEQUILIBRIUM The normal state around which the economy fluctuates. Two conditions required for long-run equilibrium:  There are no shocks:  Inflation is constant: Plugging these two conditions into the model’s five equations yields the solution on the next slide… Plugging the preceding conditions into the model’s five equations and using algebra yields these long-run values: We want to solve the model for period t. Inflation in period t − 1 is no longer variable in period t, so it becomes exogenous, in a sense, in period t. Previous period inflation was used in period t − 1 to form expectations of current period inflation, so it enters into the model in the Students sometimes confuse parameters and exogenous variables. Loosely speaking, an exogenous variable is something that we might change. Loosely speaking, a parameter is a structural feature of the model that is unlikely to change. For example, in the Solow model, we might change the saving rate to see its effects on endogenous variables, such as the steady-state level of income per capita. However, it’s very unlikely that we would change the Cobb-Douglas exponent that measure’s capital’s share in income, or the depreciation rate. In the IS-LM model, we might see how endogenous variables respond to a change in government purchases, but not to a change in the marginal propensity to consume. I said “loosely speaking” above because these are guidelines only. For example, in the present model, we consider the The model’s long-run solution expresses each of the five endogenous variables in terms of exogenous variables and parameters. In the long-run equilibrium, • output equals the natural rate of output (which means the unemployment rate equals the natural rate of unemployment) • the real interest rate equals the so-called “natural rate of interest” defined earlier in this chapter • the inflation rate equals the central bank’s target • inflation expectations are accurate (inflation is the same every period and equals the central bank’s target, so using this period’s inflation to forecast next period’s inflation will yield an accurate forecast) THE DYNAMIC AGGREGATE SUPPLY CURVE The DAS curve shows a relation between output and inflation that comes from the Phillips Curve and Adaptive Expectations: This equation comes from using the expectations equation to substitute the expected inflation term out of the Phillips curve equation. THE DYNAMIC AGGREGATE SUPPLY CURVE The intuition for the positive slope of DAS comes from the Phillips Curve: If output is above its natural rate, unemployment is below the natural rate of unemployment. The labor market is very “tight” and the economy is “overheating,” leading to an increase in inflation. (Of course, the unemployment rate is not explicitly included in this model, but students know from Okun’s Law that it is very tightly linked to output.)Students may find it odd to say “DAS shifts in response to changes in previous inflation,” thinking that previous inflation is fixed because the past is unchangeable. However, a change in current period inflation will become a change in next period’s previous inflation, and thus will shift next period’s DAS curve. THE DYNAMIC AGGREAGTE DEMAND CURVE To derive the DAD curve, we will combine four equations and then eliminate all the endogenous variables other than output and inflation. Start with the demand fr goods and services The derivation of the DAS curve was almost trivial. Not so for DAD. The next few slides walk students through (most of) the steps. See pp.440-441 for more details. The notation “A” and “B” for the coefficients in the DAD equation is not in the textbook. I have introduced it here for two reasons. First, the equation would otherwise be too long to fit on the slide. Second, the notation makes it easy for students to see the relationship between output, inflation, and the demand shock. In general, the notation makes the DAD equation less intimidating and easier to work with. When the shock causes inflation to rise, the central bank responds by raising the real and nominal interest rates. We see the real rate here. The nominal rate is shown on the following slide. Over time, both move back toward their initial values. A5 PERIOD SHOCK TO AGGREGATE DEMAND 1. Period t – 1:initial eq’m at A 2. Period t:Positive demand shock (ε > 0) shifts DAD to the right; output and inflation rise. 3. Period t + 1 :Higher inflation in t raised inflation expectations for t + 1, shifting DAS up.Inflation rises more, outputs falls 4. 4. Periods t + 2 to t + 4 :Higher inflation in previous period raises inflation expectations, shifts DAS up.Inflation rises, output falls 5. Period t + 5: DAS is higher due to higher inflation in preceding period, but demand shock ends and DAD returns to its initial position. Eq’m at G 6. Periods t + 6 and higher: DAS gradually shifts down as inflation and inflation expectations fall, economy gradually recovers until reaching LR eq’m at The sluggish behavior of inflation results from our assumption that expectations are adaptive. APLICATION: OUTPUT VARIABILITY VS. INFLATION VARIABILITY  A supply shock reduces output (bad) and raises inflation (also bad).  The central bank faces a tradeoff between these “bads” – it can reduce the effect on output, but only by tolerating an increase in the effect on inflation…. Most students can readily see that the slope of the DAD curve determines the relative magnitudes of the effects on output vs. inflation. What is less obvious is the relation between the theta parameters and DAD’s slope. You can convince students of the relationship using intuition and using math: Intuition: Large θπ and small θY means the central bank is more concerned with keeping inflation close to its target than with keeping output (and hence employment) close to their natural rates. Thus, a small change in inflation will induce the central bank to more sharply raise the real interest rate, causing a significant drop in the quantity of goods demanded. Math: In the equation for the DAD curve, output appears on the left-hand side, while inflation is on the right. The coefficient on inflation is a ratio that contains θπ in the numerator and θY in the denominator. Other things equal, an increase in θπ or a decrease in θY will increase this coefficient. Of course, the coefficient is NOT the The model of aggregate demand and supply (Chaps. 10–14) shows how fiscal and monetary policy can respond to shocks and stabilize the economy. ARGUMENTS AGAINST ACTIVE POLICY Policies act with long & variable lags, including: inside lag the time between the shock and the policy response.  takes time to recognize shock  takes time to implement policy, especially fiscal policy outside lag:the time it takes for policy to affect economy. If conditions change before policy’s impact is felt, the policy may destabilize the economy. Opponents of policy activism argue that long & variable lags hinder the effectiveness of policy. Fiscal policy requires an act of Congress. As your students may be aware, the process by which a bill becomes a law is lengthy and involved, and often fraught with political difficulty. Monetary policy has a much shorter inside lag. However, firms make their investment plans in advance, so it takes time for interest rate changes to affect investment and aggregate demand. Opponents of policy activism note that the lags are long and uncertain, making it very difficult to predict the impact of policy, which makes it difficult to determine the appropriate policy. If you have a blackboard or whiteboard handy, you might draw for students the AD/AS diagram with the economy initially in a full-employment equilibrium. Then: 1. Show the short-run effects of a negative AD shock. 2. From the new short-run equilibrium, illustrate how an activist policy of increasing AD can get the economy back to full-employment. 3. Finally, repeat step 2, but assume that the policy acts with a lag, during which time the economy’s “self-correcting” mechanism is already well underway. The result should be that the AD shift actually pushes the economy over too far to the right, so that Y is greater than the full-employment level. Thus, policy meant to reduce a negative demand shock actually causes a positive shock. Of course, after this positive shock occurs, activist policymakers might try to contract aggregate demand; but again, if there’s a lag, then they might put the economy back into recession. AUTOMATIC STABILIZATION  definition: policies that stimulate or depress the economy when necessary without any deliberate policy change.  Designed to reduce the lags associated with stabilization policy.  Examples: o income tax o unemployment insurance o welfare Why the income tax is an automatic stabilizer: Each person’s tax bill depends on his or her income. In a recession, average incomes fall, so the average person pays less taxes. It’s as if the government automatically gives people a tax cut in recessions. Why unemployment insurance is an automatic stabilizer: In a recession, people who become unemployed experience a fall in their income, and therefore reduce their spending, which further reduces aggregate demand. Unemployment insurance reduces the fall in the income of the unemployed, and so helps to reduce the drop in aggregate demand during a recession. Welfare performs a similar function. FORECASTING THE MECROECONOMY Because policies act with lags, policymakers must predict future conditions. Two ways economists generate forecasts:  Leading economic indicators (LEI) data series that fluctuate in advance of the economy  Macroeconometric modelsLarge-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies The macroeconometric models are, in many cases, more elaborate versions of the IS-LM-AD-AS model that students learned in the preceding chapters. The parameters of each equation (e.g., the MPC or the interest rate sensitivity of investment) are estimated with real-world data; then, by changing the values of the exogenous variables, or by specifying price shocks or other changes, the macroeconometric models generate forecasts of all the endogenous variables (GDP, interest rates, unemployment, inflation) at various time horizons following the shock or or policy change. FORECASTING THE MACROECONOMY Because policies act with lags, policymakers must predict future conditions. The preceding slide illustrates how forecasts are often wrong. This is one reason why some economists oppose policy activism. THE LUCAS CRITIQUE  Due to Robert Lucas who won Nobel Prize in 1995 for his work on rational expectations. The red line is the actual unemployment rate. Each green line represents the median of 20 forecasts of the unemployment rate at the date shown. The first three forecasts all failed to predict the severity of the recession (each shows unemployment falling after a quarter or two, when in fact the unemployment rate kept rising). The last three forecasts failed to predict the speed of the recovery. Similarly, a consensus of forecasts in November 2007 predicted that U.S. unemployment would rise from 4.7% at the end of 2007 to 5.0% at the end of 2008. In May 2008, the consensus forecast was that unemployment would reach 5.5% by the end of 2008. These forecasts were far off the mark: unemployment reached 6.7% in the fourth quarter of 2008. The point here is that forecasts are often not accurate, which opponents of activist policy  Forecasting the effects of policy changes has often been done using models estimated with historical data.  Lucas: such predictions are not valid if the policy change alters expectations and changes the fundamental relationships between variables. EXAMPLE OF LUCAS CRITIQUE  Prediction (based on past experience): An increase in the money growth rate will reduce unemployment.  The Lucas critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall.  Prem, Vargas and Mejía (2021 REStat): a 2014 announcement of a future incentive to coca farmers for voluntary crop substitution led to a boom in coca cultivation and cocaine production in cartel areas of Colombia, “offsetting almost 20 years and billions of dollars of U.S.-backed efforts to stop drug production and cartel action” Remember the expectations-augmented Phillips curve from Chapter 14: An increase in money growth and inflation only reduces unemployment if expected inflation remains unchanged. Perhaps that was the case in the past. But now, if the money growth increase causes people to raise their expectations of inflation, then unemployment won’t fall. Mounu Prem, Juan F. Vargas, Daniel Mejía; The Rise and Persistence of Illegal Crops: Evidence from a Naive Policy Announcement. The Review of Economics and Statistics 2021; doi: https://doi.org/10.1162/rest_a_01059 The announcement in Colombia was made by the delegations negotiating peace between FARC and government. The announcement gave time to farmers to turn to coca and thus be in a position to claim the monetary incentives. THE JURY’S OUT Looking at recent history does not clearly answer Question 1:  It’s hard to identify shocks in the data. It’s hard to tell how outcomes would have been different had actual policies not been used. Greg sums it up nicely on pp.527-528: “If the economy has experienced many large shocks to aggregate supply and aggregate demand, and if policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept economic policy, then the case for passive policy should be clear….Yet…it is not easy to identify the sources of economic fluctuations. The historical record often permits more than one interpretation. The Great Depression is a case in point….Some economists believe that a large contractionary shock to private spending caused the depression. They assert that policymakers should have responded by stimulating aggregate demand. Other economists believe that the large fall in the money supply caused the Depression. They assert that the Depression would have been avoided if the Fed had been pursuing a passive monetary policy of increasing the money supply at a steady rate.” QUESTION TWO  Should policy be conducted by rule or discretion? CH 17: GOVERNMENT DEBT AND BUDGET DEFICITS THE MOST INDEBTED GOVT’S IN DEC 2019 GOV.DEBT AS % OF GDP THE RIOT OF U.S. FEDERAL GOVT DEBT TO GDP GOVT DEBT/ GDP IN EUROPE, 1995-2019  LARGE EUROPEAN COUNTRIES GOVT DEBT/ GDP IN EUROPE, 1995-2019  PIIGS This figure shows a measure of the independence of various countries’ central banks (higher numbers = greater independence). One would expect higher average inflation in countries whose central banks are less independent, as monetary policy could be used for political purposes (e.g., lowering unemployment prior to elections). And the graph shows that this is the case. This graph appears on p.535 of the text as Figure 18-2 , and was originally in Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some The historical pattern: the debt–GDP ratio rises during wars and falls during peacetime. The exception is the substantial rise that occurred beginning in the early 1980s. PROBLEM MEASURING THE DEFICT 1. Inflation 2. Capital assets 3. Uncounted liabilities 4. The business cycle Before we assess whether the debt is a problem, we first consider whether the standard measures of the debt & deficit are accurate. It turns out they are not, for these four reasons. MEASUREMENT PROBLEM 1: INFLATION  Suppose the real debt is constant, which implies a zero real deficit.  In this case, the nominal debt D grows at the rate of inflation: D/D =  or D =  D  The reported deficit (nominal) is  D even though the real deficit is zero.  Hence, should subtract  D from the reported deficit to correct for inflation.  Correcting the deficit for inflation can make a huge difference, especially when inflation is high.  Example: In 1979 in the U.S., nominal deficit = $28 billion inflation = 8.6% debt = $495 billion  D = 0.086  $495b = $43b real deficit = $28b  $43b = $15b surplus MEASUEREMENT PROBLEM 2: CAPITAL ASSETS  Currently, deficit = change in debt  Better, capital budgeting: deficit = (change in debt)  (change in assets)  EX: Suppose govt sells an office building and uses the proceeds to pay down the debt. o under current system, deficit would fall o under capital budgeting, deficit unchanged, because fall in debt is offset by a fall in assets.  Problem w/ cap budgeting: Determining which govt expenditures count as capital expenditures. MEASUERMENT PROBLEM 3: UNCOUNTED LIABILITIES  Current measure of deficit omits important liabilities of the government:  future pension payments owed to current govt workers  future Social Security payments  contingent liabilities, e.g., covering federally insured deposits when banks fail (Hard to attach a dollar value to contingent liabilities, due to inherent uncertainty.) MEASUEREMNT PROBLEM 4: THE BUSINESS CYCLE  The deficit varies over the business cycle due to automatic stabilizers (unemployment insurance, the income tax system).  These are not measurement errors but do make it harder to judge fiscal policy stance. E.g., is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy? Solution: cyclically-adjusted budget deficit (aka full-employment deficit) based on estimates of what govt spending & revenues would be if economy were at the natural rates of output and unemployment. THE BOTTOM LINE We must exercise care when interpreting the reported deficit figures IS THE GOVT DEBT REALLY A PROBLEM? Consider a tax cut with corresponding increase in the government debt. This graph (not in the textbook) shows the actual and cyclically adjusted budget surpluses, as a percentage of potential GDP, as estimated by the Congressional Budget Office. The pink shaded bars denote recessions. (I exclude the 1960-61 recession because the data shown here start in 1962.) In recessions, we would expect the red line (actual surplus) to fall below the blue line (what the surplus would be if the economy were at potential GDP): Real GDP falls, causing decreases in tax revenues and increases in cyclically-sensitive outlays (such as unemployment insurance). During expansions, we would expect the red line to rise above the blue line. In the data, the relationship between actual and cyclically- adjusted surplus is not perfectly correlated with recession dates. But remember that recession dates are determined by whether GDP growth is positive or negative, while the cyclical adjustment is determined by whether actual GDP is greater than or less than potential  most central banks have (at least some) political independence from fiscal policymakers OTHER PRESPECTIVES INTERNATIONAL DIMENSIONS  Govt budget deficits can lead to trade deficits, which must be financed by borrowing from abroad.  Large govt debt may increase the risk of capital flight, as foreign investors may perceive a greater risk of default.  Large debt may reduce a country’s political clout in international affairs. Difference between interest rate and inflation rate Source: Eurostat - EMU convergence criterion series - annual data [irt_lt_mcby_a] , nominal interest rates on 10 year govenrment bonds - Inflation rate of the Harmonised Indices of Consumer Prices - HICP (2015 = 100) - annual data [prc_hicp_aind] Notice that the interest rates are virtually identical until mid-2008. Greece’s government bonds were downgraded to junk bond status. As a result, Greece’s government had to pay extraordinary interest rates to borrow additional funds. In other countries, the rise in rates was less dramatic, but still painful: even a modest increase in borrowing costs diverts funds that CH 18: THE FINANCIAL SYSTEM: OPPORTUNITIES AND DANGERS WHAT THE FNANCILA SYSTEM DOES The financial system helps channel founds from savers- households with income they do not need to spend immediately…to investors- firms that need funds to finance investment projects WHAT THE FINANCIAL SYSTEM DOES: 1 Financial Investment  Financial system: the institutions in the economy that facilitate the flow of funds between savers and investors  The financial system includes o financial markets, like the stock market, through which households directly provide funds for investment o financial intermediaries, like banks or mutual funds, through which households indirectly provide funds for investment  Debt finance: selling bonds to raise funds for investment o A bond represents a loan from the bondholder to the firm.  Equity finance: selling stock to raise funds for investment o A share of stock represents an ownership claim by the shareholder in the firm.  Financial intermediaries accept funds from savers and direct them to investors. o For example, banks accept deposits from households and make loans to firms. o Other examples: mutual funds, pension funds, and insurance companies WHAT THE FINANCIAL SYSTEM DOES: 2 Sharing Risk  Many people are risk averse: other things equal, they dislike uncertainty.  The financial system allows people to share risks: o Investors can share the risk that their projects will fail with the savers who provide the funds. o Savers may be willing to accept these risks for the prospect of a higher return than they could earn otherwise.  Many people are risk averse: other things equal, they dislike uncertainty.  The financial system allows people to share risks: o Savers can reduce risk through diversification: providing funds to many different investors with uncorrelated assets.  Diversification can reduce idiosyncratic risks, risks that differ across individual businesses.  Diversification cannot reduce systematic risks, which affect most/all businesses. WHAT THE FINANCIAL SYSTEM DOES: 3Dealing with Asymmetric Information  Asymmetric information: when one party to a transaction has more information about it than the other party  Adverse selection:  when people with hidden knowledge about attributes sort themselves in a way that disadvantages people with less information  Example: investors who know their projects are less likely to succeed are more eager to finance the projects with other people’s funds  Moral hazard: arises from hidden knowledge about actions, occurs when imperfectly monitored agents act in dishonest or inappropriate ways.  Example: entrepreneurs investing other people’s money are not as careful as if they were investing their own funds  The financial system helps mitigate the effects of asymmetric information.  Example: banks  Banks address adverse selection by screening borrowers for adverse hidden attributes that savers might not detect.  Banks address moral hazard by restricting how loan proceeds are spent or by monitoring the borrowers. WHAT THE FINANCIAL SYSTEM DOES: 4. Fostering Economic Growth  In the Solow model, there is one type of capital; in the real world, there are many.  Firms with lucrative investment projects are willing to pay higher interest rates to attract funds than firms with less desirable projects.  The financial system helps channel funds to projects with the highest expected returns relative to their risk.