Intermediate Macroeconomics

Introduction to Economic Fluctuations

The IS curve

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Today’s Outline – Part I

slide 1

§ facts about the business cycle

§ how the short run differs from the long run

§ an introduction to aggregate demand

§ an introduction to aggregate supply in the short

run and long run

§ how the model of aggregate demand and aggregate supply can be used to analyze the short-run and long-run effects of “shocks.”

Readings

Lecture 2 slide 2

§ Required reading: Mankiw, chapter 10

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Facts about the business cycle

Lecture 2 slide 3

§ GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.

§ Consumption and investment fluctuate with GDP,

but consumption tends to be less volatile and investment more volatile than GDP.

§ Unemployment rises during recessions and falls during expansions.

§ Okun’s law: the negative relationship between GDP and unemployment.

-2

0

2

4

6

8

Growth rates of real GDP and consumption US

Percent 10

change

from 4

quarters

earlier

Average growth

rate

Real GDP growth rate

Consumption growth rate

-4 1970

Lecture 2

1975 1980 1985 1990 1995 2000 2005 2010

slide 4

-20

-10

0

10

Growth rates of real GDP, cons. and investment US

Investment growth rate

Real GDP growth rate

Consumption growth rate

-30 1970

Lecture 2

1975 1980 1985 1990 1995 2000 2005 2010

slide 5

Percent

change 40

from 4

quarters 30

earlier 20

8

6

4

2

0

10

12

1970 1975 1980 1985 1990 1995 2000 2005 2010

Unemployment US

Lecture 2 slide 6

Percent

of

labour

force

-4

-2

0

2

4

6

8

-3 -2 -1 0

Okun’s Law

Percentage 10

change in

real GDP

1 2 3 4

Change in unemployment rate

Y

Y 3 2 u

1975

1982 1991

2001

1984

1951 1966

2003

1987

2008

1971

2009

Lecture 2 slide 7

Time horizons in macroeconomics

Lecture 2 slide 8

§ Long run

Prices are flexible, respond to changes in supply or demand.

§ Short run

Many prices are “sticky” at a predetermined level.

The economy behaves differently

when prices are sticky.

Recap of classical macro theory

Lecture 2 slide 9

§ Output is determined by the supply side: – supplies of capital, labour

– technology

§ Changes in demand for goods & services (C, I, G ) only affect prices, not quantities.

§ Assumes complete price flexibility.

§ Applies to the long run.

When prices are sticky…

Lecture 2 slide 10

…output and employment also depend on demand, which is affected by:

– fiscal policy (G and T )

– monetary policy (M )

– other factors, like exogenous changes in C or I

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The model of aggregate demand and supply

Lecture 2 slide 11

§ The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy

§ Shows how the price level and aggregate output are determined

§ Shows how the economy’s behaviour is different in the short run and long run

Aggregate demand

Lecture 2 slide 12

§ The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.

§ For now, we use a simple theory of aggregate demand based on the quantity theory of money.

§ Next week we will develop the theory of aggregate demand in more detail.

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The Quantity Equation as Aggregate Demand

Lecture 2 slide 13

§ Recall the quantity equation

MV = PY

§ For given values of M and V,

this equation implies an inverse relationship between P and Y …

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The downward-sloping AD curve

An increase in the

price level causes

a fall in real money

balances (M/P),

causing a decrease

in the demand for

goods & services.

Y

P

AD

Lecture 2 slide 14

Shifting the AD curve

An increase in

the money supply

shifts the AD

curve to the

right.

P

AD1

Y

AD2

Lecture 2 slide 15

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Aggregate supply in the long run

§ Recall from last week:

In the long run, output is determined by factor supplies and technology

Y F (K , L )

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).

Lecture 2 slide 16

The long-run aggregate supply curve

Y

P LRAS

depend on P, so LRAS is vertical.

Y does not

Y

F (K , L)

Lecture 2 slide 17

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Long-run effects of an increase in M

Y

P

AD1

LRAS

Y

An increase in M shifts

AD to the right.

P1

P2 In the long run,

this raises the

price level…

…but leaves

output the same.

AD2

Lecture 2 slide 18

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Aggregate supply in the short run

Lecture 2 slide 19

§ Many prices are sticky in the short run.

§ We assume that – 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 short-run aggregate supply curve

Y

P

P SRAS

The SRAS curve is horizontal:

The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

Lecture 2 slide 20

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Short-run effects of an increase in M

Y

P

AD1

In the short run

when prices are

sticky,…

P

Y2 …causes output

to rise. Y1

SRAS

AD2

…an increase in aggregate demand…

Lecture 2 slide 21

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From the short run to the long run

Over time, prices gradually become “unstuck.”

When they do, will they rise or fall?

In the short-run

equilibrium, if

then over time, P will…

Y Y rise

Y Y fall

Y Y remain constant

Lecture 2 slide 22

The adjustment of prices is what moves

the economy to its long-run equilibrium.

The SR & LR effects of M > 0

Y

P

AD1

LRAS

Y

P2

P

Y 2

A = initial equilibrium

A

B

C B = new short-run

equilibrium

after Central

Bank

increases M

C = long-run

equilibrium

SRAS

AD2

Lecture 2 slide 23

Stabilization policy

Lecture 2 slide 24

§ shocks: exogenous changes in aggregate supply or demand

§ Shocks temporarily push the economy away from full employment.

§ Stabilization policy: policy actions aimed at

reducing the severity of short-run economic

fluctuations.

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Demand shocks

Lecture 2 slide 25

§ 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.

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P SRAS

LRAS

The effects of a negative aggregate demand shock

Y

P

AD

AD2

1

Y

P2

Y2

AD shifts left, depressing output and employment in the short run.

A B

C

Over time, prices

fall and the

economy moves

down its demand

curve toward full

employment.

Lecture 2 slide 26

Supply shocks

Lecture 2 slide 27

§ A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)

§ Examples of adverse supply shocks:

– Bad weather reduces crop yields, pushing up food prices.

– Workers unionize, negotiate wage increases.

– New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

§ Favourable supply shocks lower costs and prices.

CASE STUDY: The 1970s oil shocks

Lecture 2 slide 28

§ Early 1970s: OPEC coordinated a reduction in the supply of oil.

§ Oil prices rose

11% in 1973 68% in 1974 16% in 1975

§ Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

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1 P SRAS1

Y

P

AD

LRAS

Y Y2

CASE STUDY: The 1970s oil shocks

The oil price shock shifts SRAS up, causing output and employment to fall.

B

There is stagflation

– combination of

falling output and

inflation.

2 P SRAS2

Lecture 2 slide 29

A

P1 SRAS 1

Y

P

AD

LRAS

Y Y2

CASE STUDY: The 1970s oil shocks

Option 1. No stabilization

B

In the absence of

further price

shocks, prices will

fall over time and

the economy moves

back toward full

employment.

2 P SRAS2

Lecture 2 slide 30

A

CASE STUDY: The 1970s oil shocks

1 P

Y

P

AD 1

B

A

C

Y2

LRAS

Y

Option 2. The

central bank

accommodates the

shock by raising

aggregate demand.

P is permanently

higher, but Y

remains at its full-

employment level.

2 P SRAS2

AD

Lecture 2 slide 31

2

Summary

slide 32 Lecture 2 32

§ Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies.

Short run: prices are sticky, shocks can push output and employment away from their natural rates.

§ Aggregate demand and supply: a framework to analyze economic fluctuations

§ The aggregate demand curve slopes downward.

§ The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

§ The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

Summary

slide 33 Lecture 2 33

§ Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run

§ The central bank can attempt to stabilize the economy with monetary policy

Today’s Outline – Part II

Lecture 2 slide 34

§ the IS curve and its relation to: – the Keynesian cross

– the loanable funds model

Readings

Lecture 2 slide 35

§ Required reading: Mankiw, chapter 11

Context

Lecture 2 slide 36

§ The first part of the lecture 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

Context

Lecture 2 slide 37

§ Now we will start developing 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).

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The Keynesian cross

Lecture 2 slide 38

§ A simple closed-economy model in which income is determined by expenditure. (due to John Maynard Keynes)

§ 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

C C (Y T )

G G , T T

I I

PE C (Y T ) I G

Lecture 2 slide 39

consumption function:

planned expenditure:

govt policy variables:

for now, planned

investment is exogenous:

equilibrium condition:

actual expenditure = planned expenditure

Y PE

Graphing planned expenditure

income, output, Y

PE planned

expenditure

PE =C +I +G

MPC

Lecture 2 slide 40

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Graphing the equilibrium condition

income, output, Y

PE planned

expenditure PE =Y

45º

Lecture 2 slide 41

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The equilibrium value of income

income, output, Y

PE planned

expenditure PE =Y

PE =C +I +G

Equilibrium

income

Lecture 2 slide 42

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An increase in government purchases

Y

PE

PE1 = Y1

PE =C +I +G2

PE =C +I +G1

PE2 = Y2 Y

At Y1, there is now an

unplanned drop

in inventory…

…so firms

increase output,

and income

rises toward a

new equilibrium.

G

Lecture 2 slide 43

Solving for Y

1 1 MPC

Y

G

Y C I G

Y C I G

C G

MPC Y G

Collect terms with Y on the left side of the

equal sign:

(1 MPC)Y G

equilibrium condition

in changes

because I exogenous

because C = MPC× Y

Solve for Y :

Lecture 2 slide 44

The government purchases multiplier

Example: If MPC = 0.8, then

Definition: the increase in income resulting from a £1 increase in G.

In this model, the government purchases multiplier equals

1

Y

G 1 MPC

5 Y

1

G 1 0.8

An increase in G

causes income to

increase 5 times

as much!

Lecture 2 slide 45

Why the multiplier is greater than 1

Lecture 2 slide 46

§ Initially, the increase in G causes an equal increase in Y:

§ But Y

Y = G.

C

further Y

further C

further Y

§ So the final impact on income is much bigger than

the initial G.

Why the multiplier is greater than 1

Lecture 2 slide 47

§ Example: the government spends and additional

£100 million on defense G=£100 million

§ The revenue of defense firms increases by £100 million, all of which becomes income to workers, managers, shareholders, etc. Hence, Y=G=£100 million.

§ The workers, managers, shareholders, etc, are also consumers and increase consumption by a fraction MPC of the extra income. C=MPC×£100

§ This additional consumption becomes income for the firms who provide the goods and services being consumed.

Why the multiplier is greater than 1

Lecture 2 slide 48

An increase in taxes

Y

PE

PE =C2 +I +G

PE2 = Y2

1 PE =C +I +G

PE1 = Y1 Y

At Y1, there is now an unplanned

inventory buildup… …so firms

reduce output,

and income falls

toward a new

equilibrium

C = MPC T

Initially, the tax

increase reduces

consumption and

therefore PE:

Lecture 2 slide 49

Solving for Y

Y C I G

C

MPC Y T

(1 MPC)Y MPC T

equilibrium condition in

changes

I and G exogenous

Solving for Y :

1 MPC

Y MPC

T Final result:

Lecture 2 slide 50

The tax multiplier

def: the change in income resulting from a £1 increase in T :

MPC

Y

T 1 MPC

0.2

Lecture 2 slide 51

0.8

0.8 4

Y

T 1 0.8

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.

Lecture 2 slide 52

The IS curve

def: a graph of all combinations of r and Y that result in goods market equilibrium

i.e. actual expenditure (output) = planned expenditure

The equation for the IS curve is:

Lecture 2 slide 53

Y2 Y1

Y1 Y2

Deriving the IS curve

Y

PE

Y

r

r1

r2

PE =Y PE =C +I (r2 )+G

PE =C +I (r1 )+G

IS

I

r I

PE

Y

Lecture 2 slide 54

Why the IS curve is negatively sloped

Lecture 2 slide 55

§ 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.

The IS curve and the loanable funds model

Lecture 2 slide 56

§ The IS curve gets its name from equilibrium in

the loanable funds market (which we studied last week)

I (Investment) = S (Saving)

S=Y-C-G

§ The IS curve shows all combinations of r and

Y such that investment (I) equals saving (S)

The IS curve and the loanable funds model

S, I

r

I (r ) r1

r2

r

Y Y1

r1

r2

(a) The L.F. model (b) The IS curve

Y2

S2 S1

IS

Lecture 2 slide 57

A reduction in

income causes a

fall in national

savings

r must increase to

restore equilibrium

in the loanable

funds market

Y1 Y2

Y1 Y2

Shifting the IS curve: G

Y

PE

r

r1

PE =Y PE =C +I (r1 )+G2

PE =C +I (r1 )+G1

IS1

The horizontal

distance of the

IS shift equals

IS2

Y

At any value of r,

G PE Y

…so the IS curve

shifts to the right.

1

1MPC Y G Y

Lecture 2 slide 58

NOW YOU TRY

Shifting the IS curve: T

§ Use the diagram of the Keynesian cross or

loanable funds model to show how an increase

in taxes shifts the IS curve.

§ Determine the size of the shift.

50

ANSWERS

Shifting the IS curve: T

Y2

PE =C2 +I (r1 )+G

IS2

The horizontal

distance of the

IS shift equals

Y

PE

Y Y1

Y2 Y1

PE =Y PE =C1 +I (r1 )+G

r

r1

IS 1

At any value of r,

T C PE

…so the IS curve

shifts to the left.

1MPC Y

MPC T Y

60

Lecture 2 slide 61

Summary

1. Keynesian cross

– basic model of income determination

– takes fiscal policy & investment as exogenous

– fiscal policy has a multiplier effect on income

2. IS curve

– comes from the Keynesian cross when planned investment depends negatively on the interest rate

– shows all combinations of r and Y that equate planned expenditure with actual expenditure on goods & services

– shows all combinations of r and Y

such that investment (I) equals saving (S)