The most idiotic Keynesian model

Y=I+C+G=I+G+aY

Y

What do we get?

• Government expenditures are good: dY/dG>0

• Animal spirits are good: dY/dI > 0

• Thrift is bad: dY/da >0

• « Keynesian multiplier » 1/(1-a)

What do we need?

• Y = C+I+G means that output is determined by demand

• To be so, it must be that demand < productive capacity

• Prices must not adjust to restore equilibrium prices are held fixed « in the short run »

• Therefore, quantities adjust and output is demand-determined

The next less stupid model: IS-LM

Y

i

IS

LM

What do we get ?

• The model now simultaneously explains interest and output

• An increase in money supply now raises output: dY/dM >0, di/dM<0

• Animal spirits, government expenditure, and dissavings now increase interest rates di/dG >0, dY/dg >0

• Expected inflation is expansionary, because the real rate is reduced (Mundell-Tobin effect)

The monetary transmission mechanism

• i = interest rate on bonds = opportunity cost of holding money

• Demand for money is for « real money » M/p, but p is fixed

• M goes up, i must fall for people to hold the extra money (the price of bonds must go up)

• A lower i means a lower r• boosts consumption and investment• Output goes up in response

What do we need?

• The demand for money as a function of i is an important ingredient of the IS-LM model

• A motive for holding money is needed

Missing bits 1: the labor market

• Ouput fluctuations were mechanically transformed into employment fluctuations by « Okun’s law »

• Δu = - 0.5 Δ (y – y*)

• Summarizes « labor hoarding » as well as the production function

Missing bits 2: the Phillips curve

Unemployment

Inflation

The AS-AD model

y

p

Missing bits 3: The foreign sector

• CF(i – i*) + NX = 0 Balance of payments identity

• NX = NX(ep/p*)

• New IS: Y = I+C+G+NX

• Under capital mobility, i = i*

• Flexible rates: e adjusts

• Fixed rates: M adjusts

Output determination, flexible rates

Y

i

LM

i*

Exchange rate determination, flexible rates

Y

e

Y

e

The monetary transmission mechanism

• M goes up, incipient fall in i

• Capital flows abroad, people sell home assets

• The demand for the home currency falls

• Exchange rate depreciates

• Exports and output goes up

• In the end, i remains equal to i*

Fiscal policy is ineffective

• An increase in public expenditure incipiently boosts output and money demand

• Interest rates go up• Capital inflow appreciates the exchange rate• To restore equilibrium on the money market,

output must return to its initial value• The fall in next export equates the increase in

public expenditure

Output determination, fixed rates

IS

i*

Y

Fiscal policy is effective

• An increase in public expenditure incipiently boosts output and money demand

• Interest rates go up• Capital inflow appreciates the exchange rate• To prevent appreciation, the government prints

money• Equilibrium in the money market is restored

when interest rates are back to their initial value• Net exports are unchanged, so ouput must go

up

The problems

• Nominal rigidities are unexplained and unspecified

• Real/Nominal dichotomy violated

• Permanent output/inflation trade-off

• The parameters are not structural => « Lucas critique »

• Expectations about the future are poorly specified

Model Utility Sticky Exogenous Monetary RationalMaximization Prices Price Non neutrality Expectations

Fixed-price equilibrium X X X XNew Classical X XNew Keynesian X X XReal Business Cycles X XNew ISLM X X X X

The rational expectations revolution

• In the 60s, policymakers in the US tried to exploit the Phillips curve to « fine-tune » the economy

• However, it then shifted up, leading to « stagflation »

• The trade-off appeared to be short-run not long-run

Why?

• We need to know why there is a trade-off in the first place.

• If people care about real things, should not be a trade-off

• Friedman/Lucas: misperceptions• Or: wages set one period in advance• In both cases, trade-off arises because

actual inflation differs from expected inflation.

Adaptive expectations

• If gvt attempts to exploit trade-off systematically, Phillips curve gradually shifts as people’s expectations adjust

• Thus, fine-tuning only works because people are fooled

• But are adaptive expectations plausible if systematic policy is pre-announced?

Response to a jump in inflation

t

y

Rational expectations

• People use all their information to form expectations

• They compute future outcomes using the right model of the economy (or the equilibrium distribution for each variable)

A RE model

Solving the model