CITY UNIVERSITY

DEPARTMENT OF ECONOMICS

MSc Programmes Review of Traditional Macroeconomics Read: David Romer, Advanced Macroeconomics, McGraw-Hill, ch. 5 1. Introduction 2. IS-LM and the AD relation 3. Open economy Mundell Fleming 4. AS 5. Phillips Curve

Introduction

Some features of traditional macro models 1. Ad hoc relationships between macro variables. 2. Static or pseudo-dynamic. 3. Analysis is based on comparative statics.

2
.

IS-LM and Aggregate Demand

In the IS-LM model, the main assumption is that the economy is demand-constrained and AS adjusts to equal AD. The main endogenous variables are national income Y and the interest rate i. In principle the interest rate could be distinguished as real or nominal but we shall assume that expected ination is zero so i represents both real and nominal. Three markets exist: Goods, Money, Financial Assets. Walras Law is used to drop one market: the nancial assets market is the one conventionally dropped. Walras Law: In a system of n markets, if all traders are subject to binding budget constraints at given prices, then if n 1 markets are in equilibrium, the nth is also in equilibrium.

2.1

Goods market and IS:

E = E(Y, i, G, T ); 1 > EY > 0, Ei < 0, EG > 0, 1 < ET < 0

is the equation underlying aggregate demand. where E = aggregate expenditure; Y = aggregate income; i = interest rate (nominal); G = government spending and T = taxes. In equilibrium, E = Y , i.e. planned expenditures equal actual income (at the aggregate level) so the equations can be written as Y = E(Y, i, G, T ); The IS curve: a locus of points in (Y, i) such that goods market equilibrium is satised at given levels of G, T . To derive the qualitative properties of this locus, totally dierentiate: dY = EY dY + Ei di + EG dG + ET dT For given values of G and T , the relationship between di and dY which must hold at all points on the IS is: + di 1 EY = <0 = dY IS Ei Thus the IS-curve is downward sloping. Example: Y = C + I + G is the standard national income-expenditure identity. Suppose C = C(Y T ), 1 > CD > 0 where D = Y T I = I(i), Ii < 0. Then the above relationship can be written as Y = C(D) + I(i) + G where D = Y T is disposable income. and totally dierentiating: dY = CD dY CD dT + Ii dI + dG where C D is conventionally known as the marginal propensity to consume out of disposable income. Therefore: di dY =
IS

1 CD + = <0 Ii

Suppose that the goods market is in equilibrium when G goes up. How do we analyse this?

At any given i, what happens to Y ? 1 dY = > 1! dG 1 CD is the famous multiplier formula. It indicates a rightward shift in IS when G increases. Similarly: dY CD = <0 dT 1 CD IS shifts left when T goes up. In the general case: dY EG = dG 1 EY The alternative question: at given Y what happens to i when G goes up? T goes up?

2.2

Money market:

Money demand: M d = P L(i, Y ); Li < 0 and LY > 0. where M is money, P is the aggregate price level. M s is exogenous. When the money market is in equilibrium, M d = M s = M , i.e. planned money holdings equal actual ones. M = L(i, Y ) P Totally dierentiate: 1 M dM 2 dP = Li di + LY dY P P The LM curve: is a locus of points in (Y, i) such that money market equilibrium is satised at given levels of M and P Analogously to the goods market: di dY =
LM

LY + = >0 Li

Thus the LM curve is downward sloped. Note that the LM is steeper the smaller is Li in magnitude and the larger is LY . Also, dY 1 = >0 dM P LY dY M = 2 <0 dP P LY The LM curve shifts right when M goes up and left when P goes up.

2.3

IS-LM and the AD relation:

The AD relation: when the price level (P ) goes up, aggregate demand for goods (Y d ) gown down. In the IS-LM model actual Y is demand driven so Y = Y d . Put the two equations together: Y = E(Y, i, G, T ) M = L(i, Y ) P Here, Y , i are endogenous and G, T , P and M are exogenous. In a complete AS-AD system, P becomes endogenous as well but the assumption that output is demanddetermined implies that there is spare capacity in the economy and output can adjust at exogenously constant prices. Totally dierentiate IS and rearrange: di = EG ET (1 EY ) dY dG dT Ei Ei Ei

Totally dierentiate LM and rearrange: di = 1 M LY dM 2 dP dY P Li P Li Li

Eliminate di: EG ET 1 M LY (1 EY ) dY dG dT = dM 2 dP dY Ei Ei Ei P Li P Li Li Let (1 EY )Li ()(+) + LY = + (+) > 0 Ei Some rearrangement leads to: = dY = 1 M EG Li ET Li dP + dM + dG + dT P2 P Ei Ei

The AD relation is expressed by the following partial derivative (holding all other exogenous variables constant): dY dP =
AD

M < 0! P 2

Shifts in the AD curve (i.e. at any given P , if some other exogenous variable changes, the AD curve shifts: dY 1 = >0 dM P dY E G Li = >0 dG Ei dY E T Li = <0 dT Ei

so the AD curve shifts rightwards if M or G increase and leftwards if T does. For eect on i, the solution procedure should be reversed and dY eliminated from the two equations. However, the qualitative eect on i can be determined using diagrams and noting how any change in one exogenous variable shifts either the IS or the LM curve. In fact it can be shown by some algebra that: dY dG =
IS

EG EG Li dY = 1 EY Ei dG

AD

so that in general when G goes up, the rightward shift in IS is greater than the overall increase in AD. This is because i also increases, partially crowding out private spending (investment). Although not explicit in the IS-LM model, it allows for many unseen inuences on the economy via the level of AD. For example EY is the marginal propensity to spend out of national income. This can be inuenced by consumer tastes, business expectations etc. A decline in business optimism can lower EY and reduce AD. The IS-LM model focuses on policy variables such as M , G and T precisely to study how government policy can be used to oset such shocks originating within the private sector. To summarise, the IS-LM system consists of two equations, one describing the IS (goods market) equilibrium and the other the LM (money market) equilibrium. In this system, Y and i are endogenous and P is exogenous along with policy variables. BecauseP is exogenous, all solutions of Y are, strictly speaking, solutions of the level of AD in the economy; hence IS-LM is a system for analysing aggregate demand.

Open economy Mundell Fleming:

Main assumptions (in the simplest case): 1. There is a small, open economy. 2. Capital is perfectly mobile between countries Foreign and domestic assets are perfect substitutes. There are no capital controls or market frictions. 3. There is no currency substitution so the demand for domestic currency depends on the same variables as in a closed economy. 4. The central bank controls the domestic money supply by open-market operations in both domestic and foreign securities. 5. The exchange rate is expected to remain constant.

Under these assumptions, interest-rate parity (IRP) requires: i = iW where iW is the interest rate on foreign securities. [The more general form of IRP is i = iW + E()

where is the spot exchange rate at the time an asset is bought and E() is the expected rate at the time when the asset pays o. ] The other change is that the IS relation is now expanded: Y = E(Y, i, G, T, q); Eq > 0 P W q= P is the real exchange rate. An increase in q tends to make domestic goods cheaper relative to foreign ones so there is an increase in planned expenditures on domestic goods. The Mundell-Fleming system is i = iW Y = E(Y, i, G, T, q) M = L(i, Y ) P with 3 equations and 3 unknowns. The third equation is labelled IRP or sometimes BOP (for balance of payment equilibrium). Y and iare endogenous in all cases. The third endogenous variable can be either or M . where

3.1

Floating rates:

In a oating rate system, is the third endogenous variable. Then M , G, T , iW . P W and P are exogenous. Note that equations can be arranged i = iW M = L(i, Y ) P Y = E(Y, i, G, T, q) First, IRP solves for i in a trivial way. Then, given i from LM we can uniquely determine the value of Y actual money demand equals planned money demand. Then

given i and Y , from IS we determine the value of at which the goods market is in equilibrium. A system of equations which can be solved in sequential fashion is called blockrecursive. This mathematical property shows up in many important models, such as in the classical model of supply-driven output (as we see later). The comparative-static properties of the system can be studied by totally dierentiating the system of equations and some rearrangements: di = diW M 1 dM 2 dP Li di + LY dY = P P Eq q Eq q Eq q Ei di + (1 EY )dY d = EG dG + ET dT + W dP W dP P P where all terms involving endogenous variables are on the LHS and all terms with exogenous variables are on the RHS. Arranging in matrix form:

1 0 LY Li Ei 1 EY

0 0
q E q

1 0 0 0 0 di 1 M 0 0 dY = 0 P P 2 Eq q d 0 0 P EG ET

Eq q PW

0 0

diW dM dP dG dT dP W

The block-recursiveness is reected in the diagonal nature of this matrix (the right hand o-diagonal elements are zero). Let denote the determinant of the 3x3 matrix of eects on endogenous variables. = LY Eq q <0

Suppose we want to calculate dY /dM . Cramers Rule states: 1 Det Li Ei

0
1 P

0 0

dY = dM

q 0 E q

1 P LY

which is the same expression as for (dY /dM )LM . Thus in the open economy with oating exchange rates, an increase in the money supply has the same eect on stimulating AD as it would have in a closed economy at constant interest rates. To understand how Cramers rule is applied, note that the matrix in the numerator is formed by taking the LHS matrix and replacing the column corresponding to dY in that matrix by the column corresponding to dM in the RHS matrix. What about dY /DG? 1 0 0 0 0 Det Li Eq q Ei EG dY 0 = = = 0! dG

Thus in an open economy oating rates, scal policy has NO eect on AD. The reason is based on the block-recursive property. With oating rates, Y is uniquely determined by the IRP and LM conditions and since G (or T ) does not directly aect either market. Hence scal policy has no eect on demand. Economic intuition: When G goes up, this tends to put upward pressure on the domestic interest rate, which results in an inow of capital (to restore IRP). The inow of capital leads to incresed demand for home currency so that the currency appreciates ( falls). This leads to a decline in E becuase net exports fall which osets the increase in G. Note that here crowding out is on exports and not on investment expenditures. To verify this, derive: 1 0 LY Det Li Ei 1 EY d = dG

0 0 EG

LY EG EG = <0 Eq q

In a large economy or if capital mobility was imperfect, an increase in G (or decrease in T ) would aect the domestic interest rate to some extent. Then it would aect money market equilibrium at constant values of M so that some eect on Y would take place.

3.2

Fixed rates:

In a xed rate system (with no capital controls), the CB stands ready to buy and sell foreign currency in order to accommodate any excess supply or demand that might exist at the given value of . These interventions lead to changes in the domestic money supply. When the CB sells foreign currency, the domestic money supply contracts and when it buys, the domestic money supply expands. Thus, in a xed rate system M is endogenous. The system can now be written: The Mundell-Fleming system is i = iW Y = E(Y, i, G, T, q) M = L(i, Y ) P This system is also block-recursive. As before IRP trivially solves i. Then given i, IS solves Y and given i and Y , LM solves M . Thus money-market equilibrium is met by changes in the money supply in this case.

The comparative statics can be expressed by means of the matrix system:

1 0 Ei 1 EY Li LY

1 di 0 0 dY = 0 1 dM P 0

0
Eq q

0
q EP q M P2

0 0 EG ET 0 0

Eq q PW 0

diW d dP dG dT dP W

Let denote the determinant of the square matrix on the LHS. Then = The eect of an increase in G: 1 0 0 Det Ei EG 0 1 Li 0 P dY dY EG = = = dG 1 EY dG

1 EY <0 P

IS

Thus in an open economy with perfect capital mobility and xed rates, scal policy is a powerful shifter of AD as no crowding out occurs. When G goes up and capital ows in, the increased demand for domestic currency is accommodated by the CB which provides more domestic currency to the market (M goes up) and thus there is no eect on exchange rates or interest rates and no crowding out of either kind. To verify: 1 0 Det Ei 1 EY Li LY dM = dG

0 EG 0

LY EG P >0 1 EY

Since M is endogenous, monetary policy cannot be used to inuence Y . Any purchase of domestic securities would tend to increase M , but this would put downward pressure on i causing a capital outow. This would lead to an increase in demand for foreign exchange and to support the xed rate, the CB would sell foreign reserves and M would fall. For a large economy or with imperfect capital mobility, again these extreme results are modied. An increase in M can be sustained as to some extent i will respond and the osetting eects will not be complete. Thus M can be used to stimulate AD but obviously this depends on how insulated an economy is from the world outside (the larger it is or the more imperfect the capital market the more insulated). One problem with xed rates is that a CB might run out of foreign reserves with which to sustain the peg. If this begins to happen, it is either forced to devalue the currency or to suspend convertibility. But if the market anticipates either action it can result in a speculative crisis as has happened in Turkey, Argentina, Mexcico, UK etc.

Thus while xed rates are believed to provide exchange rate stability under normal conditions which encourages foreign trade and investment, they can lead to very severe crises.

Aggregate Supply:

We now drop the assumption of spare capacity and xed prices. The supply side of the economy is characterised by: Aggregate Production Function. Labour Market.

4.1

Aggregate Production Function:

The Aggregate Production function is represented by: Y s = F (K, L); FK > 0, FL > 0, FKK < 0, FLL < 0. where K is the aggregate capital stock and L is aggregate labour employment. The assumed partial derivatives indicate positive but diminishing marginal product to each factor of production. However, collectively it is possible that F shows CRS. In a static macro model we also assume that K is xed over the period of analysis. This is because to increase K, investment has to take place and this takes time to mature. L however can be adjusted relatively easily within the period. Hence we ignore the role of K in the production function (we treat it implicitly) and write: Y s = F (L); F > 0, F < 0 Note that exogenous inuences can shift this function. These include, a higher level of capital and an improvement in productive technology.

4.2

Labour Market:

Let W be the average nominal wage. The price of labour is properly dened as W/P , the real wage. The labour market is characterised by an upward sloping supply curve for labour (provided by households) and a downward sloping demand curve (determined by rms).

The latter can be derived from a representative rms optimising decision: M axpF ( ) w where lower case letters indicate rm level activity. FOC: pF w 0 so that w p Since F < 0, if w/p rises, must fall for the optimality condition to hold. Thus a rm demands less labour when the price of labour goes up. F = Extrapolating to the aggregate economy: W P d is the equation for the demand for labour L . FL = At given real wages, labour demand can shift if the production technology improves or if there is a higher level of capital. The supply of labour can be determined analogously by considering the problem of a household which allocates its time between work (which brings in income to spend on consumption) and leisure. We skip this and jump to the typical conclusion of such an exercise; W ; L >0 Ls = L P Labour supply can shift if household preferences between consumption and leisure change or if there is population growth.

4.3

Equilibrium:

We are now in a position to describe the entire (closed) economy: When the labour market is in equilibrium, Ld = Ls = L. Also when the goods market is in equilibrium Y s = Y d = Y . We impose these in writing down the system W L = L P W F (L) = P Y = F (L) Y = E(Y, i, G, T ) M = L(i, Y ) P Recall that the last two equations represent the demand side. In general, Y , P , i and L are always endogenous. To go further, however, we have to distinguish between the classical and Keynesian views of the labour market.

4.4

Classical Theory:

In classical theory, the level of employment is naturally determined by an equilibrium between labour supply and demand. Underlying this is the classical belief that the real wage is always adjusts quickly to whatever level clears the labour market. Thus, the real wage is determined purely by equilibrium in the labour market. If we now consider the system above, note that the rst two equations will determine W/P (although not W and P separately) and L. Then the third equation determines Y! In the classical model, the level of aggregate supply is determined purely from the supply side of the economy! Aggregate demand has to adjust accordingly. Thus output is completely supply-determined. Finally the IS equation determines i and the LM determines P . (Once P is determined it is possible to obtain the nominal wage W ). The classical model has the following properties: Dichotomy: The supply side, i.e. labour market and production technology determine output independently of the demand side (the aggregate expenditure equation and money market equilibrium). Note that the demand side in NOT independent of the supply side so dichotomy is one-sided. This is mirrored in the mathematical property of block-recursiveness which also applies here as the model is solved sequentially. : Neutrality of money: An increase in the money supply has no eect on real variables and causes nominal variables to increase proportionately. To see this, note that if M increases it has no eect on L, W/P , Y or i since they are all determined in relationships which do not involve the LM curve. The only endogenous variable that can change is P . Moreover, since the RHS of LM is independently determined of the level of M , any increase in M must be met by a proportionate increase in P (and, in the background, in W ). : Vertical AS curve: A hypothetical increase in P has no eect on Y s . This is because of labour market clearing. Imagine an articially induced increase in P . In the labour market, at given W , labour demand will increase and labour supply will decrease. Both eects will tend to push W upwards. This will happen instantly so that the increase in P is matched by an increase in W leaving the ratio at its original equilibrium level. Thus L will remain unchanged as will Y s . Thus the eect of an increase in M can be better understood. If M goes up, all else equal, Y d rises. But since Y s does not respond, an excess demand for goods arises, pushing P up. Eventually the increase in P osets the higher M and the goods market remains at the original equilibrium level of Y . Thus the classical model does not believe that government policies can aect output or employment.

4.5

Keynesian Theory:

Keynes criticised classical theory on many grounds and his views can be formalised in many dierent ways. Hence what we shall study is only one such way. We focus on the following case: that money wages are downwardly rigid; i.e. if to reach labour market equilibrium in the classical sense requires a rise in money wages (a situation of excess demand for labour), that will happen, but if requires a fall (excess supply or unemployment), then that wont happen. We also assume that the economy is in a situation of excess supply of labour at the time we look at it. Formally this means that W is treated as exogenous and that the economy is operating o the labour supply curve. The Keynesian system can be represented by: W F (L) = P Y = F (L) Y = E(Y, i, G, T ) M = L(i, Y ) P where the Ls equation is no longer relevant. The endogenous variables are L, Y , i and P . Since W is given, W/P cannot be determined without determining P . But to determine P requires going all the way into the LM curve. In other words, this system is not block-recursive, all equations need to be solved simultaneously. Thus the Keynesian model is neither dichotomous, nor is money neutral nor is the AS curve vertical. To understand the shape of the AS curve, conduct the following thought experiment. Suppose P increases hypothetically. In the labour market the initial impact will be to create an increase in the demand for labour and decrease in supply. In a exible market, W would rise. But here, W is xed and labour supply is not binding anyway (employment is driven by labour demand). Hence the increase in labour demand leads to more employment (recall that we are in a situation of unemployment to begin with). More L means more Y being produced. Hence the AS curve is upward sloping in the Keynesian case. The Keynesian model also allows for government policy to aect real variables. Increases in G or M can both shift the AD curve out and create a movement along the upward sloping AS. This reduces unemployment. Keynes had a special theory in which monetary policy was unable to inuence Y or L. This was based on the notion of a liquidity trap: a situation of such low interest rates that agents are willing to hold unlimited amounts of wealth purely as money. In this case the LM curve is horizontal (as Li = and the AD curve is vertical and cannot be shifted by increases in the money supply). However, G can be used in such a case. To see this look at the expressions for dY /dM and dY /dG in the section on AD and evaluate the terms at Li = .

Phillips Curve:

The Phillips Curve (PC) was discovered in the 1950s by empirical studies of the relationship between wage ination and unemployment in the UK: an increase in wage ination was found to be associated with a decrease in the rate of unemployment. Later studies found that an increase in CPI ination was also associated with decrease in the rate of unemployment. It was in this version that the PC came to be seen as a policy insight: governments could ne tune the economy by picking an ideal point of this ination-unemployment tradeo. However, in the 1960s, the concept of a PC began to be challenged as studies found it was hard to pin down its existence since the ination-unemployment relationship seemed to be all over the place. At that time, Milton Friedman proposed a theory which reconciled the existence of a PC over short periods of time with the fact that over long periods, the PC appeared to be quite unstable. His explanation can be derived from the AS model studied previously. Suppose is the (unique) value which W/P takes when the labour market is in classical equilibrium. Now suppose that workers and rms negotiate money wages Wt (we have to introduce time indicators now), i.e. the money wage paid at time t, but that this negotiation takes place at time t 1. At time t 1, if the price level that would prevail at time t were known in advance, then the agreed money wage would be Wt = Pt . However, at time t, workers and rms cannot be sure what Pt will be. Hence, the best they can do is to form an expectation of Pt at t 1. Let us denote this by Et1 Pt . Hence, the money wage will be set as Wt = Et1 Pt . Now suppose that in recent times there has been no ination. In this case, it is reasonable that labour markets will expect Et1 Pt = Pt1 . In this case, Wt = Pt1 . So long as the rate of ination remains zero, then Pt = Pt1 and the labour market will remain in classical equilibrium. On the other hand, suppose that at some point, the CB starts following an expansionary monetary policy which pushes ination to be positive. Initially the labour market might not realise it and wages will keep being set as Wt = Pt1 . However, actual Pt will exceed its past value so that Wt Wt Wt < = = Pt Pt1 Et1 Pt Thus the actual real wage at time t will fall below its expected (market-clearing value). In this situation rms will demand more labour. Workers for their part will be slower in realising that they are not receiving the real wage they had expected to receive.

This is not because they are less smart than entrepreneurs but because the information a household requires to calculate the real wage it receives is more complicated than the information that a rm needs to have to gure out the real wage on its omen product. This temporarily rms will hire more workers and workers will be willing to get hired at this lower real wage. Thus there will be a temporary tradeo between higher ination and a lower unemployment rate. Over time, however, workers will realise that ination is positive and then will begin to factor that into their wage negotiations. For example, if ination is x%, then workers will demand wages according to Wt = Pt1 (1 + x). Obviously if Pt = Pt1 (1 + x) then W t/Pt = again and the economy will be back at the market-clearing level of unemployment. If the CB now makes ination accelerate to x (x > x) the again temporarily there will be a PC eect as higher ination will lead to lower unemployment but ultimately, wages will be set according to the higher ination rate. Thus, given wage-setting behaviour which takes into account the past history of ination in setting nominal wages it is possible that changes in the rate of ination can temporarily aect employment and output but this cannot take place forever. Thus in the LR there is no PC. Friedmans analysis contributed the following expressions; The natural rate of unemployment: The rate of unemployment towards which the economy gravitates in the long run when actual and expected ination are equal. Core ination: The rate of ination when the economy is at the natural rate of unemployment. While Friedman denied the possibility of a stable PC, his theory did allow for shortterm ination-unemployment relationships that looked like PC. Lucas (1972) challenged even this possibility. Lucas critique: Economic agents will take into government policy and the regimes which govern it in forming expectations of macroeconomic variables. If the CB follows an inationary policy, then this fact is publicly known and expectations of future prices will account for it without any necessary lag between the time that actual ination goes up and the public realise that it going up. In this case, even a SR PC is not possible.