CHAPTER 1 INTRODUCTION TO FLUCTUATIONS KEYNESIAN ECONOMICS

MASTER EPP MACRO 2 2010 Yann ALGAN

1.INTRODUCTION
How does the economy react to economic shocks in the short-run ? Recurrent fluctuations in the short run around the long-run trend

GDP growth rate in France since WWII

 Recurrent crisis: Financial and Economic Crisis 2008-2009

Source IMF 2009, Precentage change

Source: IMF 2009, Percentage change

 Global interactions between markets and countries

Percentage change

Okun Law

The end of decoupling

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 Prices of goods : the return of deflation?

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Financial assets

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Fluctuations and macroeconomic policies What role for monetary policies ?

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 What role for fiscal stimulus ?

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Basic framework: keynesian economics Short-run analysis with price and wage rigidities Shortage of demand on the product market Output is driven by aggregate demand Shortage of demand on the labor market Involuntary Unemployment Animal Spirits and State intervention

Basic framework: IS/LM Hicks (1937), based on the General Theory Keynes (1936) Static model with rigid prices and shortage of demand
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Illustration of the relevance of price rigidity

Menu costs on the goods market

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Wage contracts

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2. Product Market
2.1 Components of aggregate demand
Components of GDP Consumption (C): largest component (2/3 of GDP) Private investment (I) : Public investment (G) Net exports (X M) Simplification ISLM: closed economy Y=C+I+G

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Decomposition of growth in Europe

Decomposition of growth in France

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2.2 Behaviors
Consumption Disposable income: (+) YD = Y-T = Income - Tax Interest rate i : (-) - Trade-off consumption-saving - Debt of households (ex. Subprime crisis)

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Simplification Role of income and marginal propensity to consume C = C (YD) o YD = Y-T Ex.: C = c0 + c1. YD

Empirically: marginal propensity to cosume on average between .3 and .5, but close to 1 for borrowing constrained people 20

Investment Definition Flows of spending to increase capital stock: component of aggregate demand in the short run. Highly volatile French case

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Determinants

I= I(Y,i) + -

- Aggregate demand : role of anticipations and animal spirits - Interest rate: cost of borrowing or trade-off with financial assets:

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Fiscal spending Budget constraint

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Evolution of French public debt

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2.3 Product market equilibrium : IS

Aggregate demand Z = C (Y-T) + I(Y,i) + G Equilibrium on the product market Total output Q is equal to total income Y and to aggregate demand Z Accountability definition of GDP Q = Y=Z Y = Z = C(Y-T) + I(Y,i) + G IS relationship
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 Causal relationship for Keynes: In case of price rigidity and demand shortage : Z

Alternative representation of the equilibrium IS Total savings : S(Y-T) = Y T C(Y-T) Equality savings and investment

S(Y-T) = I(Y,i) + G - T

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Example

One gets

(where

)
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Illustration 45 diagram

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IS curve

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Basic Keynesian Multiplier

Impact of a fiscal stimulus? Basic answer regardless of financial market Ex.:

Mechanism If G increases by 1 $, Z increases by 1 $, so does output and income This yields extra demand, output, and income of , leading to an increase in demand by ..
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Impact of a tax cut? If

An increase in public spending is more efficient than a tax cut

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Illustration

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3. Financial market equilibrium

3.1 Money demand
Basic trade-off - Real balances: liquid but no return - Financial asset (bonds here): illiquid but yields a return Basic relationship - MD increases with income Y : transaction motives decreases with interest rate i : speculation motives MD / P = Y. L(i) : Money demand (+, -)
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3.2 Equilibrium on the money market

Equilibrium: - Money supply : M/ P - Targeted by the Central Bank: Ex M3 target for the ECB (interest rate targeting) - Equilibrium : M/P= MD / P or M/P = Y. L(i) LM relationship: All (Y,i) compatible with money market equilibrium

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LM curve Positive relationship between Y and i on the money market

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Illustration of an increase in money supply

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4. Macroeconomic Equilibrium
IS-LM equilibrium
Simulatenous equilibrium on the product and money market

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Monetary integration Equilibrium on the product market depends on the money market - Money demand for transaction - Interest rate influences Investment (and consumption in a more general framework)

Interaction between the product maket and the money markets is at the core of the non-neutrality of money

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Involuntary unemployment
Labor market activity driven by aggregate demand Situation of unemployment: Equilibrium employment is determined by labor demand side Aggregate demand drives production and thus labor demand N (ex. production Y=N) Y Z Unvoluntary unemployment: Unemployment due to the lack of aggregate demand on the product market and not from too high wages ! Equilibrium: no spontaneous adjustment of the markets through prices, adjustment by shortage of quantities Room for State intervention
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5. Economic policies
Assessment of the impact of demand policies in the IS-LM framework Basic framework : static, no anticipations, price stickiness But good starting point for the short run

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5.1 Fiscal Policy

Example: decrease in G or increase in T

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Interaction with monetary markets and crowding out effect

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What is the size of the multiplier ? Impact of an increase by 1% of fiscal spendings

Positive effect in the short run but vanishes over time . Why ? Next chapter : AD/AS model
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Case study: the Barro Krugman argument

Robert Barro: Government spending is not free lunch How can we identify the causal effect of fiscal shock ? Potential instrument: military spendings (WWI, WWII, Vietnam war) Barro estimates 0,8: crowding out effet Paul Krugman : War and Non-Remembrance The problem with war is war

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How ambitious and efficient are the current fiscal stimulus?

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How efficient is the French stimulus plan ?

Conclusion: what will happen with the withdrawal of fiscal stimulus?

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5.2 Monetary Policy

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Illustration Increase by 1% of the FED interest rate (or money contraction)

Decrease in Z (lower I and C)

Decrease in Y

Decrease in N
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Higher u IS/LM relevant in the short run

little effect on prices

But price adjustment in the long run (next chapter)

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Financial crisis and Monetary Policy

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5.3 Policy Mix

Example: FED policy during the financial crisis Inverse Example: German reunification

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