Macroeconomics Midterm (Chapters 10-15)

Front 1

Lecture 10: Business Cycles

Back 1

Business Cycles

Front 2

GDP in the long run

GDP in the short run

Consumption and investment

Unemployment rises during

Okun's Law

Back 2

grows about 3-3.5 percent per year

fluctuates largely

fluctuate with GDP (c less volatile, I more volatile)

during recessions (falls during expansions)

the negative relationship between change in GDP and change in unemployment

Front 3

Leading Economic Indicator Index (LEI Index):

Back 3

-forecasts changes in economy (6-9 month range)

-include strings like new orders and new permits

-has increased over the long run while fluctuating

Front 4

Long run:

Short run:

Back 4

prices are flexible, respond to changes in supply or demand

prices are "sticky" at a predetermined level

--> the economy behaves much differently when prices are sticky

Front 5

Chapters 3 - 8

output is determined by

changes in demand (C, I, G) only affect

prices are _____ and takes place in the ____

Back 5

the supply side --> K, L and technology

prices, not quantities

flexible, applying in the long run

Front 6

when prices are sticky,

demand affected by

Back 6

output and employment also depend on demand

fiscal policy (G and T), monetary policy (M), and exogenous changes in C or I

Front 7

aggregate demand

quantity theory of money equation:

an increase in the price level (P):

An increase in M shifts the AD curve:

Back 7

shows relationship between price level and Qd

MV = PY --> inverse relationship with P and Y

Causes a fall in real money (M/P), causing a decrease in the demand for goods and services

to the right

--> demand axis are Y in the x and P in the Y

Front 8

Aggregate supply in the long run

output is determined by

Ybar =

Ybar is the

full employment means

long run aggregate supply curve:

an increase in M:

Back 8

factor supplies and technology

F(Kbar, Lbar)

full employment/natural level of output, at which the economy's resources are fully employed

that unemployment equals its natural rate (>0)

vertical line --> Ybar does not depend on P

--> axis are Y in the x and P in the Y

raises the price level but leaves output the same

Front 9

Aggregate supply in the short run

all prices are

firms are willing to sell

SRAS curve is

an increase in aggregate demand (M, example)

Back 9

sticky - stuck at a predetermined level in the SR

as much at that price level as customers will buy

horizontal: P fixed, firms will sell at demand level

causes output to rise but price level is constant

Front 10

In the short run equilibrium if

Y > Ybar, then overtime P will

Y < Ybar, then over time P will

Y = Y bar, then over time P will

--> the adjustment of prices is what moves

if M increases,

Back 10

increase

fall

remain constant

the economy to its long run equilibrium

the demand curve shifts right, and in the short run output increases, but in the long run price increases on AD2 until it gets to LRAS (vertical)

Front 11

shocks:

exogenous decrease in velocity:

negative demand shock:

Back 11

exogenous changes in aggregate supply or demand, which temporarily push the economy away from full employment

fewer people use their money for transactions, so there is a decrease in demand for g&s

shifts AD to the left, causing output to decrease in the SR, but in the LR price decreases along AD2 until it gets to LRAS (vertical) at Ybar

Front 12

A supply shock alters

1970s oil shock

Back 12

production costs and prices firms charge (adverse examples: bad weather, unions, regulations, good ones lower costs and prices)

shifted SRAS up, causing output and employment to fall in SR but in LR no more shocks made it so P decreased until equ. back to point A in the LR

--> increased inflation and unemployment, decreased output, before a gradual recovery

Front 13

stabilization policy:

if oil prices are shocked

Back 13

policy actions aimed at reducing the severity of short run economic fluctuations

FED raises demand by increasing M, permanently increasing P but keeping Y at full employment lvl by making AD 2 = LRAS at new price level

Front 14

Lecture 11: the IS Curve

Back 14

The IS Curve

Front 15

The IS-LM model is the basis

model focuses on ___ and assumes P is

Back 15

of the aggregate demand curve

the short run and that its fixed (SRAS horizontal)

Front 16

The Keynesian Cross model says

I =

PE =

Y =

Y- PE =

Back 16

income is determined by expenditure

planned investment

C + I + G = planned expenditure

actual expenditure

unplanned inventory investment

Front 17

Elements of the Keynesian Cross

consumption function, C =

government policy variables, G and T =

I is

Planned expenditure, PE =

equilibrium when

Back 17

C(Y - T)

Gbar and Tbar

Ibar

C(Y - Tbar) + Ibar + Gbar

Y = PE: actual expenditure = planned expenditure

Front 18

graph of planned expenditure:

graph of equilibrium condition:

graph of equilibrium value of income:

Back 18

Y (x axis meaning income/output) v PE (y axis): linear positive with MPC slope and PE = C + I + G

Y (x axis) v PE (y axis): linear positive (45 degrees) graph of Y

PE = Y when two curves intersect --> equilibrium income (Y) v planned expenditure

Front 19

If actual expenditure is greater than PE

If actual expenditure is less than than PE

An increase in government purchases (G)

Back 19

Y is too large, unplanned inventory accumulation causes income to fall to the left

Y is too small, unplanned drop in inventory causes income (output) to rise to the right

planned expenditure curve shifts up, causing output and thus income to rise to the right

Front 20

deltaC =

government purchases multiplier:

multiplier is greater than 1 because

Back 20

(MPC)(deltaY)

the increase in income from a $1 increase in G

--> ΔY/ΔG = 1 / 1- MPC --> multiplier is the amount an increase in G would increase income

ΔY=ΔG at first, but then C increases, so Y increase more, so C increase more, etc. etc.

Front 21

an increase in taxes

ΔY =

the tax multiplier definition:

the tax multiplier =

the tax multiplier is

Back 21

reduces consumption and thus PE since there is an unplanned inventory buildup, so firms reduce output and income falls

ΔC = MPC * (ΔY - ΔT) = (-MPC/1-MPC) * ΔT

the change in income resulting from a $1 increase in T

negative (reduces C and thus income), greater than 1 (multiplier effect on income) and is smaller than government spending multiplier

ΔY/ΔT = (-MPC/1-MPC)

Front 22

The IS curve is

IS curve equation is

deriving the IS curve

IS curve axis and shape

Back 22

a graph of all combinations of r and Y that result in goods market equilibrium, so when actual expenditure (output) = planned expenditure

Y = C(Y - Tbar) + I(r) + Gbar

decreasing r increases I, PE, and thus Y

Y (x) v r (y) --> negatively sloped linear curve, as r decreases, Y increases because I increases

Front 23

Shifting the IS curve with ΔG:

Shifting the IS curve with ΔT:

Back 23

increases PE which increases Y, so the IS curve shifts right because Y is higher at each value of r

--> ΔY = (1/1-MPC)(ΔG)

decreases consumption, which decreases PE, which decreases Y, which shifts IS to the left

--> ΔY = (-MPC/(1-MPC)) * ΔT

Front 24

current research

-fiscal multiplier

-multiplier during recessions

Back 24

ratio of a change in national income to the change in government spending that causes it

no evidence that its higher when unemployment is high

Front 25

The theory of liquidity preference says

the supply of real money balances:

(M/P)s (money supply) graph

the demand for real money balances:

Back 25

the interest rate is determined by money supply and money demand

is fixed at (M/P)s = Mbar / Pbar (r has no effect)

M/P (real money balances) on the x, r (interest rate) on the y, and (M/P) is vertical

(M/P)d = L(r), decreasing at a decreasing rate

Front 26

equilibrium: the interest rate (r) adjusts

Fed raises the interest rate

Quantitative easing

Back 26

to equate the supply and demand for money so that Mbar / Pbar = L(r)

by reducing M, shifting supply line to the left

FED increases M to lower r to encourage investing

Front 27

In the LM curve, money demand =

The LM curve is a graph of

The equation for the LM curve is:

Back 27

L(r, Y) --> Y back in the function

all combination of r and Y that equate the supply and demand for real money balances

Mbar / Pbar = L(r,Y)

Front 28

as output increases,

LM curve axis

LM curve derived is

LM curve is upward sloping because

Back 28

L(r,Y) shifts up to a higher interest rate (r)

are Y v r

an increasing line --> as Y increases, r increases

an increases in income raises money demand, and since the supply is fixed, there is excess demand for money so interest rates have to rise to restore equilibrium in the money market

Front 29

ΔM shifts the LM curve --> a decrease in M

an increase in cash usage

Back 29

causes interest rates to rise at the same level of output, so the LM curve shifts upward

causes the L(r,Y) curve to shift right because the market for real money balances increases, causing interest rates to go up at equal Y, so the LM curve shifts upward at each level of Y

Front 30

short run equilibrium

key assumption is that prices

studies have shown

Back 30

satisfies the equilibrium conditions in the goods and money markets --> when IS and LM intersect

---> gives the equilibrium level of income (Y) and interest rate (r)

do not change

that prices do change

Front 31

Facts about price changes

Back 31

1. price spells are 2x as long in Europe than US

2. frequency of price changes varies by product ------> (high for energy products, low for services + industrial goods)

3. differences in price changes across countries is partly related to consumption structure

4. no evidence of less price rigidity --> price decreases are not uncommon, except in services

5. price changes sizable compared to inflation

Front 32

Chapter 13: Applying IS-LM

Back 32

Chapter 13: Applying IS-LM

Front 33

The IS curve represents:

The LM curve represents:

The intersection of the two determines:

axis of the two are

Back 33

equilibrium in the goods market ( Y = C(Y - Tbar) + I(r) + Gbar )

equilibrium in the money market ( Mbar/Pbar = L(r,Y) )

unique combination of Y and r that satisfies both

Y on the x and r on the Y

Front 34

An increase in government purchases

1) IS curve shifts...

2) Which causes...

3) So investment...

Back 34

1) IS curve shifts right by 1/1-MPC * deltaG so income and output rise

2) money demand rises, so r rises

3) so investment decreases, so the final Y is smaller than (1-MPC) * delta G

--> IS Curve Shift

Front 35

A tax cut

Back 35

1) consumers save (1-MPC) of the tax cut, so the IS curve shifts by (-MPC) / (1-MPC) * deltaT

2) money demand rises so r rises

3) so investment decreases, so the final Y is smaller than (-MPC) / (1-MPC) * deltaT

--> effects on r and Y are smaller for delta T than for an equal delta G b/c consumers save some

--> IS Curve Shift

Front 36

Monetary Policy: An increase in M

Back 36

LM Curve Shift

LM curve shifts down (or to the right< so r falls to investment increases and Y rises (new intersection point on IS is father to the right)

Front 37

Congress increases G, possible FED responses

1) Hold M constant

2) Hold r constant

3) Hold Y constant

Back 37

1) Hold M constant: IS shifts right, LM doesn't shift, so Y increases to Y2 and r increases to r2

2) Hold r constant: Fed increases M to shift LM curve right so Y ends up increasing more to Y3 and r remains the same

3) Hold Y constant: To keep Y constant, FED reduces M to shift LM curve left to intersect the new IS curve at Y1, r increases to r3

Front 38

IS shocks:

LM shocks:

Back 38

exogenous changes in the demand for goods and services (stock market crash lowers C)

exogenous changes in the demand for money (the Internet reduces money demand)

Front 39

Shocks to the IS-LM Model

1) Housing Market Crash:

2) Increase in money demand

Back 39

1) IS shifts left, so r and Y fall, C is lower due to lower Y, I rises because r is lower, and u rises because Y is lower (Okun's law)

2) LM shifts left, causing r to rise and Y to fall, C falls due to lower income, I falls because r is higher, and u rises because Y is lower (Okun)

Front 40

Causes of the US recession

1)

2)

3)

Back 40

1) stock market decline --> decrease in C

2) 9/11 led to lower spending and IS shift left

3) corporate account scandals lowered I

Front 41

The Fed's policy instrument:

Back 41

The fed changes the money supply and shifts the LM curve to achieve its target --> only targets interest rates, actually changes M

Front 42

In the long run, changes in P

aggregate demand curve

Back 42

shift LM and affect Y

captures relationship between P and Y

Front 43

1) Deriving the AD curve: an increase in P

2) Monetary Policy and the AD Curve

3) Fiscal Policy and the AD Curve

Back 43

1) leads to a decrease in M/P, so LM shifts right, so r increases, I decreases, so Y decreases (Y v P, as Y increases, P decreases, negatively sloped)

2) an increase in M, LM shifts right, r decreases, I increases, so Y increases at each value of P (AD curve shifts upward)

3) (increase in G or decrease in T) increases AG because T goes down, C goes up, IS shifts right, and Y increases at each value of P

Front 44

A negative IS shock shifts

in the new short run equilibrium

Over time, P

IS and LM shocks

Back 44

IS and AD to the left, so Y falls

Y is less than Y bar

falls, so SRAS moves down and M/P increases so LM moves down until Y = Ybar

shift the AD curve

Front 45

Chapter 14:

Back 45

Aggregate Supply

Front 46

In previous chapters, P was assumed to be

two models of aggregate supply in the SR:

Back 46

stuck in the short run, so SRAS curve horizontal

sticky price model, imperfect information model

Front 47

the sticky price model and imperfect information model both imply that Y =

Y and P positively related, so

Back 47

Ybar + alpha(P - EP)

Y: aggregate output

Ybar: natural rate of output

alpha: a positive parameter

P: actual price level

EP: expected price level

SRAS curve upward sloping

Front 48

reasons for sticky prices:

individual firm's desired price p =

firms with flexible prices

firms with sticky prices

Back 48

long term contracts, menu costs, firms not wishing to constantly change prices

--> assumption is firms set their own prices

P + alpha(Y - Ybar), where a > 0

set prices to desire price as shown above

have to set price before they know P and Y so p = EP + alpha (EY - EYbar)

Front 49

in sticky price model, p =

s =

P =

Back 49

EP + alpha (EY - EYbar) = EP (assuming output = its natural rate)

fraction of firms with sticky prices

s(EP) + (1-s)(P + alpha(Y-Ybar)

-> price set by sticky price firms * s + price set by flexible firms * 1-s

Front 50

derive that P =

High EP -->

High Y -->

Back 50

EP + ((1-s)(a)/s)*(Y-Ybar)

-High P, if firms expect high prices, firms that set P in advance will set them high

-High P, high income leads to high demand, so flexible firms increase P (more flexible, larger impact)

Front 51

AS Equation for Sticky Price Model

Y =

Back 51

Y bar + a(P-EP)

where a = s/(1-s)*alpha

Front 52

imperfect information model

three assumptions:

supply of each good depends on:

at time of production decision,

If P rises but EP does not,

Back 52

1) wage and prices flexible

2) supplier produces one good, consumes many

3) supplier knows nominal price of the good she produces but not the overall price level

relative price: nominal price / overall price level

supplier does not know price level so uses EP

supplier thinks relative price rises, so she produces more, so Y will rise if P above EP

Front 53

long run average supply:

short run average supply:

axis:

Back 53

vertical line at Ybar

upward sloping curve - Y = Ybar + a(P - EP)

Y in the x and P in the Y

Front 54

a positive AD shock

Back 54

increases output (intersection of SRAS1 and AD2 at Y2) and P above expected level, but then EP rises so SRAS shifts up and output returns to its natural rate at an increased P3

Front 55

The phillips curve states that

cyclical unemployment:

phillips curve (derived from SRAS): π =

Back 55

π depends on expected inflation Eπ

the deviation of the actual rate of unemployment from the natural state

Eπ - B(u - u^n) + v, where B > 0

Front 56

SRAS says:

Phillips curve says:

Back 56

output is related to unexpected movements in price level

unemployment is related to unexpected movements in the inflation rate

Front 57

adaptive expectations:

so, phillips curve becomes: π =

inflation inertia:

Back 57

approach that assumes people form expectations of future inflation based on recent past inflation

π -1 - B(u - u^n) + v

this implies inflation has inertia, so in the absence of a shock it will remain at its current rate, as past inflation influences expectations of current inflation, which influences the wages and prices that people set

Front 58

two causes of rising and falling inflation

cost push inflation
demand pull inflation:

Back 58

inflation resulting from supply shocks --> bad shocks raise production costs so P goes up so inflation rises

inflation resulting from demand shocks --> increased demand causes unemployment to fall so inflation goes up

Front 59

graphing the phillips curve

axis:

in the short run,

so the curve is

Back 59

u in the x and pi in the y

policymakers face a tradeoff between pi and u

negatively sloped with a -B slope linearly

Front 60

shifting the phillips curve

an increase in Epi shifts

over time...

Back 60

the short run PC upward

people adjust expectations so tradeoff only holds in SR

Front 61

the sacrifice ratio:

to reduce inflation,

if sacrifice ratio is 5, to reduce inflation from 6 to 2%

Back 61

measures % of a year's real GDP that must be forgone to reduce inflation by 1%

policymakers contract aggregate demand, so unemployment rises about natural rate

GDP loss = inflation reduction * sacrifice ratio = 20 --> cost of disinflation is loss of GDP

Front 62

rational expectations:

Back 62

people base their expectations on all available information, including about current and prospective future politices

Front 63

supporters of rational expectations believe

if u = u^n and pi = Epi = 6% and the FED announces it will do whatever it needs to reduce inflation from 6% to 2%

Okun's law:

Sacrifice ratio =

Back 63

the sacrifice ratio may be very small

Epi will fall, perhaps by 4 points, so pi can fall without an increase in u

1% of unemployment = 2% of lost output

lost GDP / total disinflation, ie percentage points of GDP lost for 1% point reduced inflation

Front 64

natural rate hypothesis:

Back 64

changes in aggregate demand affect output and unemployment only int he short run, and in the long run the economy returns to the classic model described in earlier chapters

Front 65

alternative hypothesis: hysteresis:

negative shocks may

Back 65

the long lasting influence of history on variables such as the natural rate of unemployment

increase u^n, so economy may not fully recover because worker skill could decrease while unemployed and unemployed outsiders could become structurally unemployed (fd on wages)

Front 66

both sticky price and imperfect information model imply that

Phillips curve often used

Phillips curve says inflation depends on

people form expectations on inflations either

natural rate hypothesis v hysteresis

Back 66

output rises above its natural rate when price level rises about expected price level

for forecasting inflation based on unemployment

expected inflation, cyclical unemployment, and supply shocks

with adaptive expectations (inertia, looks at past) or rational expectations (look at everything)

NRS says changes in AD affect Y and employment only in SR, H says AG can have permanent effects on Y and employment

Front 67

Chapter 15: The Great Depression

Back 67

Chapter 15: The Great Depression

Front 68

three main components of macroeconomic model of fluctuations:

Choices:

types of shocks:

Back 68

agents, consumers, and firms --> all tradeoff

leisure choice, savings choice, production choice

productivity shock, labor wedge, capital wedge

Front 69

what caused great depression (and prolonged it?)

Back 69

1) monetary shocks (decline in money supply leads to decline in output.. M plummeted, but doesn't account for prolonged depression)

2) financial intermediation shocks (bank runs might account for initial decline but not for prolonged depression)

3) trade war

4) labor frictions and efficiency frictions (account for prolonged depression)