macro week 7 IS-LM-PC-WS-PS
#2 decrease in public spending in the short run and medium run what is A1 and A2
A1 initial equilibrium assume the economy is at the natural level of unemployment, interest rates and working at full speed A2 is a point we are going to have to show short run equilibrium- prices and inflation expectations are fixed. Short run adjustments are limited. Medium run expected values adjust. Its takes so long for expectations to adjust because the labour market adjusts very slowly In the medium run everything will adjust in proportion Easier to start in the top diagram as we already know what happens
what happens to the curves in A3 when public spending decreases
A3 - going to move slowly down the IS curve- reduce interest rates several times to stimulate the economy. Drop in the interest rate will increase investment which will lead to higher output which will imply that employment needs to increases wages are going to go up and so prices are going to go up and inflation is going to go up As the economy starts growing we are going to move up along the philips curve back to where we were in the beginning. A1= A3 on the philips curve Inflation back at a stable lower but now lower than it was in the beginning. Because the economy was reducing for a long time- its going to be lower than it was In equilibrium expectations are going to fully adjust WS3 is going to be on top of WS1 A1=A3 Logical conclusion: if output goes up from A2 to A3 unemployment needs to go down from A2 to A3 because you cant have more production without less unemployment.
what does an increase in z lead to?
An increase in z leads to an increase in the worker's bargaining power- workers demand higher real wages and thus to a SR increase in W/P and Unemployment...
What are the SR and MR effects of an increase in z on Y, i, P, pi, U???? Where do we start in the graphs ????
Comes in the philips and WS-PS curve so can start in either. Hard to understand whats going to happen in the short run as it is a medium run change like the change in m. A1 initial equilibrium Y=Yn U=Un change in inflation=0 A2=SR expected inflation fixed, price expectations fixed, output and unemployment change A3= expectations change and go back to natural level, inflation change=0 Un=m+z/ alpha Medium run equilibrium not going to be the same
Conclusion for short run and medium run
Conclusion In the short run: Interest rate goes down Output goes up Unemployment goes down Change of inflation became positive Prices go up Inflation up In the medium run: Interest rate goes back to where it was rn Output back to Yn Unemployment back to Un Change of inflation back to 0 Prices go up Inflation up
Conclusions?
Conclusions • Shocks or changes in policy typically have different effects in the short run and in the medium run. • In the SR, output is determined by demand and the economy can move away from the natural level of output, real interest rate and unemployment (Yn, rn and un) • In the MR, people and firms will adjust their expectations so that pt=p^e and pi t= pi ^e and hence ∆pi = 0, the output gap is zero (Y=Yn) and therefore u = un Difference between the medium and short run is expectations Conclusions • Disagreements about the effects of various policies depend on how fast you think the economy adjusts to shocks. • Movements in output around its trend are called output fluctuations (business cycles). • Economic fluctuations are the results of shocks and their dynamic effects, called the propagation mechanism. Will be periods of booms and busts- every ten years Uk there is a recession in between there is a boom. Reason economy reverts to this is the adjustment between the short run and the medium run. In the medium run the economy has to go back.
What happens in the medium run?
Expectations going to change people know that unemployment is low nad output is high so workers when they renegotiate their contracts are going to demand higher wage. Expected price level go up, expected inflation go up The impact on the economy: Atart in the bottom diagram- expected price level higher than before. Ratio equal to 1 again. So back to WS 1 again Change in Inflatio nrates drop- interest rates move back up. r3= the real interest rate. y3= to the initial level of output Economy back to the level it was at the beginning- unemployment back to the riginal level and output back ot the original level
Reason its important to study the medium
Extension: The IS-LM-PC-WS-PS Model Reason its important to study the medium is that there might be policies that are very positive in the short run but not in the long run.
Fiscal Consolidation Revisited: SR and MR effects
Fiscal Consolidation Revisited: SR and MR effects Austerity measures- at some point there has to be some kind of fiscal consolidation. To increase public saving and reduce the deficit. Can use the model to study this We saw what the impact was in the short run previously. Could be an increase in T or a decrease in G Lets use the IS-LM-PC-WS-PS model to understand the SR and MR effects of a fiscal consolidation (i.e. G↓) • Represents a contraction in Fiscal Policy in order to reduce Budget Deficit (i.e. austerity) Where do we start in the graphs ???? will depend on the case we are analysing. Have to decide in each case where do we start
describe the basics of teh IS-LM-PC-WS-PS curve
IS-LM on the top show the equilibrium in the short run- dont have to look at the supply side Bottom diagram is the WS-PS model Philips curve in the middle work as the bridge between the short run and the medium run point A1 where the economy is in equilibrium-when we are at the natural level of output then we are at the natural level of equilibrium Change in inflation =0 real interest rate= to the natural interest rate. In each diagram we are going to find A2 =Short run And A3 = the medium run in the diagrams Assumptions are in the short run output and unemployment does not need to be equal to the natural level- because peoples expectations take a while to change. In the medium run peoples expectations have adjusted- the economy will have to return to hte natural level. Will depend on the policy- if there is a change in fiscal or monetary or an oil shock the path will change The textbook does not include this model: does not give us the full picture Important to study the 3 models together so you can study the short run and medium run at the same time
The effects of an expansionary monetary policy
Imagine a central banks decides to stimulate the struggling economy by buying a large amount of bonds (increases Ms)? What are the SR and MR effects of an decrease in r on Y, i, P, pi, U???? Where do we start in the graphs ???? Ms ↑
why is there a permanent increase in the rate of inflation and level of prices?
In A1 difference between inflation and expected inflation is 0 2%-2%=0 In A2 output becomes bigger thean th e natural level and unemployment is lower than the natural level which makes prices and inflatio ngo up;. Output too high unemployment too low expected price fixed. Price goes up inflation foes up Difference between inflation and expected inflation becomes positive In A3 expectations change they are gonig to chang because output is too high an unemployment is too low. Go up until we are back in the condition that inflation is =0 The expectation has gone up. The level of inflation is now higher . permanent increase in the rate of inflation, permanent increase in the level of prices
more on expectations
In A2 unemployment is too high and output is too low Infaltion becomes negative This means that the difference between output and expected output is going to have to be bigger than 0. Expected does not change but price level is going to drop immediately. Price level is going down because price levels are going down A3 pi is going to change People notice unemployment is too high and output is too low. Firms and workers want to keep the ratio constant Pi-pi e =0 The level of inflation in period 3 is lower than it was in period 1 because expectations lag behind whats happening in the real world Mian mechanism of adjustment is through the labour market changes in wages and prices that ensure that the real wage does not change provide the adjustment that the economy needs. Contracts come for renewal once a year. WS-PS In period A1 the expected price is equal to the price In p3 will be equal to 1 aswell But in period 2 because expected price level stays the same and price leel changes WS shifts to the right Need to understand that the adjustment happens through the labour market and that adjustment is very slow.
overall what happens in the short run when public spending decreases?
In A2 we have an output gap Y<Yn, u>un we are in recession CB will lo0wer interest rates to respond to this crisis and stimulate the economy back to where it was. Unless the CB acts we wil get deflation so are forced to act. Lower the real interest rate.
What happens to the WS-PS curve when there is a decrease in public spending?
In the bottom diagram unemployment is going to move upwards In A1 expected price level over price level =1 because expected level = to actal level so ratio is =1 In A2 the expected price does not change but price 2 is going to fall . numerator the dame denominator smaller so bigger than 1 ratioWhy do prices fall? Because change in inflation is coming down. Everything else stays the same u and Z The reason the WS curve shifts is because the price is adjusting. Firms are going to lay off workers because they are producing less. This is
What is the impact of this policy in the short run?
In the short run and medium run Makes sense to start at the top Increase in money supply decreases the LM curve- new level of interest rate r2 so higher level of output y2. Stimulate the economy cost of money cheaper- economy going to expand Phillips curve Y2.yn output above the natural level then inflation pressures wil start building up inflation pressures will be positive. Firms are going to be hiring more workers- competing with other firms. Nominal wages will start increasing. Firms do not wnat to change the level of real wage. Change of inflation rate becomes positive. In the bottom diagram when output is above the natural level and price expectations are fixed in the short run- whole ratio comes down. So WS curve shifts to the left. pe1/ p2 <1. Lower level of unemployment In the short run output goes up unemployment goes down. This is because firms need to increase output. Its going to push the price of wages
how does an increase in m affect the real wage?
Increase in m is going to affect the markup and real wage because 1/1+m is going to change: whole ratio is going to become lower as the fraction will get smaller Price sweating curve move downwards New real wage thats permanently smaller New point is A3 so equilbiirum in the medium run WS3 is after all the adjustments the fraction is going to stayu the same. All adjustment through the prices- new equilbiruim on the old WS curve Permanently higher level of unemployment. Permanent change in wages
what is stagflation?
Increase in pieces increase in inflation and output goes down This is called stagflation- characteristic of oil shocks. Prices go up output goes down unusual normally This is because unemployment suffers a permanent change Dont go back to the natural level of unemployment
increase in z on the philips curve in the medium run?
Increase in z move pC curve uip to PC2 to the left going to be A3. going to lead to a permanently lower level of output WS 3 is going ot be when the expected price and prices have changed. Expected price 2/ new prices p3 will be equal to 1 New point equal ot he medium run point Increase in unemployment benefits- cost of firms go up, workers demand higher wages will move up to the new philips curve inflation higher Central bank will intervene as inflation is a concern so they increase interest rates to r2 As the interest rate goes up the economy will start moving down along the phillips curve to a lower level of output Change of inflation still positive at A2 short run so they are going to increase in the interest rates again Change in inflation still positive until inflation = 0 A3 in the phillips curve.
why does money supply increase?
Money supply increases- when the central bank decides to expand its monetary policy by buying a large amount of bonds- shift the money supply to the right- drop the interest rate
what has permanently changed now?
Output permanently lower- permanently lower investment rates. Unemployment permanently higher Prices permanently higher Inflation rate higher even though it is stable And interest rate permanently higher Argument covnservative government gave to reducing benefits nad universal credit after 2008 was to have the reverse effect of this. This was just economics perspective but there is a social aspect.
PC Relation:
PC Relation: pi- pit-1=(alpha/L) (Y-Yn) Output in the horizontal axis But we must remember that the Phillips curve can also be defined as: pit-pit-1=(m+z)-alphaut In terms of markup and z - unemployment. This was used to derive and it can look like this second equation. In the medium run m and z they are not always constant. And this expression is going to tell us what shifts the PC curve
what happens to hte philips curve in the medium run?
Philips curve going to move up In the medium run change in inflation =0 and y=yn u=un so new philips curve moves to the left and is A3 medium run
What happens in the short run:
Prices go up : oil prices permanently increase the price of the firms Because of the massive increase in prices the central bank is going to try and corntol inflation by increasing interest rates in the short run which will shift th eLM curve up in the short run. Output is going to drop= move up the IS curve to the short run equilibrium level A2 Short run needs to be between Yn and Yn2 on the philips curve. Lines up with A2 on IS-LM curve Prices at A2 inflation is still growing. Prices have started to go down but still increasing Central bank going t intervene again by increasing interest rates again Central bank will stop increasing as inflation has come down until it reaches the change in inflation = 0 as the central bank doesn't need to increase interest rates as inflation is under control In the short run because expectations do not change and prices 2 have gone up so the whole ratio is going to be smaller so the WS curve is going to shift to left. We dont know how much to the left as it doesnt matter but draw the new Ws curve such that the new intersection A2 isbetween Yn and Yn2 In the short run unemployment from Yn to Y2 then to Yn2 This happens with oil prices increase or chang ein regulation
Review: The IS-LM-PC Model
Review: The IS-LM-PC Model IS Relation: Y= C(Y-T) +I(Y, r+x) +G focus changes in taxes and public spending LM Relation: r = r straight horizontal line- defined by the central bank PC Relation: Alpha is the slope
what happens in the short run when public spending goes down to the IS-LM curve?
Short run equilibrium When public spending goes down the IS shifts to the left LM curve does not shift as it is not affected y public spending so will move along the LM curve to the left- lower level of output Y2 and the same level of interest rates This means there is going to be a recession So prices are going to decline- because the economy is shrinking, firms do not need as many workers- people losing their job- prices slowly come down. Change in inflation is going to be negative- just means inflation rate is coming down not inflation.
Some conclusions:
Some conclusions: In the short run there is some massive pain for everyone- drop in output, recession alot of people lose their jobs ut in the medium there are some benefits that might justify doing this in the first place Even though output is back at the natural level r is now permanently lower than rn so investment is going to be higher than before. More investment and less public spending. Increasing productivity potentially and innovation. Jobs created technological advancement Even though inflation is stable again- the leverl of inflation in period 3 is lower than it is in period 1. Final level stable and lower than it was in A1. Drop in public spending will reduce the public debt- it will reduce te interest payment on the public debt.it will increase public savings to be reused in investment. Protect future generations from having lots of public debt Although the policy looks like it makes little sense in the short run, in the medium run there are some important benefits to take into account. We need to look at both. Governments have to decide if it is worth not being votes . period of austerity means the public is better off.
why does catchall variable z increase?
The Effects of an Increase in Z z↑ Let's consider an increase in catch-all variable z (caused by an increase in unemployment protection - makes it higher to fire employees or rise in unemployment benefits for example)
how does an oil price shock affect m?
The Effects of an Increase in the Price of Oil A (permanent) increase in the price of oil is equivalent to an increase in the mark-up (m). This is because a permanent increase in oil prices, leads to a permanent increase in costs of production, forcing firms to increase prices to maintain the same profit rate. Markup used as a change in regulation and also oil prices. React in the same way What are the SR and MR effects of an increase in m on Y, i, P, pi, U???? Where do we start in the graphs ???? Could start in the middle diagram or the bottom diagram
why does an increase in oil price affect firms?
The Effects of an Increase in the Price of Oil Oil effects the prices of firms, the electricity price when there is a shock it effects all inds of commodities, which will increas the costs of firms dramatically. Over the last 40 years, there have been two sharp increases in the real price of oil, the first in the 1970s and the second in the 2000s.
timeline of oil price shocks:
The Effects of an Increase in the Price of Oil • 1970s: OPEC (the Organization of Petroleum Exporting Countries) act as a monopoly and increased oil prices. 2 shcoks then • 2000s: The fast growth of emerging economies led a rapid increase in world oil demand, and thus a steady increase in real oil prices.before the financial crisis • 2008: A large recession led to a sudden decrease in the demand for oil, and thus falling oil prices. • 2014 and after: A combination of increased supply due to the increase in US shale oil production and the partial breakdown of OPEC led to sudden drop in oil prices.prices have been kept down $50 per barrel down from $120 a few years back. They predict that after covid prices will jump back up
where does the unemployment rate need to be on the WS-PS curve
The equilibrium unemployment rate has to be between the two natural levels of unemployment on the WS-PS curve Hast o occur through the WS curve Prices go up but the expected price levels have not changed In the medium run an even bigger increase in unemployment Labour market plays an important role in understanding what happens Temporary increase in real wage- lead firms to fire people then another temporary increase. Prices go down- increase in unemployment rebalance the labour market Central bank only react to keeping inflation stable.
The reason the economy moves from the short run to the medium run
The reason the economy moves from the short run to the medium run is because in A2 output is higher than the new natural level of output unemployment is below the new natural level of unemployment- economy overheating. Expectation of prices and inflation go up Change of inflation becomes negative Even though in A3 inflation is stable inflation is higher in A3 than it was in A1 because prices were growing for many years- expectations were fixed- they grew very fast so increase in inflation for several years. In A3 inflation is stable at a much higher level than before. Inflation moves from a initial 2% to a stable but much higher 6% because the oil prices increase costs permanently Most of the adjustment in the medium run happens through the labour market so need to WS PS curve
The role of expectations in the MR adjustment
The role of expectations in the MR adjustment Philips curve-starts with change in inflation= 0 Z2 we have a negative chang eof inflation A3 it goes back up It happens because of expectations because businesses and workers know that output is below the natural level and unemployment is above the natural level In the short run inflation is fixed Between A2 and A3 expected price level is going to change. Because workers and firms will slowly adjust their expectations to a lower price- they know unemployment is too high and output is too low. Workers and firms are oging to negotiate a new wage. If prices come down wages also need to come down ot keep the ratio constant. Expected price level is slowly going to decline until we reach a new equilibrium In A1 inflation - expected inflation = 0 5%-5%=0
what is neutrality of money?
This is called Neutrality of money. Increasing monetary policy in the short run has some impact but in the medium run it doesnt change amy of the variables except the price level adn the inflation rate. Everything else goes back. Thats why we call monetary policy the neutral policy- doesnt affect any real variable. Is this worthwhile? Most economists would say no by itself. Problem of inflation and the economy is back to where they started. If the cb cares about level of inflation it will have to reverse this policy. Reduce interest rates above rn and have a really negative impact. Looks good in the short run. Have to look at the medium run to see the full picture Balance of short run and medium run
What shifts the PC Curve?
Upward sloping curve When output gap is positive, prices are going to go uip When output price is negative prices are going to go down When Y=Yn at its natural level the right hand side becomes 0 So change in inflation is 0 When change of inflation is 0 that is going to tell us where the unemployment at the natural level is. Does not mean inflatio nis 0 jus means its not moving.
WS- PS relation
WS relation: W/P = P^e/P F(u, z) PS Relation: W/P =1/ (1+m) The wages setting determines how wages are set: real wage =unemployment catchall variable z Price level is not equal to the future price level in the medium run Price setting relation show how prices are set in the economy
Now we need t look at this version of PC pit-pit-1=(m+z)-alphaut
When m or z increase: Right hand side becomes bigger so change inflation is going to be bigger so PC curve goes upwards and the opposite is also true. Hes going to use Notation PC (m,Z) to show what moves the philips curve.
Why are m and z special?
Why are they special? A change in either m or z will have a permanent effect on both Un and Yn such that the MR equilibrium is not the same as the initial equilibrium... Remember that: Un=m+z/ alpha The natural rate of unemployment=markup+z/alpha alpha is a constant does not change- slope of the philips curve. Fixed in the short run but in the medium change If m goes up Un goes up If z goes up then un goes up
what happens ot he rate of inflation in the short run on the philips curve?
Will go to a high point on the philips curve instantly then move down to the natural leve Even though on A3 change in unemployment is natural the inflation level is much higher at A3 than at A1. might stabilise but much higher level than it was before.prices would permanently be higher than before unless the central bank increases interest rates even more na dmake the recession even worse
why would Z change?
• Understand what happens to the Economy when the catch-all variable z changes (as a result (e.g.) of a permanent increase of the minimum wage or an increase in unemployment benefits) (this is in the next video)
when does markup change?
• Understand what happens to the Economy when the markup m changes (as a result of (e.g.) a permanent increase of collusion among firms as a result of less stringent competition laws or a permanent increase in the oil price) could be caused by collusion like cartels or an increase in the oil price