Intermed Macro Theory
Intermed Macro Theory ECN 101
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University of CalifomiaDavis TA Jason Lee ECN 101Spring 2007 Quarter Email jawleeucdavisedu Handout 7 I IS Curve Up until now we have been assuming that investment I is determined exogenously In reality investment depends on the interest rate IIr The relationship between investment and the interest rate is negative A higher interest rate implies that the cost of borrowing is higher and this would reduce the level of investment With this relationship in place we are now ready to derive the InvestmentSavings IS curve w The IS curve summarizes the relationship between the interest rate and the level of income The curve shows for any given interest rate the level of income that brings the goods market to equilibrium Figure 1 shows how we derive the IS Curve t 1 6 oquot t 103ng Suppose we start with an interest rate of r0 At that given interest rate the goods market is in equilibrium at Y 0 What happens if the interest rate suddenly decreases to r1 At a lower interest rate investment will increase This will shift the planned expenditure curve upward At the new equilibrium point output will be higher at Yr Thus a lower interest rate implies a higher output We have thus derived the IS curve FISCAL POLICIES AND THE IS CURVE 0 Any change in scal policies that increases planned expenditures will result in a rightward shift in the IS curve 0 Any change in scal policies that decreases planned expenditures will result in a leftward shift in the IS curve Figure 2 shows what happens to the IS curve when there is an increase in government expenditure Figure 2 Increase in G causes IS curve to shift to the right Vii I g I Fig 39igr Y 393 Yaw An increase in G results in an upward shift in the planned expenditure curve The new equilibrium output Y is higher at the same level of interest rate As a result the IS curve shifts to the right 11 LM Curve LM Curve The LM curve summarizes the relationship between the interest rate and the level of income The curve shows for any given interest rate the level of income that brings the money market to equilibrium We use the theory of liquidity preference to describe the money market The theory simply says that interest rates adjust to balance the supply and demand for money balances Supply of Real Money Balances gtWe assume that the supply of real money balances is fixed and does not depend on the interest rate P P M is fixed by the Federal Reserve P is fixed since we are looking only at the short run Dem and for Real Money Balances MSZW The demand for money is a function of 2 variables The interest rate and the level of income MPd LrY o MP l and r are negatively related A higher interest rate increases the opportunity cost of holding cash For example if Washington Mutual was paying 50 interest for its savings accounts you would definitely want to hold less cash in your wallet or purse and deposit more in the bank 0 MP l and Y are positively related If you are richer you would want to hold more money because you have greater expenditures rich people buy more goods and services Just ask Oprah Figure 3 shows how the supply and demand for real money balances determines the real interest rate Figure 3 Money Market Equilibrium I ll q quot 3 a Lax Once we understand how the money market equilibrium is determined we can now easily derive the LM curve DERIVING THE LM CURVE What would happen to the money market if there was a sudden increase in Y We know that an increase in Y would result in a greater demand for real money balances thus the money demand curve will shift to the right The new equilibrium will result in a higher interest rate Thus an increase in Y will lead to an increase in r Thus in the LM curve there is a positive relationship between the interest rate and the level of output See Figure 4 Figure 4 Deriving the LM Curve WV i 397 l G quot llrv M Mr Yul M1 X D 9 alt SHIFTS IN THE LM CURVE Monetary policy will cause the LM curve to shift 0 An increase in the money supply will cause the LM curve to shift to the right 0 A decrease in the money supply will cause the LM curve to shift to the left Figure 5 A Decrease in the Money Supply 035 gt Y A decrease in the money supply will shift the money supply curve to the left The resulting equilibrium interest rate is higher at r1 Note that output did not change So for any given level of output there is a higher real interest rate This is captured by the LM curve shifting to the left 111 ISLM Model EFFECT OF FISCAL AND MONETARY POLICIES ON THE ISLM MODEL How does a change in fiscal policy affect the shortrun equilibrium in an economy Example 1 A decrease in G Step 1 Draw the goods market equilibrium A decrease in Gwill cause the planned expenditure curve to shift down resulting in a decrease in equilibrium output Step 2 At any given interest rate output is lower so the IS curve shifts to the left Step 3 At the new shortrun equilibrium where LMIS the real interest rate falls and the output level falls due to the decrease in G LEW Step 4 There is one additional comment We ve seen in Step 3 that output drops because of the decrease in G There will also be an affect on the money market Recall that a lower income level will result in a decrease in the demand for real money balances If we hold money supply constant this will result in further lowering the interest rate With the lower interest rates firms will tend to invest more This increase in investment partially offsets the fall in Y that would have occurred due to the decrease in G The fall in Y is smaller in the ISLMmodel than it is in the GoodsMarketModel How does a change in the money supply affect the shortrun equilibrium Example 2 A Decrease in the Money Supply Step 1 Draw the money market equilibrium A decrease in the money supply will shift the supply curve to the left The new equilibrium interest rate will be higher Step 2 At any given level of output the interest rate is now higher so the LM curve will shift to the left Step 3 At the new shortrun equilibrium where LMIS the real interest rate increases and the output level falls due to the decrease in M aquot Step 4 Again as with scal policy changes a change in monetary policy will also have an effect on the other market the goods market in this case The higher interest rate will lower investment which will decrease planned expenditure and income Y This mechanism monetary transmission mechanism explains how monetary policy affects the income level OTHER SHOCKS TO lSLM 0 Consumer confidence or lack of confidence can affect the IS curve by affecting consumption 0 Any shock that would affect the demand for money For example retailers charging a 5 fee to customers who use credit cards would increase the demand for cash IV From ISLM to Aggregate Demand Aggregate Demand showed the relationship between the price level and the output level We can use the ISLM model to derive this relationship What would happen to the ISLM model if the price level increases Step 1 We know that price does not show up in the goods market but it does show up in the money market as MPS An increase in P will cause the supply of real money balance to get smaller shift to the left As a result the equilibrium real wage will be higher for any given level of output The LM curve will shift to the left 5 3 Q va b Y Y P 9 IA Step 2 Reintroducing the IS curve we see that a leftward shift of the LM curve will result in a higher equilibrium real interest rate and lower real output level I MK KEY CONCLUSION AN INCREASE IN THE PRICE LEVEL WILL RESULT IN A DECREASE IN OUTPUT LEVEL Hence since price and output are negatively related we have derived the AD curve If fiscal or monetary policy change and we hold the price level constant this will lead to a shift in the AD curve 0 An expansionary monetary or fiscal policy will shift the AD curve to the right 0 A contractionary monetary or fiscal policy will shift the AD curve to the left Practice Problems 1 According to the ISLM model what happens to the interest rate income consumption and investment under the following circumstances a The central bank increases money supply b The government increases government purchases c The government increases taxes 2 Consider the economy of Finland The consumption function is C 200 075Y T The investment function is I 200 7 25r G 100 T 100 The money demand function is MPd Y 100r The money supply M 1000 and the price level is 2 a Derive an equation for the IS curve b Derive an equation for the LM curve c Find the equilibrium interest rate and the equilibrium level of income d Suppose that the government purchases are raised from 100 to 150 How much does the IS curve shift What are the new equilibrium interest rate and level of income e Suppose that the money supply is raised from 1000 to 1200 How much does the LM curve shift What are the new equilibrium interest rate and level of income CHAPTER FOURTEEN Stabilization Policy macro Learning objectives In this chapter you will learn about two policy debates 1 Should policy be active or passive 2 Should policy be by rule or discretion l CHAPTER 14 Stabilization Policy slide 1 Question 1 CHAPTER 14 Stabilization Policy slide 2 US Real GDP Growth Rate1960120014 MM V W Vi Uilw WWW V l l 1960 1965 1970 u l i 1975 1980 1985 l l i 1990 1995 2000 CHAPTER 14 Stabilization Policy slide 3 Arguments for active policy Recessions cause economic hardship for millions of people The Employment Act of 1946 it is the continuing policy and responsibility of the Federal Government topromote full employment and production The model of aggregate demand and supply Chapters 913 shows how fiscal and monetary policy can respond to shocks and stabilize the economy CHAPTER 14 Stabilization Policy slide 4 Change in unemployment during recessions increase in no of peak trough unemployed persons millions July 1953 May 1954 211 Aug 1957 April 1958 227 April 1960 February 1961 121 December 1969 November 1970 201 November 1973 March 1975 358 January 1980 July 1980 168 July 1981 November 1982 408 July 1990 March 1991 167 CHAPTER 14 Stabilization Policy slide 5 Arguments against active policy 1 Long amp variable lags insi e lag the time between the shock and the policy resporse takes time to recognize shock takes time to implement policy especially fiscal policy ouEide lag tine time it takes for policy to affect economy if cmdltlorls change befcre poiieys impact is felt ti en polCy may enci Lp destabilian the economy DUWYER i stabilization Pulle siiaaa Automatic stabilizers def n ion policies that stimulate or depress the e o o n necessary without any deliberate policy change esigned to reduce the lags associated with stabilization policy x a unemployment 39nsurance a welfare mnrjzgu stabilizattnnPoliqy slim Forecasting the macroeconomy Because policies act with lags policymakers must predict future conditions Ways to generate forecasE Leading economic indicators data series that uctuam in advance ofthe econo m MaCrDeCDanelTiC models Largesscale models with e t39 s imated parameters that can ed to forecast the 2o The LEI index and Real GDP 1960s The Index of teacii g Eco70mm annual Fermmage mange source ofLEI dam M Con gure Hoard eadlng tmnonicinuiasiors ealGDP momma stabilization Policy siiaaio i o 395 sowuofLEldnm response ofendogenous variables to shocks 1 ammmam and policies pimps stabilizationpollcy gm giants stabilizationPollpy Sim The LEI index and Real GDP 1970s The LEI index and Real GDP 1980s zur g is g is g in g in g 5 o 5 e o g o g a a gas Eio g 45 Eis u an r i o 1972 ism 1975 1978 i o isoo isoa ism isoo isso source ofLEldnm M Con vwce Board momma stablltzauonPnliuy isas eaoino Ecunumlc lndlcatuls cal GDP Slldf ii The LEI index and Real GDP 1990s Enema annual Fermnl ge change issu 1992 as 1995 1995 mm zuuz source ofLEIdnm eadlrlg Ecurlumlc indicaiurs m Confmm Hoard eal GDP Mistakes Forecasting the Recession of 1982 uquot mvl ym m at v y no in mm stabilization Pnllcy in Forecasting the macroeconomy Because policies act with lags policymakers must predict future conditions The preceding slides show that the forecasts are often wrong This is one reason why some economists oppose policy activism The Lucas Critique Due m Robert Lucas won Nobel Prize in 1995 for rational expecmtionsquot Forecasting the effects of policy changes has oft been done using models estimamd with historical dam Lucas poinmd out that Such predictions would 39 e alters not be valid If the policy chang 39 nges the fundamental relationd1ips between variables 90171sz stabilizatibnpullpy gllggl goings stabilization PnllL y slidgl An example of the Lucas Critique Prediction based on past experience an increase n the m ey growth ram will reduce unemployment The Lucas Critique points out that increasing the money growth rate may raise expected in ation in which case unemployment would not necessarily fall The Jury s Out Looking at recent history does not clearly answer Question 1 It s hard to identify shocls in the data I and it s hard to tell how things would have been different had actual policies not been used mmzma stabilizaunri Pnliuy slidev militant Slablllzallnrl Policy Slidel Question 2 DUWYER1J stactlizaticn Policy sum Rules and Discretion basic concepts Policy conducted by rule Policymakers announce in advance how policy will respond in various situations and c it themselves to following through Policy conducted by discretion As events occur and circumstance hange policymakers use their judgment and apply whamver policies seem appropriate at the time Damian staultzauon Pilile sum Arg um ents for Rules 1 DistIust cf policymakers and the political process misinformed politicians politicians39 interesE sometimes not the same as the interesE of society gwrtmc staclllzatlcanllw slidezn Arguments for Rules The Time Inconsistency of Discretionary Policy def A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement stmys policymakers credibility thereby reducing effectiveness oftheir policies ovmcm staplltzatlpnpcllpy else 21 Examples of TimeInconsistent Policies To encourage investment government announces it wont tax income from can ital But once the factories ae built the govt reneges in order m raise more mx revenue comm stabilizatlcnpclw m2 Examples of TimeInconsistent Policies To reduce expected in ation the Centr a unces itwill tighten monetary policy m cut inmrSt rams momma staclltzaucnPnlluy 5W5 Examples of TimeInconsistent Policies Aid m poor countTies is oontingent on scal reforms The reforms dont oocur but aid is 39 y becaise the donor countries citizens m starve Darrin stabilization Pulle slide24 Modeling TimeInconsistent Policies Central Bark mli llmlzes Lu n u ynz n u w a 17 r see appenle il39 WW5 we Optimal discretion Optimal rule better lxt u u moran stabilizatan Pulle was Monetary Policy Rules a Constant money supply growth rate advocated by Monetarists stabilizes aggregate demand only if Monetary Policy Rules a Gonsmnt money supply gowth rate b Targ t gowth rate of nominal GDP ey velocity is stable whenever nominal GDP grows slower than mrgeted decrease money grow when nominal GDP growth exceeds mrget Quinn stabilization Pmle WE mmm Stablllzgimrl Policy 5mg Monetary Policy Rules a Consmnt money supply growth rate b Target growth rate of nominal GDP c Target the inflation rate automatically reduce money growth enever 39n ation rises above the target ra Many countTies central banks now practice inflation targeting but allow themselves a little discretion Monetary Policy Rules a Gonsmnt money supply gowth rate b Target gowth rate of nominal GDP c Target the inflation rate d The Taylor Rule Target Federal Funds rate based on inflation ra e gap between actual amp fullaemployment GDP momma StablllzatlnnPnllL y lldam manna stablltzauunPnlluy slaw The Taylor Rule John Taylor has proposed the following m tary poli y rule 7 i 72 2 05n 2 05v Y where nominal interest rate fed funds rate a inflation Y Y the output gap mnrrzku stabilization Pulle silage The Taylor Rule i 1r 2 05n 2 05v Y if 7 2 and output is at its natural rate monetary policy targets the real then Fed Fmds rate at 2 and the nomiral rate at 4 For each merp ointi crease in 7 mm policy is automatically tightened to raise te by 0 5 the real Fed Funds ra For each one percentage poirt that GDP alls ic t below is natural rate mm policy automat eases to reduce the Fed Funds Rate by 0 5 mmzpla stabilizatlnriPnliqy ally lidell Does Greenspan follow the Taylor Rule Percent 1587 teen was iaae iaaa znnz Quinn ldUlllqllqill Ulli slide 2 Central Bank Independence A policy rule annomced by Central Bank will work only if the announcement is credible Credibility depends in part on degree of independence of central bank mnma stabilizauoripollcy slat z In ation and Central Bank Independence i slain Newman My mum Australia W FranceNWWmden Japan Belgian may Unlined 573129 gizzs am many gamma stabilization Policy Slideglh Chapter summary 1 Advocams of active policy believe frequentshocksle m udu ti 39 eve the long amp variable lags associamd with monetary and scal policy render them 39neffective and possibly destabilizing heptpolicy 39ncreases volatility in output employment DUWYER1A Stabllllaunrl PDllEy Sims CHAPTER EIGHT Economic Growth macro Introduction In the Solow model of Chapter 7 the production technology is held constant income per capita is constant in the steady state Neither point is true in the real world 19292001 US real GDP per person grew by a factor of 48 or 22 per year examples of technological progress abound see next slide CHAPTER 8 Economic Growth ll slide 2 Learning objectives I Technological progress in the Solow model I Policies to promote growth I Growth empirics Confronting the theory with facts I Endogenous growth Two simple models in which the rate of technological progress is endogenous CHAPTER 8 Economic Growth 5mm Examples of technological progress I 1970 50000 computers in the world 2000 51 of US households have 1 or more computers I The real price of computer power has fallen an average of 30 per year over the past three decades I The average car built in 1996 contained more computer processing power than the first lunar landing craft in 1969 I Modems are 22 times faster today than two decades ago I Since 1980 semiconductor usage per unit of GDP has increased by a factor of 3500 I 1981 213 computers connected to the Internet 2000 60 million computers connected to the Internet Tech progress in the Solow model I A new variable E labor efficiency I Assume Technological progress is laboraugmenting it increases labor ef ciency at the exogenous rate g AEEg CHAPTER 8 Economic Growth N Slide 4 CHAPTER 8 Economic Growth slide 3 Tech progress in the Solow model I We now write the production function as Y FK L x E I where L x E the number of effective workers Hence increases in labor ef ciency have the same effect on output as increases in the labor force CHAPTER 8 Economic Growth slides Tech progress in the Solow model Notation y LE output per effective worker a capital per effective worker lower case means per effective workerquot as Rlt rti Production function per effective worker Y k Saving and investment per effective worker y c s k i cHArrER a Ecqngmipgiowtti ll led Tech progress in the Solow model is n gk brealceven investment the amount of investment necessary to keep k constant ConsisE of 5k m replace depreciating capiml nk to provide capital for new workers gk to provide capiml for the new effective workers creamd by technological progress gamma Ecqnp pQIlel siren Tech progress in the Solow model 6ngk sfk k Capllal per worker k i anew ER Soto SteadyState Growth Rates in the Solow Model with Tech Progress Varlable Symbol 323ng gfafg CtS VEworker k KLXE J 0 gii i ewoker V W 3 0 Lutputpl oki YLygtltE g Total output Y y gtltE gtltL n g more Economiggigwth ll slidtB The Golden Rule To find the bldel39i express 6 in terms Rule capital stock of k c e r ma a n gllt c is maximized when MDK 5 n g or e lvalel39itl I comma Economiseiowlhll Policies to promote growth Four policy questions 1 Are we saving enough Too mud1 2 what policies might change the saving rate 3 How should we allocate our investment e en privately owned physical capital public infrastructure and human capital 4 what policies might encourage faster technological progress some Ecunumlc Gmwth ll i eta M 1 Evaluating the Rate of Saving 1 Evaluating the Rate of Saving Use tre blden Rule to determine wnetiner To estimate MPK e a we u our saving rate and capital stock are too high three fac about the us economy too iow or about rignt 1 k 25 y 39 To do this we need to compare The capiml smdlt is about 25 times one Mikes to n 9 ear sGDP IfMDK76gtn gtinenweare beiowtine k 01 blden Rule steadv state and snouid increase 5 About 10 of GDP is used to replace it Mike 5 lt n 9 w are above tine depreciat39ng capital blden Rule steadv state and snouid reduce s 3 MPKX k 03 y Capital 39ncome is about 30 of GDP coma 3 Economic Gluwlh ii 51412 EHAFYERE Economic Gruwm ii lide 1 Evaluating the Rate of Saving 1 Evaluating the Rate of Saving 1k25y 1k25y 2 ak01y 2 6k01y 3MPKXk03y 3MPKXk 03y To determine MPKdivide 3 by 1 K 0325 012 To determine Jdivide 2 by 1 is 01 25 004 4 Hence MPKe is 012 e 004 008 cwrsno Economic Growth ii aims enema o Economiceiown ii sim 1 Evaluating the Rate of Saving 2 Policies to increase the saving rate I From the last Slide MPK r E O 08 e uce tne government budget deficit u S reai GDP grows an average of 3vear rDlUS so n g 0 03 R d or increase tine budget su increase incentives for private saving reduce capitai gains tax corporate income estate tax as tnev discourage saving n Thus in the u s MPKr i repiace federal income tax wit a is 008gt003ng Cmclusion consumption tax Me U s is DeUw ine Guideri Rue sieedv sieie expand av incentives for inns individuai irwe increase our saving reie we wiii nave resier retirement accounts and other retirement growin uniii we gei in a new sieedv sieie wiin savings accoune nigner consumpiion per capila DHAWERE Economic Growin ii slidz17 cwrsno Economic Growin ii Sums 3 Allocating the economy s investment in the Solow model there39s one type of capital in the real world there are many which types we can divide into three categories 7 human capital the knowledge and skills that Workers acquire through education How should we allocate investment among these types cameo a Ecnnnmlc Gluwlh ll also Allocating the economy39s investment two Viewpoints 1 Equalize tax treatment of all types of capital in all industries then let the marketallocate investment to the type with the highest marginal product 2 Industrial policy Govt should actively nc urage investment in capital of certain types or h certain industries because they may ha e positive externdltles bvrproducE that private investors don t consider EHAFIERE Economic Growth ll lldeig Possible problems with industrial policy Does the govt have the ability m pick w39nnersquot choose industries with the highest return m capiml or biggest exmrnalities Would politics eg campaign contributions rather than economics influence which industries get preferential treatment 4 Encouraging technological progress Patent laws encourage innovation by granting temporary monopolies to inventors of new products Tax incentives for RampD GranE to fund basic research at universities Industrial policy e courage snecific industries that are key for rapid tec rogress subject to the concerns on the precedrng Slde WHERE EepnumlEGlWH slldgm cwrm Economiociowthii may CASE STUDV E I r 7 The Productivity Slowdown XP 33973 IONS Measu mrrzoo Economic Growth ll Sum rementprobems increases in productivity not fully measured 7 u y would measurement problems be worse after 1972 than before oil prices Oil shocks occurred about when productivity slowdown began 7 Eu en why didn39t productwity speed up when oil prices fell in the midetgsosv cHArrERS Ecunumchluwlhll slldzz Explanations The bottom line Worker quality 19705 large influx of new entranE inm labor force baby boomers women New workers are less productive than experienced workers The depletion ofideas Perhaps the slow growth of 19721995 is normal and the true anomaly was the rapid growth from 194871972 9W9 E 9 W3 A new i 55 E ism i CASE STUDV CASE STUDV T and the new economyquot T and the new economyquot Apparenth the computer revolution dlch39t affect aggregate productith until the mid1990s Two reasons 1 Computer lndustrv39s share of GDP much bigger in late 1990s than earlier 2 Takes time for firms to determine how to utilize new technologv most effectivelv The big questions will the growth spurt of the late 1990s cmtlnue Will I I remain an ergine of gowlh ewws Ea slid 3 Emma Gl wm ll tsiim Growth empirics Confronting the come ence plollllnlodel M n rg SoiOW modelS Steam State embitg Solow model predicts that other things equal balanced growth a many variables grow Door countle Wllh lOWef VA and KA J awe Same rate should grow faster than rich mes Solow model predicts m and KL grow at If true then the income gap between rich amp same rate 9 so that KY should be constant poor countries would Shflnk over time and Thls is true ln the real World Wm Standade converge Solw model Drede real wage gowa at same In real world manv poor countries do NOT fate 65 YA whlle real rental Ulce l5 cm tant grow faster than rich ones Does this mean Also true in the real world the Solow model fails7 I momma Economiceiowthii gm I DHAVJERE Economisatuwthll swam Convergence No because other things aren39t eoual n samples of countries with similar Savings Qgc pop growth rates income gaps shrink about 2ye in larger samples if one controls in saving popu ation grow a incomes converge by about 2year What the Solow model reamDredlcm is conditional convergence 7 countries co rwerge to their own steady states which are determined bysaving population growth and d cai n And this prediction comes tru EHAFTERB Economiceiuwlhll ar for differences human capital e in the reai Worid SW tn Factor accumulation vs Production ef ncy Two reasons why income per capita are lower in some countIies than others 1 Differences in capital physical or human per wor 2 Differences in the efficiency of production the height of the productlm function leS both factors are important countries with higher capital pnys or human per Worker also tend to have higher production efficiency cwtzva EEUaniE Gmwtli ll ildeCH Endogenous Growth Theory I Solow model39 7 sustained growth in living standards is due to tech progress 7 the rate of tech progress is exogenous Endogenous growth set o els productivity and living standards is endogenous QHAVYERE Economitemwmll theory in which the growth rate of sildgC i A basic model Production function K where A is e amount of output for each unit of capiml A is exogenous amp constant Key difference between this model amp Solow M i constant here diminishes in Solow Investment sv Depreciation 5K Equation of motion for mtal capital K sv 5 were Economic Gluwth ll rilde34 A basic model AK sv 7 6K Divide through by K and use if AKget AKK 5A 7 a If 5A gt is then income will grow forever and investment is the engine of growthquot Here the permanent growth rate depends ot on s In Solow model it does n HAWERS Economic Gmwihii aiitsss Does capital have diminishing returns or not es if quotcapitalquot is narrowly defined plant amp equipment s not with a broad de nition of Iquot physical amp human capiml dge emap cap iba knowle Some economisE believe that knowledge exhibits increasing returns simmers Economic Gluwth ll sites A twosector model 39 Two sectors 7 manufacturing tirms produce goods 7 research universities produce knwiedge that increases labor etticiencv in manctacturing u fraction of labor 39n research u is exogenous IMfg prod func v pm 11 39Res prod func AE guE Cap accumulation AK sY 7 8K comer e Ecnnnmlc Gluwlh it may A twosector model In the steady state mfg output per worker and the smndard of living grow at rate AEE gu Key variables 5 affects the eve of income but not lE rowth rate a as in Solow model Ll affects evet growth rate of income Question Would an increase in u be unambiguously good for the economy EHAFYERE Economic Growth ll lldeCE Three facts about RampD in the real world 1 Much research is done bv tirms seexing DroflE 2 Firms profit from research because n nven ented creating a stream mmo l protits until the patent ex ires there is an advantage to being the tirst fll m on the market with a new product 3 innovation produces externalities that reduce the cost of subsequent innovation 6 3 8 3 U I Much of the new endogenous growth theory attempts to hcorporate these facts into models to better mderstand tech progress QHAVYER a Ecpnemireiowth ll side Is the private sector doing enough RampD The existence of positive externalities in the creation of knowledge ilgge that the private sector is not doing enough RampD But there is much duplication of RampD effort among oompeting firms Estimams The social return to RampD is at least 40 per year Thus many believe govt should encourage RampD were Economic Gluvvth ll almam Chapter summary 1 Kev results from Solow model with tech progress steadv state growth rate of income per person depends solelv on the exogenous rate of tech progress the u s has much less capital than the Golden Rule steadv state 2 Wavs to increase the saving rate increase public saving reduce budget deticit tax incentives for private saving more Economic Ginwlh ll My Chapter summary 3 productivitv slowdown amp new economv arlv 0s Dl OCLlctlvltv growth fell in the u s and other countries Mid 1990s Dl OCLlctlvltV growth increased probablv because of advances in 1 T 4 Empirical studies ow model explains balanced growth conditional convergence Crooscountrv variation in living standards due to ditterences in cap accumulation and in production etticiencv chArTERS Economicciewthll sllda E CHAPTER EIGHTEEN Money Supply and Money Demand macro Banks role in the money supply The money supply equals currency plus demand checking account deposits M C D Since the money supply includes demand deposits the banking system plays an important role CHAPTER 18 Money Supply and Money Demand slide SCENARIO 1 No Banks With no banks D 0 and M C 1000 CHAPTER 18 Money Supply and Money Demand slide 4 Chapter objectives Money supply how the banking system creates money three ways the Fed can control the money supply why the Fed can t control it precisely Theories of money demand a portfolio theory a transactions theory the BaumolTobin model CHAPTER 18 Money Supply and Money Demand 5mm A few preliminaries Reserves R the portion of deposits that banks have not lent To a bank liabilities include deposits assets include reserves and outstanding loans 100percentreserve banking a system in which banks hold all deposits as reserves Fractionalreserve banking a system in which banks hold a fraction of their deposits as reserves CHAPTER 18 Money Supply and Money Demand slide 3 SCENARIO 2 100 Percent Reserve Banking Initially c 1000 D 0 M 1000 I Now suppose households deposit the 1000 at Firstbank FIRSTBANKS I After the deposit c 0 balance sheet I I I D 1000 Assets L1ab111t1es M 1000 reserves 1000 dep0s1ts 1000 100 Reserve Banking has no impact on size of money supply CHAPTER 18 Money Supply and Money Demand slide5 SCENARIO 3 FractionalReserve Banking suppose banks hoId 20 ofdeposIB In reserye maKIrIg Ioans wIth the rest FIrstbarIK wIII make 500 In Ioans The money suppIy no FIRSTBAN39K S w equaIs 1500 balance sheet The deposItor suII Assets Liabilities has 31000 In deposits 1000 demand depomr bu now the borrower hoIds 800 In currency came 15 Munay Sunpty and MuneyDamand WE SCENARIO 3 FractionalReserve Banking Thus In a fracton eserye bankmg system banks Create money The money suppIy w equaIs FIRSTBANK S no 31m Wm Sheet The depostor suH Assets Liabilities has 31000 W reserves 200 deposits 1000 demand deDOSIB can 800 but now the borrower hoIds 800 In currency hAVIERIa MoneySupnIyanaMuneypemand SW SCENARIO 3 FractionalReserve Banking suppose the borrower depOSIB the 500 In Secondbank InIuaIIy Seoondbank s baIance sheet Is SECONDBAN39K S Butmen Secmdbank wIII balance sheet Ioan 50 of thIs Assets I anbxlmes deposIt deposits 800 and IE baIanoe sheethII Iook IIke unIs cwrema Money uppiy and Money Demand SIM SCENARIO 3 FractionalReserve Banking if thIs 540 Is eyentuaIIy deposIted In ThIrdbanK then ThIrdbanK wIII Keep 20 of It In reserye and ban the rest out HIRDBANK I S ancesheet Assets Liabilities deposits 640 cwren 1E Muney suanyanu quey Daman We Finding the total amount of money OngInaI deposIt 1000 other Ien ng TotaI money SLDDW 1rrX10w where rr tIo ot reseryes to deposIts In our exampie rr O 2 50 M 3130 Money creation in the banking system A tractIonaI reserye bankIng system creates money but It doesn t create weaith bark Ioans ege borrowers some new money and an equaI amount ot new oebt onerren 1E MuneySuppIyanaMuney Demand SIM cwren 1E Muney SuppIy and Muney Demand mm A model of the money supply exogenous variables the monetary base 5 c R Contro edby the sambabank the reservesdeposit ratio rr RD de as on regulatrpns amp bank polcles the currencysdeposit ratio cr CD depends on househpcs preferences EHAFTER is 9952 Solving for the money supply Definitions M C D B C R Hence MB c DjC 2 MB 60 1CD RD MB cr 1cr rr r PWLEE 13 me ya The money multiplier M mB Where m cr 1cr rr If we do not have 100 reserve banking noe rn gt 1 If monemry base changes by AB then AM rn x AB rn is called the moneymultiplier s c slam Exercise MmB Where mcr1crrr Suppose households declde to hold more of thelr money as currency and less n the form of demand deposlts 1 Determlne lmpact on money supply 2 Expialn the intuition for your result EgArrzg rs slat 5 Solution to exercise Impact of an lncrease ln the currencyndepoclt ratlo Acr gt o 1 An lncrease ln cr lncreases the denomlnator of m proportlonaiiy more than the numerator So In falls causlng M to all too 2 If households deposlt less of ther money then banks can39t make s an o ns so the banklng system Won t be able to create as much money cumin ls Maney Supply andMuney Demand 5W Three instruments of monetary policy mama may Supplyandmuneyvsmauu cw Open market operations denmtbn e purchase or sate ot gmemment bonds bv the Federai Reserve how rt works It Fed buvs bonds trom the pubic rt pavs wrth new dottans rncreasrng 5 and theretore M EWTE39E E eves 1e Reserve requirements de ton Fed reguiattons that redure banks to hotd a mrnrmum reserverdeposrt ratro how rt works Reserve requiremenE attect rr and me It Fed reduces reserve requiremenm then barks can ma e more bans and reate more monev trom each deposrt r 5W1 were The discount rate defrmtbn The rnterest rate that the Fed charges on ioans rt makes to banks how rt works en barks borrow trom the Fed ther reserves rncrease aiiowtng them to make more toans and create mo onev m m m can hcrease 5 bv icwertng the drscount rate to rnduce banks to borrow more reserves trom the Fed c c Shdtm Which instrument is used most often Open market operations Most frequentiy used changes tn reserve redurremenm Least treduenttv used changes h the drscount rater Largetv svmbotrc d is a iender of iast resort does not usuaHv make ioans to banks on demand EgArrzg 15 rshddh Why the Fed can39t precisely control M M mB Where m Cr 1cr rr Househoids can change cr causrng m and M to change Banks otten hotd excess reserves reserves above the reserve redurrement 1t banks c ange ther ekcess reserves th rr m and M change I camera MnneisuppixzandMunegDemand My CASE STUDY Bank failures in the 1930s From 1929 to 1933 Over 9000 banks closed Money supply fell 28 camera Murray SuppigandMungyDemand cam Table 181 The Money Supply and its Table 181 The Money Supply and its Determinants 1929 and 1933 Determinants 1929 and 1933 Augusz1929 March1933 August 1929 March 1933 Money Supply 265 190 Money Supply 265 190 Currency 39 55 Currency 39 55 Demand dcposrrs 225 13 5 Demand deposits 22 5 135 Monetary Base 71 84 Monetary Base 71 84 Currency 3 9 5 5 Cu ency 3 9 s s eserves 32 29 Res rves 32 29 Money Multiplier 37 23 Money Multiplier 37 23 Reserveideposmrario 014 021 Reserverdeposmrano 014 021 Currencyideposlt ratio 017 o 41 Currencyideposlr ratio 017 o 41 lcr rose due to loss of confidence in banks rr rose because banks became more cautious increased excess reserves cHAPTER1a Money Supply and Money Demand 5W Z4 CHAPTER1B Money Supply and Money Demand Siydazs Table 18139 The Money Supply and its 9 Determinants 1929 and 1933 COUId quot5 happen aga39n 39 Augusr1929 Marzh1933 M quotEY5 PP39Y 26395 1 I Many policies have been implemented Currency 39 35 h 1930 t t h Demand dcposrrs 225 13 5 S39l cet e 5 Preve suc Mmnary gm 71 34 Widespread bank failures Currency 3 9 5 5 MW 3 29 I Example Federal DepOSIt Insurance E Money Multiplier 37 23 to prevent bank runs and large swings in Raserveideposmrario 014 021 the currencydeposit ratio Currencyideposlt ratio 017 041 The rise in or and rr reduced the money multiplier cHAPTER1a Money Supply and Money Demand w E CHAPTER1B Money Supply and Money Demand W327 Money Demand A simple portfolio theory Two types of theories Portfolio theories MPd Lrs rb 11 W emphasize store of value function relevant for M2 M3 Where not relevant for M1 As a store of value quot5 eXPeCted real return 0 StOCkS M1 is dominated by other assets rh expected real return on bonds Transactions theories 72 expected inflation rea return on money emphasize medium of exchange function W wealth also relevant for M1 Note LiY is a simplification of this theory Yisa proxyfor W and 39 IF I rh cHAPTER1a Money Supply and Money Demand 5m 23 r CHAPTER1B Money Supply and Money Demand swam The BaumolTobin Model A transactime theory of money demand I Nota ion totai Spending gone g nterest rate in Saving costofa trip to the b gifatriptake51 ank 5 minutes msumers Wage 12hour then F 3 makes t and the ramaiiv Wer tne year 5 accomt Money holdings over the year Money noigi ngs v Average V 2 1 me merge 15 MunsySugpiyandMuneyDamand SIM enema 1e MuneySuppiyane Muney Damand gram Money holdings over the year Money holdings over the year Money Money noigings noigings V V v2 12 1 Time 13 23 1 WW QHgWEme Mpn y qppiygndMuney emanii mm enema 1a MuneysunpiyanuMeney Demand may The cost of holding money Finding the costminimizing N In general average money hold39ngs YZN 0m 39Foregone int est 39xYZN Cost of N trips m bank Fx Thus Total Cost iv2N FN Given v i and F conilmer dwoses N m minimize mtai cost were MuneySupprandMunestmand iFuiegune mieresi MN 7051 DHHpS m iTuiai cus1 new mrrza e Muney Suppiitand Muney Demand sneeze Finding the costminimizing N Total Cost iY 2N FN Take the derivative of toml cost with respect N then set it equal to zero 0 7iY2NZ F Solve for the costrminimizing m m ViY 2F cmwrzk 11 was The money demand function Cost minimizing m ViY 2F To obtain the money demand function plug m Into the expression for average ings Average money holdings YZN xYF 2i Money demand depends positively on v md F and negahvely on i CW KPAI r 4 t slim The money demand function The BaumoirTobln money demand tunction YF 2i How the B T money demand fmc dittens trom the mmey demand tunc trom prevlous chapters B T shows how F attecn mmey demand VT implies that the ncome elasticity ot mmey demand 0 5 interest rate elasticity of money demand 70 5 cxnmgxn A nu MnneyDamanu XE RCI s E The impact of ATMs on money demand Bur39ng the 19805 automatic teller mad1ines became widely available How do you think this affecmd m and money demand Explain grime gunmen chasm Financial Innovation Near Money and the Demise of the Monetary Aggregates Examples of financial innovation mutual funds are baskes of stocks that are easy to redeem 7 just write a check onrmonebary asses having some of the liquidity of money are called near money Money amp near money are close substitutes and switching from one to the other is easy cwwrzku Muney supply and Money Demand my Financial Innovation Near Money and the Demise of the Monetary Aggregates The rise otnear mone makes money demand less stable md complicams monetary policy 1993 the Fed switd1ed from tageting monetary aggregates m targeting the Federal Funds rate 11139s change may help explain why the us economy was so stable during the rest otth 905 CNAPIERH Money Supply and Murray Demand an 41 University of CalifomiaDavis TA Jason Lee ECN lOlIntermediate Macro Email jawleeucdavisedu Handout 8 1 Aggregate Demand AD Curve So far in our model we have shown that monetary policy is determined exogenously by the Federal Reserve In other words we have said that the Fed chooses some interest rate arbitrarily and that rate of interest determines shortrun output In actuality the Federal Reserve does not choose interest rates haphazardly but rather the rate it chooses depends usually on the level of current in ation in the economy A monetary policy rule is a rule that tells the Fed what monetary policy rule to pursue for a given economic situation Generally we can make the following statement regarding monetary policy rules 0 The Fed does not like in ation Ifthe level of current in ation is high the Federal Reserve will pursue a tigh monetary policy by raising the interest rate Conversely when the in ation level falls below a target level the Fed will pursue a loose monetary policy and lower the interest rate in order to stimulate the economy 0 We can capture the above monetary policy rule by the following equation 0 R2 f 7rt 7 The Fed has some target interest rate 77 that it expects If the current in ation 7239 exceeds the target interest rate the Fed will raise Rt Ifthe current in ation falls below the target interest rate R must fall to hold the equation The parameter W simply measures how aggressive the Federal Reserve is in ghting in ation Deriving the AD Curve We know that IS curve can be expressed as I 5 RR f We also know the monetary policy rule is R 17 W05 7 Substitute the monetary policy rule into the IS curve to get the equation for the AD curve IQ 54ng 77 Figure 1 shows how the AD curve looks graphically Note that shortrun output is on the horizontal axis while current in ation is on the vertical axis The relationship is negative Looking at the equation for the AD curve you can see that a higher level of current in ation will increase the second term which will reduce shortrun output I The same logic can be applied to a low level of current in ation Figure 1 Recall that we assume that the economy m in rm starts at longrun output so E 0 and E 0 In that case current in ation would have to be 77 according to the equation for the AD curve n mumpmmnacmv23Eamz What s the economic intuition behind the AD curve Assume that current in ation is higher than the target level in ation The Federal Reserve loathing in ation will adopt their tight monetary policy and raise interest rates Higher interest rates as we have seen in earlier chapters reduces investment and hence reduces output Thus high levels of in ation will reduce shortrun output by this reasoning Moving along the AD vs Shifts in the AD Curve 0 Movement along the AD Curve Changes in the in ation rate will cause movement along the AD curve Higher in ation rates will move up along the curve while lower in ation rates will move down along the curve Shifts in the AD Curve Demand shocks will cause a shift in the AD curve Anything that would have caused the IS curve to have shifted will shift the AD curve in the same direction For example we saw how a fall in consumer con dence will shift the AD curve to the le Another factor that will shi D curve is a change in the target in ation 77 If for some reason the target in ation were to be raised this would have the effect of shi ing the AD curve to the right 11 Aggregate Sung Curve Here things are simple The aggregate supply curve is a slightly rewritten Phillips Curve Recall that in Chapter 11 the Phillips Curve was written as A7 GE 6 Where A7 m 7 TLH Plugging in the de nition of A7 to the Phillips Curve we get 7rZ 7 7rH GE Bwhich we can rewrite to get our formula for the AS Curve Figure 2 mmquot n w mm mAumlnuyplymmx n pmquot r The economic intuition as to why the AS curve slopes upward is that as shortrun output exceeds potential output rms struggle to meet demand Firms must run their factories 247 and pay workers more in overtime hours They pass on these costs in the form of higher prices and hence in ation increases III Puttin It All To ether ASAD Model Now that we have nally all the pieces of our shortrun model we can combine the AS and AD curves together Figure 3 shows the ASAD framework Figure 3 The steadystate or longrun Mmquot equilibrium will be where the AS and AD curves intersect We will always assume the economy starts at this point At that point shortrun output is 0 and the in ation rate is the target interest rate an a 0mm 9 s mmrnmma Now that we have the framework in place let s do several examples to see how we use the ASAD model for analysis Example 1 Decline in Oil Prices Step 1 Start at longrun equilibrium We always start where the AS and AD curve intersects At that point we are at potential output E 0 and TL 77 In Figure 4 this is point A Step 2 Identify whether the AS or AD curve will shift A decline in oil prices is a decline in the cost of a major input for many rms Costs will be lower for rms at any production level We would expect rms to pass some of these cost savings to consumers in the form of lower prices Thus at any given level of shortrun output in ation will be lower The AS curve will therefore shift outward to the right Generally the only reason why the AS curve would shift would be either a change in expected in ation 7111 or an in ation shock 6 Step 3 Find the new sh01t run equilibrium Find where the new AS curve intersects the AD curve This is point B Note that at this new shortrun equilibrium shortrun output is higher while in ation is lower than initial levels Step 4 Explain what happens during transition and nd the new long run equilibrium The transition phase is a little tricky to explain conceptually If you have dif cultly understanding the concept please see the alternative explanation below for a more intuitive explanation As we saw in step 2 the economy experiences a negative price shock causing the shift downward of the AS curve until we reach a new shortrun equilibrium point B At that new shortrun equilibrium we have a lower in ation rate 72391 The next year we assume that the in ationprice shock is over and 6 returns to 0 Does the AS curve return immediately to its former position Although 6 returns to 0 we do not return to the original AS curve because expected in ation is now lower Recall that expected in ation is just in ation observed last period But during the last period in ation had fell to 72391 this would cause the AS curve to be lower than it normally would if in ation had not changed AS in Figure 4a The new equilibrium will be where the new AS curve intersects AD curve point C Note that at point C equilibrium in ation 72392 is still below the initial in ation and output is still below potential The following year the same thing will occur Expected in ation is now at 72392 which is still lower than intial The AS curve will be lower than it would normally be AS3 and we ll have a new equilibrium level of in ation and output Point D This process will continue until our expected in ation once again returns to our orignal target in ation rate At that point shortrun output will return back to its potential long run level Figure 4A TI Step 4 Alternative Economic Intuition In this alternative explanation of the transition from the shortrim to the longrim the curves move in the same direction as above Under this line of reasoning the economy cannot remain at this higher shortrim output in the longrim and must return eventually back to potential output What is the economic rationale behind this transition What occurs is that when shortrim output increases to I71 rms nd they must run their factories longer and keep their workers working more hours in order to meet higher demand This increases the input costs for rms and thus they have to raise their prices to re ect their higher production costs This is equivalent to shi ing the AS curve upward to the le This is a gradual process since prices are sticky in the shortrim The AS curve is gradually shi ing to the left The IS curve will stop shifting once we are back at potential output point A Note that the economy will always return to potential output and we return to where we started initially in terms of in ation and shortrim output However the economy did experience a boom temporarily Figure 4B shows the above scenario graphically IMSR A gtB nutB A Example 2 The Fed raises the target in ation rate Step 1 Start at longrun equilibrium This is Point A Step 2 Identify whether the AS or AD curve will shift If the Fed changes increases the target in ation rate the only tool they have at their disposal is monetary policy The Fed will adopt a loose monetary policy lower the Fed Fund rate in order to boost output and hence increase in ation The monetary policy curve will shift down A downward shift in the monetary policy curve will shift the AD curve to the right At this point it might be useful to summarize under what scenarios the AD curve might shi t AD curve will shift to the right if 1 There are positive demand shocks These are shocks that would shift the IS curve to the right 2 Loose monetary policy by the Fed The Fed adopts a loose monetary policy when they are trying to lower interest rates boosting output and hence raising target in ation The AD curve will shift to the left if the opposite occurs Step 3 Find the new shortrun equilibrium In this case shortrun equilibrium will be where the new AD curve intersects the AS curve Point B Step 4 Explain what happens during transition and nd the new longrun equilibrium The new shortrun equilibrium point Point B has higher in ation and higher shortrun output than the initial point A Like example 1 the economy is producing above potential output and that is putting a strain in the resources available to 39rms in meeting this high demand As a result input costs for firms slowly creep up and as they do firms pass these higher costs to their customers The AS curve will slowly