FIND A SOLUTION AT Academic Writers Bay

ECOS2002 Intermediate Macroeconomics

Week 5:

Christopher Gibbs

University of Sydney

Semester 1, 2021

Agenda

• The stylized facts of the business cycle

• Recap of the Keynesian goods market

• The IS relationship

The long and the short

Long-run model ) potential output, long-run inflation

• Solow-Swan and Romer models give potential output.

• MV = PY quantity theory of money gives long-run

inflation (∆M = π).

Short-run model ) current output, current inflation

• IS-LM (Old Keynesian)

• AD-AS (Neoclassical synthesis)

• IS-MP-PC (New Keynesian)

Recessions

Definition (Recession)

Two consecutive quarters of negative real GDP growth.

1 It is also characterized by large increases in the

unemployment rate.

Recessions

-5.0

-2.5

0.0

2.5

5.0

7.5

1960 1970 1980 1990 2000 2010

research.stlouisfed.org

Gross Domestic Product by Expenditure in Constant Prices: Total Gross

Domestic Product for Australia©

Real Gross Domestic Product

(Percent Change from Year Ago)

Recessions

9 8 7 6 5 4 3

10

11

12

1980 1985 1990 1995 2000 2005 2010 2015

research.stlouisfed.org

Civilian Unemployment Rate

Unemployment Rate: Aged 15-64: All Persons for Australia©

(Percent)

How to model short run fluctuations

The long and the short

Definition (Potential Output)

Potential output is the output of the economy when all factors

of productions are fully utilised at their long-run sustainable

trends.

• Recall we assumed L = L¯ and all available K was employed

in our growth models.

The long and the short

• Two ways to think about short-run fluctuations:

– Our textbook likes the idea of long-run trend

Yt = Y¯t + Y^t (1)

where Yt is current output, Y¯t is potential output, and Y^t is

the short run fluctuations.

– Alternative is the plucking model” or the asymmetric

model:

Yt = Y¯t – Gap (2)

The long and the short

The long and the short

Figure: Source: Garrison (1996) EI

The long and the short

• The output gap:

– Note that both of these decompositions can be thought of

as a gap between potential and actual.

output gap = Yt – Y¯t (3)

The long and the short

• How do we measure potential?

– Well in reality we can’t. But, we try:

– Past trend

– Pick a point in the past where we believe we were at

potential, then use characteristics such as labour force

participation, capacity utilization, and demographic

characteristics to infer where we are now in relation to that

time.

– This fact will be very important for policy analysis and one

reason why economists who use the same models can often

disagree on the correct course of action.

• The level of output consistent with full employment

i.e. the natural rate of unemployment.

The Short-Run

• Two short-run relationships in the data:

1. The Phillips Curve – relationship between inflation and the

output gap.

2. Okun’s law – relationship between unemployment and the

output gap.

The Short-Run

The Short-Run

The Short-Run

Figure: Australian Data: Okun’s Law

The Short-Run

The Phillips Curve is also often represented as relationship

between inflation and unemployment rather than inflation and

the output gap.

The Short-Run

Figure: Old version of the Phillips Curve: Phillips Curve is the

relationship between unemployment and inflation.

The Short-Run

Figure: Smith (2008) JMCB

The Short-Run

Figure: Smith (2008) JMCB

The Short-Run

Figure: Smith (2008) JMCB

The Short-Run

• History of the Phillips Curve

– Although, the relationship can be demonstrated as a result

of the AD/AS model. It was first noticed empirically when

analyzing inflation data for the United Kingdom in the

early 1960’s by A.W. Phillips.

– It was then independently confirmed to hold true in the

United States.

The Short-Run

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0

Unemployment

CPI Inflation

U.S. Phillips Curve 1960 – 1969

Figure: The Phillips Curve – US CPI and Unemployment 1960-1969

The Short-Run

• When this relationship was found, many economists

believed that through government policy, a specific point

on the Phillips curve could be chosen for the economy.

• However, this view proved to be shortsighted.

• The relationship hinges on expected inflation.

The Short-Run

• Milton Friedman predicted that the Phillips Curve relation

would not hold.

– The economy will always tend towards the Natural Rate of

Unemployment (NRU) and if the government attempts to

lower the level of unemployment below the natural rate by

raising inflation, they would only be successful until people

revised their expectations. Once people expected a higher

rate of inflation, the economy would move back to the NRU.

The Short-Run

Figure: Phillips Curve Relation: 1960-2008

The Short-Run

• Our goal over the remaining 7 weeks:

1 Develop a short-run model that can explain those

relationships.

2 Incorporate policy into the model.

3 Analyse the role policy can play in macroeconomic

fluctuations.

A static model of the business cycle

Outline

• We are departing from the textbook for a few lectures.

• Our goal is to develop the static model that underlies the

dynamic model of the business cycle given in the textbook.

• Once we have built the model we will connect it back to

the textbook model.

The IS/LM Model

• This model that roughly depicts the economy described

J.M. Keynes in The General Theory.

• It is a pure demand side model meaning that in its most

basic form it does not ask about supply constraints in the

economy. We will add this later.

• It was built to think about economies that are depressed.

The IS/LM Model

• Components of the IS/LM model

– Three markets

1 Goods market

2 Money market

3 Bond market

– Price level exogenous

– No supply constraints

Keynesian Cross Review

• A model of the Demand for Goods and Services – The

Demand Side

Y = C + I + G + Nx

= C + I + G + Ex – IM

Y + IM = C + I + G + Ex (4)

– Key Question: What determines GDP?

Keynesian Cross Review

• Consumption (C)

– Disposable Income (Income – Taxes = YD = Y – T)

– The consumption function

C = F(YD) (5)

• Consumption is a function of disposable income

– We assume that there is a positive relationship between

consumption and YD.

– This equation is called a Behavioral Equation

Keynesian Cross Review

• Let’s define the consumption function as a linear

relationship (Note I use a different notation then the book.

I think mine is better. The intuition is the same.)

C = C0 + C1YD (6)

C1: The marginal propensity to consume C0: Autonomous

consumption

Keynesian Cross Review

• For now lets investment, government spending, and taxes

be exogenous

– Investment: I = I¯

– Government spending: G = G¯

– Taxes: T = T¯

– Net exports: Nx = Nx ¯

• So demand for goods and services is

Demand = C0 + C1YD + I¯+ G¯ + Nx ¯

• Equilibrium Condition ) Supply = Demand

Y = C0 + C1YD + I¯+ G¯ + Nx ¯ (7)

Keynesian Cross Review

Solving For Equilibrium

Y = C0 + C1YD + I¯+ G¯ + Nx ¯ (8)

sub in for YD

Y = C0 + C1(Y – T¯) + I¯+ G¯ + Nx ¯ (9)

solve for Y

Y = C0 + C1Y – C1T¯ + I¯+ G¯ + Nx ¯

Y – C1Y = C0 – C1T¯ + I¯+ G¯ + Nx ¯

Y (1 – C1) = C0 – C1T¯ + I¯+ G¯ + Nx ¯

(10)

(11)

(12)

(13)

Y =

1

1 – C1

[C0 – C1T¯ + I¯+ G¯ + Nx ¯ ]

Keynesian Cross Review

• The Determination of GDP/Income

– The Multiplier

1-1C1

– Example: (intuition: One person’s spending is another

person’s income) If C1 = :8 i.e. if someone gives you a

dollar you spend 80 cents of it.

– That 80 cents now becomes another person’s income

– They in turn spend :8 ∗ ($0:80) = $0:64

– That 64 cents now becomes another persons income

– They in turn spend :8 ∗ ($0:64) = $0:51

GDP “= $1 + $0:80 + $0:64 + $0:51 + :::

Keynesian Cross Review

• This process can be approximated by well know infinite

series: The Geometric Series

GDP “= $1 + 0:8($1) + 0:82($1) + 0:83($1) + :::

• What does this add up to?

Keynesian Cross Review

S = 1 + C1 + C12 + C13 + ::: + C1n

S = 1 + C1[1 + C1 + C12 + ::: + C1n-1]

S = 1 + C1[1 + C1 + C12 + ::: + C1n-1 + (C1n – C1n)]

S = 1 + C1[S – C1n]

S = 1 + C1S – C1n+1

S – C1S = 1 – C1n+1

S(1 – C1) = 1 – C1n+1

S = 1 – C1n+1

1 – C1

• Now, as n gets really large, C1n+1 ≈ 0.

Keynesian Cross Review

• Autonomous Spending

– C0 – C1T¯ + I¯+ G¯ + Nx ¯

Y = 1

1-C1 [C0 – C1T¯ + I¯+ G¯ + Nx ¯ ]

* *

Multiplier Autonomous Spending

Keynesian Cross Review

Figure: Comparative Statics

Keynesian Cross Review

Figure: Comparative Statics

The IS Curve

Now let’s expand on the Keynesian Cross

The IS Curve

• Investment (I)

– Investment depends negatively on the real rate of interest

I = I(r)

I = I0 – I1R

The IS Curve

Graph examples and equilibrium with interest rates.

The IS Curve

• The IS (Investment-Saving) curve – relating the real

interest rate, money, and output

• Deriving the IS curve

1 Start with goods market graph

2 Draw a new graph below

3 Label x-axis ’Y’ and the y-axis ’R’

4 Pick an initial nominal interest rate, R0

5 Use this value to draw in a planned expenditure or goods

market demand curve.

6 Now change R0, suppose R ” ) R1 > R0.

7 Now we can find two points in (Y, R) space.

- Assignment status: Already Solved By Our Experts
*(USA, AUS, UK & CA PhD. Writers)***CLICK HERE TO GET A PROFESSIONAL WRITER TO WORK ON THIS PAPER AND OTHER SIMILAR PAPERS, GET A NON PLAGIARIZED PAPER FROM OUR EXPERTS**

QUALITY: 100% ORIGINAL PAPER – **NO PLAGIARISM** – CUSTOM PAPER