Macroeconomics Notes PDF

Preview

Summary

Economic Principles A review of the Aggregate Demand Aggregate Supply To review the derivation of the objectives: To derive the Aggregate Demand schedule and the Aggregate Soskice Chapter Model simply describes the short and equilibrium state of under which the Price Level and Output balance. The AD...

Description

Economic Principles I

MACROECONOMICS Revision Notes 1 A review of the Aggregate Demand / Aggregate Supply Model: Aim: To review the derivation of the AS-AD model Learning objectives: To derive the Aggregate Demand schedule and the Aggregate Supply schedule. Carlin & Soskice Chapter 2. The AD/AS Model simply describes the short and medium-run equilibrium state of the Macroeconomy under which the Price Level and Output balance. The AD curve represents a locus of equilibrium between the IS and LM curves. The IS schedule is derived from Goods Market equilibrium and the LM schedule from Money Market equilibrium. We then turn our attention to the AS curve which is a graphic representation of Labour Market equilibrium. IS Curve (Goods Market Equilibrium): The Multiplier The IS curve is downward sloping as Investment shares an inverse linear relationship with the real interest rate (which is plotted on the y axis) and hence the higher the interest rate the lower investment (and vice-a-versa). Since Output is directly dictated by Investment (and Output is on the X axis) higher real interest rate = lower Investment = lower levels of Output. Hence:

1) 2) 3) 4)

Change in size of multiplier = change in gradient of IS Curve. Change in interest sensitivity of investment = change in gradient of IS Curve. Change in Govt. Spending = shift in IS Curve. Change in Autonomous Consumption = shift in IS Curve.

LM Curve (Money Market Equilibrium): Speculative (Asset) Motive

Transactions Motive

In equilibrium MD = MS (naturally), hence: Since Money Supply is set exogenously by the BoE:

1) 2) 3) 4)

Increases in Velocity of Money = Flattening of the LM Curve. Higher interest sensitivity of Asset Demand = Flatter LM Curve. Increase in Money Supply = Shift outwards of LM Curve. Price Level Increase = Shift inwards of LM Curve (since Real Money Supply falls).

Putting the IS/LM model together requires us to assume that the nominal and real interest rates are the same (as we derive IS with the real interest rate (r) and LM with the nominal interest rate (i)). This is why the IS/LM model only works in the Short-run (no inflation). Key Assumption: Money Market adjusts rapidly whilst Goods Market adjusts slowly.

ISLM = AD:

Naturally this diagram is fairly selfexplanatory. Since the LM curve is referenced with regard to the Real Money Supply, a change in the Price Level will cause it to shift. As it does so, the interest rate changes and Output alters in the Goods Market to account for this. Therefore, for each and every Price level there is a new equilibrium in the IS-LM diagram with it’s own Output level. It stands to reason from this definition of the AD curve that anything which shifts either the IS or the LM relation (Except for Price Level!) will lead to a corresponding shift in the AD curve.

Aggregate Supply: The Perfectly Competitive (Neoclassical) Labour Market is a combination of a downward sloping Labour Demand (Marginal Product of Labour) curve, which slopes downwards due to decreasing returns to Labour inputs, and an upward sloping Labour Supply curve. Workers act atomistically and have no wage bargaining power. Firms have no wage setting power either. The Competitive Labour Market therefore looks like this:

(P.T.O for diagram)

In the Imperfectly Competitive Labour Market however, things are different. 1) Wage Setting by Trade Unions: Finds a balance between Wages so high that they make the firms price uncompetitive (hence reducing demand for their goods and thus employment) and so low that Workers quality of life is reduced. The mark-up they attain is known as Union Wage Premium. 2) Efficiency Wage Setting by Firms: Wage premium could also come about as result of firms setting Wage above market clearing to attract most productive workers and with lowest search costs to find them (they will come to you). Efficiency Wages Assume that there is a positive relationship between the wage paid by a firm and the effort put in by its workers. This can be motivated in various ways: 1. Nutritional explanation: workers who are well fed can work harder (relevant for development economics) 2. The wage acts as a signal for the firm to attract good quality workers, that is the firm is unable to observe precisely the quality of the workers it hires and uses the wage as a signal. 3. The firm is unable to monitor precisely the effectiveness of its workers. Assume that the penalty for being caught shirking is dismissal, then a higher wage raises the cost of shirking, persuading workers to work hard. Or as Henry Ford put it: “If you pay people peanuts, you get lazy monkeys”. Summarise all these arguments into an effort function such as: E E (W j , WR )

Where Wj is the wage paid by the individual firm and WR the reservation wage which can be thought of as a combination of unemployment benefits and the wage that workers could obtain working for E

E

other firms (i.e. Transfer Earnings). Logically: W  0 ; W  0 j R

i.e. The greater the wage offered to the employee, the greater his Economic Rent (assuming Trasnfer Earnings stay fixed), thus the opportunity cost of getting fired if he is caught shirking and hence the greater effort the employee expends. Conversely the greater the worker’s Transfer Earnings, the less his Economic Rent (assuming wages offered by the firm stay fixed) and the lower the opportunity cost of the sack for shirking, thus the lower his efforts will be. Now consider a representative firm that maximises profit, taking price as given.   PY  W j N

Where we assume a production function of the type Y  f (EN ) because it is not just the labour input (number of hours) that determines output but also the effort with which those hours are worked. Now the firm needs to choose two things: the number of labour hours that it wants to demand ( N) and the wage it wants to offer (Wj). So differentiating we have: W  P f N E 1  W j 0  P f N  j E N  P f N N E  0  P f N E 1 W j N W j W j

Where fN is the marginal product of labour (notice the application of the chain rule to differentiate the argument of the production function which is ‘EFFECTIVE LABOUR’ that is the number of labour hours multiplied by the effort). Now substituting the first condition into the second…

E Wj

E E  W j 1 

W j 1 E Wj

which means that the condition for optimum is to choose that wage for which the elasticity of the effort function with respect to the wage paid by the firm is equal to 1. Now this condition is purely determined by the shape of the effort function and is totally unrelated to market conditions. Therefore the level of the wage need not be the market clearing wage and it is likely to be above that level. The result is a Wage Setting curve which lies above the Perfectly Competitve Demand for Labour curve, hence involuntary unemployment and a rigidity (or stickiness) of the wage as it is only changes in the effort function which are going to motivate the firm to change the wage it offers. If you consider the diagram representing the effort function, the lower (towards the origin) portion represents the region where increasing the wage increases the effort by more than the actual increase in the wage. This means that the elasticity of effort w.r.t. the wage is higher than one. Graphically the slope of the effort function at each point is increasing. Now, whilst the firm is in this region it pays for the firm to raise the wage it offers, because it obtains a disproportionately greater increase in effort as a result. Conversely in the upper region of the effort function (further away from the origin) further increases in the wage do not lead to proportional increases in effort. Indeed the effort function tapers asymptotically to a constant and after this point increasing the wage further will not lead to any higher effort at all. So offering a wage in this region is not optimal, and the firm will lower its offer. In this region the elasticity of the effort function is lower than one. The only condition for optimum is precisely where the elasticity of the effort function with respect to the wage offered is one, because any lower than that a marginal improvement in effort could be obtained at the price of a less than proportional increase in the wage, whilst any higher than that level, insufficient increases in efforts are obtained at the price of higher and higher wage rises. Graphically, take a 45° line, where this line is tangential to the effort function we are going to have a condition of unitary elasticity because the slope of the line tangential at that point and the ray from the origin that connect to that point are the same. Knowing that point we can trace the level of the wage on the horizontal axis. There is no reason to believe that the effort function will be the same for all industries and indeed it is likely to vary leading to different (involuntary) unemployment rates across different sectors of the economy:

Hence the Wage Setting curve lies above the Labour Supply curve by a given margin:

Thus there is Involuntary Unemployment at the market clearing wage (W1). Another cause of Involuntary Unemployment is Price Setting by firms with greater control over price: Generally a firm with the power to choose a price which maximises profits will pay a Real Wage below the Competitive level and this translates into a Price Setting curve which lies below the Labour Demand curve:

In general, a flat Price Setting Labour Demand curve is used (for reasons I don’t really understand, so I’m not going to bother to try and describe them).

By overlaying the Imperfectly Competitive Labour Market curves (WS and PS) on to the Perfectly Competitive Curves (Labour Supply and Labour Demand) we can see the extent of Involuntary Unemployment etc:

AD / AS not a particularly good model for analysing shocks and policy responses but is useful is helping to determine the Price level and provides a further lens for comparing Macroeconomic models. The Long-Run AS curve is vertical above a point determined by the Perfectly (or Imperfectly) Competitive Labour Market Equilibrium level of Output. If Wages and Prices adjust immediately to AD shocks then Output does not change in response to AD shocks, only Price level does. Hence we move up and down a vertical AS curve. The Short-Run AS curve is upward sloping however, because in the Short-Run Wages and individual Prices are assumed to be fixed. Thus as AD increases (due to G, I or C0 for example), Prices rise and employers increase Output to sell at the new higher price. This is a movement along the SRAS curve. When Wages are subsequently bid-up (in an attempt to return Real Wage to it’s former level), firms immediately pass on this cost and prices rise again. Thus Real Wage has not increased and in the Long-Run employment once more falls to it’s Long-Run level. In short, Employment level is fixed at LRAS level because Real Wage will never rise whilst Wages and Prices are instantly flexible, and since Real Wage is fixed, so is level of Employment. To encourage extra workers, you’d have to pay more.

2 Inflation and Unemployment Aim: To introduce the Phillips relationship between Inflation and Unemployment in its different incarnations. Learning objectives: To distinguish between the short run and the long run Phillips curve. To examine the effectiveness of stabilisation policies under different specifications of PC. Carlin & Soskice Chapter 3. Inflation is good because: 1) Oiling the Wheels of the Labour Market: Keynesians argue Nominal Wages are sticky downwards. Hence if Price level ↑ whilst Nominal Wage constant, Real Wage ↓ and labour market can adjust to new equilibria quicker. 2) Debt Relief: If Nominal interest rate on debt fixed, higher inflation = lower Real interest rate. Often counter though by higher initial Nominal rates or variable Nominal rates. 3) Room to Manoeuvre: Moderate level of inflation tends to help keep Nominal interest rate sufficiently above 0 to avoid a liquidity trap. 4) Tobin Effect: Moderate Inflation can stimulate Investment. Buying machines means your cash isn’t eroded by inflation and so it’s real value doesn’t fall. New-Keynesian Macroeconomists state 3 main causes of inflation (Robert Gordon’s Triangle Model): 1) Cost-Push Inflation: Increases in costs of raw materials (such as oil) and labour costs (due to decreased productivity for example). Also known as “Supply Shock Inflation”. 2) Demand-Pull Inflation: Increases in AD due to higher G and C for example. This type of inflation is more favourable to quicker economic growth as it stimulates investment to meet higher Demand. 3) Built-in Inflation: Resulting from Adaptive expectations and linked to the “Price/Wage Spiral”. Phillips Curves: Inertia-Augments Phillips Curve (based on Adaptive Expectations): π = πt-1 + (y - ye) Current Inflation Lagged Inflation Output Gap This can be translated into a Philips curve diagram with Inflation on the y axis and Output on the x axis:

It is clear to see that each SRPC is defined by 2 things: 1. Lagged Inflation Rate (πt-1) – This fixes the height of the SRPC. 2. Slope of the WS curve. The steeper the WS curve, the higher the Wage increase / decrease for a given fluctuation in Output level and hence the greater the change to Inflation for a given Output Gap. – This fixes the slope of the SRPC. The Long-Run Philips Curve (shown in red) highlights the fact that Inflation is stable (i.e. constant) at (and only at) the equilibrium Output level. Lucas Critique: Phillips curve relationship may exist but cannot be exploited as attempts to do so cause it to break down. Disinflation is costly: Only way to reduce inflation in the above diagram is to increase Unemployment above it’s “natural” level. Costless disinflation could be achieved in we could make actors “forget” past inflation and have them incorporate their inflationary expectations, together with the Output gap into their wage claims (and hence into actual inflation). This means that the Phillips curve is then based on Rational expectations and the Expectations Augments Phillips Curve is given by: π Current Inflation

= πt-1 + α (y - ye) + ε = Expected Inflation + Multiple of Output Gap + Shocks

For the Inflation Target (πT) set by the Central Bank to be credible, it must be consistent with: π = πT + ε i.e. The Inflation Rate does not systematically deviate from it’s target level (only randomly - in response to shocks). Rational expectations mean that the only difference between what economic actors expect Inflation to be and what it turns out to be is given by random events (ε). I.e. rational economic actors do not make systematic errors. When applied to our model, rational expectations means: πE ≡ E(π) ≡ E(πT + ε) ≡ E(πT) + E(ε). Since the error term is expected to be 0: πE = πT. Subbing this identity back into our first equation gives: π = πT + α(y – ye) + ε If we re-arrange this, we get: y – ye = 1/α (π – πT – ε) = 1/α (π – πT) Hence:

y = ye + 1/α (π – πE)

Lucas Surprise Supply Equation

This simply states that Output only deviates from it’s equilibrium level in response to deviations of inflation away from expected inflation (caused by random shocks). Lucas Supply highlights that under assumptions of Rational Expectations, Credible Monetary Policy and Zero Inflation Inertia, there is no need for systematic Monetary Policy since economy returns directly to equilibrium once shocks have disappeared. This is not in fact the case though, as Inflation Inertia means that once shifted away from equilibrium the economy cannot return costlessly of it’s own accord. Central Banks (as a consequence) regularly engage in systematic policies to stabilise Output back to the equilibrium (the so called MR rule).

In reality both the “Adaptive Expectations” and the “Rational Expectations” models of the Phillips curves are over-simplistic. Downplaying the information limitations faced by both policy makers and economic actors and oversimplifying the expectations formation mechanism may lead to some common problems, such as the suggestion of Phillips curves being able to forecast inflation more accurately than is in fact the case or the indication of an exploitable long-run trade-off. This all leads to the IS-PC-MR equation set by which Central Banks attempt to stabilise the economy around it’s equilibrium level of Output: If we simplify the IS equation which was: To simply:

y = A – ar

(i.e. Holding the Multiplier, Autonomous Consumption & Government expenditure constant). We can see that the only thing affecting Output is the interest rate (through it’s effect on Investment). Thus there must be some stabilising rate of interest (rs) which corresponds with equilibrium Output: ye = A – ars can subtract this identity from the IS equation to get: y – ye = – a(r – rs) Equation)

(IS

i.e. Output Gap = some multiple of the gap between the stabilising interest rate and the actual rate. Thus Central Bank will choose a rate of interest which will cause Output to change to a level consistent with their inflation target. The inertia augmented Philips curve needs no modification: π = πt-1 + (y – ye) Equation)

(PC

N.B. Using Inertia Augmented because if we assumed Rational Expectations instead (Expectations Augmented Phillips Curve) then there would be no need for systematic policy and thus no IS-PC-MR rule anyway. The final rule (MR Rule) is derived from the Central Bank’s Output – Inflation trade-off. y – ye = –b(π – πT) Equation)

(MR

States that given a certain Phillips Curve the Central Bank will choose a certain level of Output and Inflation. Higher “b” = More Inflation Averse (indifference curves lie closer to LRPC):

Sacrifice Ratio: Cumulative level of Unemployment required to achieve a given reduction in Inflation. Gradualist: Lower “b” – indifference curves lie closer to LRPC (takes longer to reduce inflation). Cold-Turkey: Higher “b” – indifference curves further from LRPC (quicker to reduce inflation but more unemployment required. If SRPC is linear then Sacrifice Ratio same for Gradualist and Cold-Turkey. If not then it may differ. LM Rule vs. MR Rule: MR Rule (Keynesian): i) Ultimate determinant of price level and inflation is policy, ii) Instrument of policy is the short-term nominal interest rate, i.e. the Base Rate (possibly set in line with the Taylor Rule), iii) Active stabilisation policy, Taylor Rule: Set out in 1993 by John B. Taylor of Stanford University. It essentially states the magnitude of interest rate change that a Central Bank should deliver in their attempts to deliver their inflation target:

r0 – rS = 0.5(π0 – πT) + 0.5(y0 – ye) Which essentially states that the Central Bank should choose an interest rate for which:

The difference between the interest rate (r0) and the stabilising interest rate (rS) is equal to half of the gap between current (π0) and Target inflation (πT) plus half the gap between current (y0) and potential Output (ye). This was an empirical description of how the Federal Open Market Committee (FOMC) in America (equivalent of the MPC) behaved. Not designed to be a hard and fast rule but more of a very close guideline for Monetary Policy-makers. Taylor Rule may have helped Rational Expectations in giving analysts a possible way in which to guess Central Banks (if indeed they follow it). Lags between interest rate cuts / rises and their real effects on the economy are assumed. According to the Bank of England: Maximum effect of a Base Rate change on Output (spending / saving decisions) is estimated to take up to 1 year. Maximum effect on Price level (inflation) is expected to take up to 2 years. 

Problem with MR Rule is the Deflation Trap (see “Why not deflation in section 5”). This requires either Expansionary Fiscal policy or a recovery of Autonomous I...