Scribd
Upload
65 views

Warm-Up Question 1: How Was Your Break? Warm-Up Question 2: Explain Difference Between Short-Run and Long-Run Phillips Curve

- The document discusses dynamics in macroeconomics, specifically analyzing how shocks pass through the economy over time from the short-run to the long-run. - It provides an example of a negative investment shock, tracing its effects on output and prices in both the short-run and long-run while considering the role of monetary policy responses. - It also discusses the zero lower bound on interest rates and how this can result in larger declines in output in response to shocks if monetary policy is unable to stimulate the economy through lower rates.

Uploaded by

Joey Zahary Ginting
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
65 views

Warm-Up Question 1: How Was Your Break? Warm-Up Question 2: Explain Difference Between Short-Run and Long-Run Phillips Curve

- The document discusses dynamics in macroeconomics, specifically analyzing how shocks pass through the economy over time from the short-run to the long-run. - It provides an example of a negative investment shock, tracing its effects on output and prices in both the short-run and long-run while considering the role of monetary policy responses. - It also discusses the zero lower bound on interest rates and how this can result in larger declines in output in response to shocks if monetary policy is unable to stimulate the economy through lower rates.

Uploaded by

Joey Zahary Ginting
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 44

Warm-up Question 1: How was your break?

Warm-up Question 2: Explain difference between


Short-run and Long-run Phillips curve.

1 / 41

Macroeconomics
Robert Kirkby

September 9, 2015

Warm-up Question 1: How was your break?


Answer: Amazingly good.
Warm-up Question 2: Explain difference between
Short-run and Long-run Phillips curve.
Answer: Expectations, Shifting of.

2 / 41

Dynamics

Recap of last class:


Unemplyment and Output.
Phillips Curve: short- and long-run.
Expectations.
Inflation of the 70s (& 80s).

This week and next: Using our models to think about dynamics of
economy.

3 / 41

Dynamics

Dynamics: how changes in the economy play out over time.


Eg. a positive demand shock (fall in oil prices), leads to increased
output and inflation. Central bank reacts by increasing interest rates.
So net increase in output and inflation is smaller. Gradually all of this
passes and we return to where we started.
Before we try and trace shocks through the economy and over time
lets revise the various relationships/equations making up our model
economy.

4 / 41

Model Components
Rough schematic of our model of the economy (so far ;).

Phillips curve (long-run and short-run)

5 / 41

Dynamics

Dynamics: how changes in the economy play out over time.


To analyze dynamics we will think about
1

Initial shock: (unexpected) change to demand/supply/policy.


Could also think about changes to expectations about future shocks.

2
3

Short-run response to shock.


Adjustment from short-run to long-run.

6 / 41

Dynamics: Example

In this example will go through step-by-step through all different parts


of economy.
From shock, its effects, policy response, final effects in short- and
long-run.
Just to see this all together once. Future examples will be more direct, and more
like tutorial/test/exam.

Our first step is the initial shock.

7 / 41

Dynamics: Example
Shock: a fall in investment.

8 / 41

Dynamics: Examples

Step 2: Short-run response to the shock.


We are now going to trace the shock through the economy.
Think of next few slides as all occouring at roughly the same time.

9 / 41

Dynamics: Example
Fall in investment means any given interest rate now associated with
lower output.

Recall: we can also think of this as the interest rate that makes S=I.
10 / 41

Dynamics: Example
So IS curve shifts down/left.
Any given interest rate now associated with lower output.

11 / 41

Dynamics: Example
Fall in equilibrium combinations of interest rate and output.

Note: Monetary policy responds to shock by decreasing interest rate.


Movement down-left along the Monetary Policy Rule.
12 / 41

Dynamics: Example
So AD curve shifts down/left.

13 / 41

Dynamics: Example
Fall in equilibrium values of price and output.

14 / 41

Dynamics: Examples

Step 2: Short-run response to the shock.


Done!
Summary: Fall in investment leads to downward shift in IS curve and
falling output. Monetary policy partly offsets this by reducing interest
rates. Appears as downward shift in AD curve, and get lower prices
(intuitively, lower inflation) and lower output.
Call this type of shock a negative demand shock, as it decreases
demand (shifts AD curve downwards).

15 / 41

Dynamics: Examples

Step 3: Long-run response to the shock.


Depends on whether the negative shock to investment is temporary or
permanent.
If temporary, then in long-run AD curve will go back to where it was.
If permanent, then in long-run AD curve will stay in new location.

16 / 41

Dynamics: Example
Transitory negative shock to investment: long-run AD curve goes
back to where it was.

17 / 41

Dynamics: Example
Long-run equilibrium is same as the original equilibrium.

18 / 41

Dynamics: Example
Permanent negative shock to investment: long-run AD curve
permanently lower.

19 / 41

Dynamics: Example
Long-run equilibrium where AD crosses the LRAS.
Same output as originally, but lower price level.

SRAS will shift.


20 / 41

Dynamics: Example

Dynamics:
1
2
3

Shock.
Short-run equilibrium.
Long-run equilibrium.

Note that we excluded possibility that change in investment might


change the LRAS.

21 / 41

Dynamics: Example

Our analysis included policy respose of Monetary Policy.


Lower interest rates as we moved down-left along Monetary Policy Rule curve.

What if there had been no monetary policy response?

22 / 41

Zero Lower Bound

One example with no monetary policy response would be that cannot


cut interest rates as they are already zero.
The Zero Lower Bound (ZLB) on interest rates.
We describe economy as in a Liquidity Trap.

23 / 41

Dynamics: Zero Lower Bound


Monetary Policy Rule incorporating Zero Lower Bound.

24 / 41

Dynamics: Zero Lower Bound


At ZLB a negative investment shock leads to no response in interest
rate.

(Negative investment shock shifts IS curve left)


25 / 41

Dynamics: Zero Lower Bound


At ZLB a negative investment shock leads to a bigger fall in output.

(Negative investment shock shifts IS curve left)


26 / 41

Dynamics: Zero Lower Bound

At Zero Lower Bound interest rates do not react to negative shocks


to IS.
Get a larger fall in output. Graph
More generally true in sense that the less monetary policy reacts to output, the more output will fall in response to
negative shock to IS curve. (When Monetary Policy Rule curve is flatter.)

Liquidity Trap.
The AD curve would be vertical for economy in Liquidity Trap (at
ZLB). Explain
Subtle point: ZLB is in nominal interest rate, but effect of Monetary
Policy Rule is through real interest rate.

27 / 41

Zero Lower Bound


During Great Recession Eurozone, US, and UK all hit Zero Lower
Bound.

Dont actually set interest rate at zero. Tend to stop just before that.
28 / 41

Zero Lower Bound


During Great Recession Eurozone, US, and UK had large falls in
output.

29 / 41

Zero Lower Bound


Japan fell into Liquidity Trap in 1990s.

30 / 41

LM curve

For rest of today we will look at Liquidity-Money (LM) curve.

31 / 41

LM curve
We use a model with IS curve and Monetary Policy Rule.

32 / 41

LM curve
We discussed how Monetary Policy Rule on interest rates could be
related to money.
Money Demand and Money Supply.

33 / 41

LM curve

Monetary Policy Rule: relates interest rate and output.


Underlying idea: Reactions of central bank to output generate the
relationship.
An alternative is the Liquidity-Money (LM) curve.
Liquidity-Money (LM) curve: relates interest rate and output.
Underlying idea: Respose of Money Demand to output generates
relationship.
Via equilibrium requirement that Money Demand=Money Supply.

34 / 41

LM curve
Alternative: a model with IS and LM (liquidity-money) curve.

35 / 41

LM curve
Underlying idea: Respose of Money Demand to interest and output
generate relationship.
Via equilibrium requirement that Money Demand=Money Supply.

Increase in Y , shifts MD up-right, leads to increase in r .


ie. Positive relationship between Y and r .

36 / 41

LM curve
LM curve: positive relationship between Y and r .

37 / 41

LM curve

LM curve: positive relationship between Y and r .


Intuition: increase in Y , increases money demand, so money market
equilibrium (MS=MD) requires increase in interest rates.
Involved adding assumption that Money Demand depends on output.
And deleting role of central bank in determining interest rates.

Why does Money Demand depend on output? How much money you
want to hold depends on how much you would like to buy.
(Transactions motive for money.)

38 / 41

Summary

Dynamics of a negative investment shock.


Zero Lower Bound, Liquidity Trap.
Liquidity-Money (LM) curve as alternative to Monetary Policy Rule.

39 / 41

Final Thoughts

Was our example relevant for the Great Recession?


We will talk about this later as we do some more examples of shocks
and dynamics.
To do so we will need to think how the Finacial Crisis might relate to
our model.
How would a financial crisis shift the curves around?

Different shocks and dynamics are likely to be relevant for different


recessions.
All happy families are alike; each unhappy family is unhappy in its
own way. Tolstoy, Anna Karenina.

40 / 41

Further Material:

FRED (Federal Reserve Economic Database) is a great source for


economic data.
Chapter 28 of Case, Fair & Oster.
Chapter 26 of Case, Fair & Oster.

41 / 41

Zero Lower Bound


Fall in output is bigger due to ZLB than if there was no ZLB.

Back
42 / 41

Zero Lower Bound


AD curve would be vertical: Changing Price moves Monetary Policy
Rule but output remains the same.

(Recall: We derived AD curve from how Price moves Monetary Policy Rule curve and the effect on output.)
Back
43 / 41

You might also like