Putting it all Together IS-LM-FE. The Macroeconomy.
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Transcript of Putting it all Together IS-LM-FE. The Macroeconomy.
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Putting it all Together
IS-LM-FE
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The Macroeconomy
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The Macroeconomy
• Labor Markets
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The Macroeconomy
• Labor Markets– Labor supply is determined by household
preferences– Labor demand is determined by productivity
(w/p = MPL)– In equilibrium, Labor Supply = Labor Demand– The real wage (w/p) is determined
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The Macroeconomy
• Capital Markets
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The Macroeconomy
• Capital Markets– Savings is determined by household behavior– Investment is determined by productivity
Pk*(r+d) = P*MPK– In Equilibrium, Savings = Investment– The real interest rate is determined
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The Macroeconomy
• Money Markets
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The Macroeconomy
• Money Markets– Money Demand is determined by households– Money Supply is chosen by the central bank– In equilibrium, Money Demand = Money
Supply– The Aggregate price level is determined
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IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets
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IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets– FE (Full employment) represents the labor
market equilibrium
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IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets– FE (Full employment) represents the labor
market equilibrium– LM (Liquidity/Money): Represents the Money
Market equilibrium
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IS-LM-FE
• IS-LM-FE theory is nothing new. Its simply a more compact representation of labor/capital/money markets– FE (Full employment) represents the labor
market equilibrium– LM (Liquidity/Money) represents the money
market equilibrium– IS (Investment/Savings) represents the capital
market equilibrium
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?– Is labor demand influenced by rising/falling interest rates?
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?– Is labor demand influenced by rising/falling interest rates? NO
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates?
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates? NO
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Labor Market Equilibrium and the FE curve
• Recall that a labor market equilibrium defines a real wage such that labor demand equals labor supply. Once employment is determined, output can be found.
• How is this labor market equilibrium effected by interest rates?– Is labor demand influenced by rising/falling interest rates? NO
– Is labor supply influenced by rising/falling interest rates? NO
• If both labor supply and labor demand are independent of interest rates, then equilibrium employment is independent of interest rates.
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Labor Market Equilibrium and the FE curve
• Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output
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Labor Market Equilibrium and the FE curve
• Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output
• If interest rates fall to 3%, neither labor supply nor labor demand are affected and output is still $15T
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Labor Market Equilibrium and the FE curve
• Suppose that at an interest rate of 5%, equilibrium employment produces $15T of output
• If interest rates fall to 3%, neither labor supply nor labor demand are affected and output is still $15T
• The FE curve represents all possible labor market equilibria
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Labor Market Equilibrium and the FE curve
• How would a positive technology shock influence the FE curve?
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Labor Market Equilibrium and the FE curve
• How would a positive technology shock influence the FE curve?
• A positive technology shock would raise employment and output – regardless of the interest rate. Therefore, the FE curve moves to the right
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Labor Market Equilibrium and the FE curve
• How would a positive technology shock influence the FE curve?
• A positive technology shock would raise employment and output – regardless of the interest rate. Therefore, the FE curve moves to the right
• In fact, any shock which increases (decreases) employment/output moves the FE curve to the right (left)
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
• How would the capital market equilibrium be influenced by a drop in interest rates?
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
• How would the capital market equilibrium be influenced by a drop in interest rates? – Is savings affected?
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
• How would the capital market equilibrium be influenced by a drop in interest rates? – Is savings affected? Yes, savings falls.
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
• How would the capital market equilibrium be influenced by a drop in interest rates? – Is savings affected? Yes, savings falls.
– Is investment affected?
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Capital Markets and the IS Curve
• Recall that a capital market equilibrium defines an interest rate such that savings equals investment
• How would the capital market equilibrium be influenced by a drop in interest rates? – Is savings affected? Yes, savings falls.
– Is investment affected? Yes, investment rises.
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Capital markets and the IS Curve
• That is, a drop in interest rates would create excess demand for investment. How would income have to adjust to return to an equilibrium?
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Capital markets and the IS Curve
• That is, a drop in interest rates would create excess demand for investment. How would income have top adjust to return to an equilibrium?
• A rise in income would increase savings and eliminate the excess demand 0
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Capital markets and the IS Curve
• Suppose that with output of $10T, an interest rate of 5% clears the capital market
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Capital markets and the IS Curve
• Suppose that with output of $10T, an interest rate of 5% clears the capital market
• A capital market equilibrium with an interest rate of 3% would necessarily be associated with a higher level of output (say, $15T)
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Capital markets and the IS Curve
• The IS curve represents all possible capital market equilibria
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Capital markets and the IS Curve
• The IS curve represents all possible capital market equilibria
• Suppose that a negative technology shock lowers the demand for investment. How would the IS curve be affected?
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Capital Markets and the IS Curve
• Lower investment demand would result in lower interest rates. Note that total output doesn’t change – only the composition of demand (investment falls, consumption rises)
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Capital markets and the IS curve
• A negative technology shock results in an equilibrium with the same total output, but a lower interest rate. Hence, the IS curve shifts down
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Capital markets and the IS curve
• A negative technology shock results in an equilibrium with the same total output, but a lower interest rate. Hence, the IS curve shifts down
• In fact, any shock that causes interest rates in the capital market to fall (rise) causes the IS curve to shift down (up)
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Money Markets and the LM Curve
• Recall our money market equilibrium
M = k*PY
Where M is nominal money supply, PY is nominal income and k is a constant that is negatively related to the interest rate
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Money Markets and the LM Curve
• Recall our money market equilibrium
M = k*PY
Where M is nominal money supply, PY is nominal income and k is a constant that is negatively related to the interest rate
• We considered two possible types of equilibrium– Classical: Prices adjust to clear the money market
– Keynesian: Prices are fixed, output and interest rates adjust to clear the market
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Money Markets and the LM Curve
• Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)
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Money Markets and the LM Curve
• Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
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Money Markets and the LM Curve
• Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed
– Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls)
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Money Markets and the LM Curve
• Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed.
– Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls)
• Therefore, with fixed prices, lower interest rates result in excess demand for dollars. How do we get back to an equilibrium?
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Money Markets and the LM Curve
• Given a fixed supply of real balances (M/P) each interest rate will have a corresponding level of output so that money demand equals money supply ( M/P = k*Y)
• Suppose interest rates fall. How is the equilibrium affected?
– Real Money Supply is assumed to be fixed
– Money demand will, however, rise, due to the lower opportunity cost of holding dollars (velocity falls)
• Therefore, with fixed prices, lower interest rates result in excess demand for dollars. How do we get back to an equilibrium?
• Income will have to fall to lower money demand.
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Money Markets and the LM Curve
• The LM curve represents the combination of output and interest rates that clear the money market given a level of real money balances (M/P)
• The upward slope reflects that as interest rates rise (thus lowering money demand), output must rise to compensate
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Money Markets and the LM Curve
• What shifts the LM curve?
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Money Markets and the LM Curve
• What shifts the LM curve? If prices are fixed, the LM curve is controlled by the central bank.
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Money Markets and the LM Curve
• What shifts the LM curve? If prices are fixed, the LM curve is controlled by the central bank.
• An increase in the money supply must be matched by an equal rise in money demand (through lower interest rates and higher income) – LM moves right.
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The LM curve and classical economics
• Note that LM curve is drawn for a fixed supply of real balances (M/P). If prices are fixed, an increase (decrease) in the money supply shifts the LM curve right (left)
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The LM curve and classical economics
• Note that LM curve is drawn for a fixed supply of real balances (M/P). If prices are fixed, an increase (decrease) in the money supply shifts the LM curve right (left)
• However, in classical economics, prices are flexible. Therefore any increase in money supply is matched by an equal increase in prices – (M/P) is constant. Therefore, the central bank has no control over the LM curve.
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Putting it all together: IS-LM-FE
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Putting it all together: IS-LM-FE
• FE: Labor market equilibrium
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Putting it all together: IS-LM-FE
• FE: Labor market equilibrium
• IS: Capital market equilibrium
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Putting it all together: IS-LM-FE
• FE: Labor market equilibrium
• IS: Capital market equilibrium
• LM: Money market equilibrium
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IS-LM-FE and Classical Economics
• Recall that classical economics emphasizes flexible prices.
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IS-LM-FE and Classical Economics
• Recall that classical economics emphasizes flexible prices.
• Flexible prices eliminates the need for the LM curve (the price level will always adjust to insure that the money market clears)
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Classical Economics and Technology Shocks
• Suppose that the economy hit by a temporary negative productivity shock
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Classical Economics and Technology Shocks
• Suppose that the economy hit by a temporary negative productivity shock
• The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices?
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Classical Economics and Technology Shocks
• Suppose that the economy hit by a temporary negative productivity shock
• The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices?
• Higher interest rates as well as lower output lower money demand – this causes prices to rise.
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Classical Economics and Technology Shocks
• Suppose that the economy hit by a temporary negative productivity shock
• The FE curve shifts to the left. The shock is temporary, so IS is unaffected. The result is lower output and higher interest rates. What happens to prices?
• Higher interest al well as lower output lower money demand – this causes prices to rise.
• Higher prices lowers real balances – LM shifts left.
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Classical Economics and Monetary Policy
• The LM curve is irrelevant in classical economics because the Fed can’t influence real balances.
• For example, a decrease in money supply will result in a proportional decrease in prices – the LM curve doesn’t move.
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IS-LM-FE and Keynesian Economics
• Keynesian economics stresses fixed prices – this gives the central bank control over the LM curve (i.e., the ability to influence output)
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IS-LM-FE and Keynesian Economics
• Keynesian economics stresses fixed prices – this gives the central bank control over the LM curve (i.e., the ability to influence output)
• Once the level of output has been determined, the labor market provides the appropriate level of production. Therefore, in Keynesian economics, it’s the FE curve that’s irrelevant
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Keynesian Economics and Monetary Shocks
• Suppose that the federal reserve decreases the money supply (prices are fixed)
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Keynesian Economics and Monetary Shocks
• Suppose that the federal reserve increases the money supply (prices are fixed)
• The decrease in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise.
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Keynesian Economics and Monetary Shocks
• Suppose that the federal reserve increases the money supply (prices are fixed)
• The decrease in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise.
• Lower output and employment is represented by the FE curve shifting left.
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Keynesian Economics and Monetary Shocks
• Suppose that the federal reserve decreases the money supply (prices are fixed)
• The increase in real balances shifts the LM curve to the left. Output (and employment) falls and interest rates rise.
• However, once prices are allowed to adjust, prices drop – this shifts the LM curve back to the right. (Money is neutral in the long run)
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Keynesian Economics and Technology Shocks
• With a temporary decrease in technology, the FE curve shifts left, but the equilibrium remains at the intersection of Is and LM – the economy is at “above capacity” employment.