IS-MP-PC : A Short-Run Macroeconomic Model

Aggregate DemandMonetary Policy and Aggregate Demand

Phillips CurveAggregate Supply

IS-MP-PC : A Short-Run Macroeconomic Model

Bilgin Bari

Bilgin Bari IS-MP-PC : A Short-Run Macroeconomic Model



1 Aggregate DemandDerivation of Aggregate Demand

2 Monetary Policy and Aggregate DemandMonetary PolicyAD Curve

3 Phillips CurvePhillips Curve

4 Aggregate SupplyAggregate Supply




Derivation of Aggregate Demand

Aggregate Demand

Keynes (1936), The General Theory of Employment, Interest, andMoney

Aggregate Demand : The total amount of outputdemanded in the economy.

to understand aggregate demand, we need to know IS curve.

IS curve describes the relationship between interest rate andaggregate output when goods market is in equilibrium.





Planned Expenditure

Planned Expenditure : The total amount of spending ondomestically produced goods and services.

Planned Expenditure = Aggregate Demand

Ype = C + I + G + NX





Consumption Expenditure (C)

C = C + (mpc × YD)− cr

C : autonomous consumption expenditurempc : marginal propensity to consumeYD : disposable income (Y-T)c : a parameter reflects how consumption respond changes in thereal interest rater : real interest rate

⇒ Real interest rate affects on savings decisions.





Planned Investment Spending (I)

I = I − dr

I : Fixed Investmentd : a parameter reflects how investment respond to changes in thereal interest rate.

⇒ Real interest rate affects on investment decisions through costof finance.

Goverment Purchases and Taxes

Goverment Purchases : G = GTaxes T = T → disposable income : Y − T





Net Exports (NX)

NX = NX − xr

NX : autonomous net exportx : a parameter reflects how net export respond to changes in thereal interest rate

⇒ real interest rate affect net export through the exchange rate :

changes in real interest rate → changes in return → capital flow →changes in export and import prices → changes in net export





Goods Market Equilibrium

Y = Ype

Y = C + I + G + NXY = C + (mpc × YD)− cr + I − dr + G + NX − xrY = C + I + G + NX + (mpc × Y )− (mpc × T )− (c + d + x)r

subtracting mpc × Y from both dies of equation

Y − (mpc × Y ) = Y (1−mpc) =C + I + G + NX − (mpc × T )− (c + d + x)r

dividing both sides of equation (1−mpc)

Y = [C + I + G + NX − (mpc × T )]× 11−mpc −

c+d+x1−mpc r





IS Curve

Y = [C + I + G + NX − (mpc × T )]× 1

1−mpc︸︷︷︸−c + d + x

1−mpcr︸︷︷︸

The equation shows how to determine aggregate output whengoods market is in equilibrium.

It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.

First component of the equation explains shifts in IS curve(given interest rate)

Second component of the equation explains movements on IScurve (changes in real interest rate)




Monetary PolicyAD Curve

Monetary Policy

Central Banks use a very short-term interest rate as theirprimary policy tool.

The interest rate is overnight interest rate at which bankslend to each other.

We need real interest rate : r = i − πe- changes in nominal interest rate → changes in real interestrate (only if actual and expected inflation remain unchangedin the short-run)- We know prices are sticky in the short-run.

Central bank can determine the real interest rate in theshort-run.not long run, because prices are flexible in the long-run.

In the long-run, real interest rate is determined by theinteraction of saving and investment.





MP Curve

MP curve indicates the relationship between the real interestrate which central bank sets and the inflation rate.

r = r + λπ

MP has an upward slope :- Policy makers follow Taylor principle to stabilise inflation.- Interest rate is raised more than any rise in expectedinflation.- Real interest rate rise if there is a rise in inflation.

Shifts in MP curve shows changes in stance of monetarypolicy :- tightening of monetary policy : MP ↑- easing of monetary polcy : MP ↓





AD Curve

MP curve

shows how central bank respond to changes in inflation withsetting interest rate

IS curve

shows how changes in interest rate affects equilibrium output.

AD curve

shows the relationship between the quantity of aggregate outputand inflation rate(given inflation expectations and stance ofmonetary policy)








Phillips Curve

Phillips Curve I

A.W.Phillips (1958), ”The Relationship Between Unemploymentand the Rate of Change of Money Wages in the United Kingdom:1861-1957”, Economica 25

”periods of low unemployment were associated with rapidrises in wages, while periods of high unemployment wereassociated by low growth in wages”

Phillips curve shows the negatif relationship betweenunemployment and inflation.




Phillips Curve

Phillips Curve II

When labor markets are tight (the unemployment rate is low)firms may have difficulty hiring qualified workers and mayhave hard time keeping their present employees. Because ofshortage of workers in the labor market, firms will raise wagesto attract needed workers and raise their prices at a morerapid rate.




Phillips Curve

Phillips Curve III

M. Friedman (1967), ”The Role of Monetary Policy”, AmericanEconomic Review 58E. Phelps (1968), ”Money-Wage Dynamics and Labor-MarketEquilibrium”, Journal of political Economy 76

Real wages ⇒ When workers and firms expect the price levelto rise, they will adjust nominal wages upward so that the realwage does not decrease.

The Long Run ⇒ In the long run, all wages and prices areflexible. This is called natural rate of unemployment

π = πe − ω(U − Un)




Phillips Curve

Phillips Curve IV




Phillips Curve

Phillips Curve V

The short run and the long run :

There is a short-run trade-off between inflation andunemployment.

There is no long-run trade-off between inflation andunemployment.

1973-1979 Oil Price Shocks

oil price shock → negative supply shock

import price shock → cost-push shock

workers push wages to keep nominal wages constant

π = πe − ω(U − Un) + ρ




Phillips Curve

Modern Phillips Curve

Firms and households form their expectations about inflationby looking at past inflation.πe = π−1

π = π−1 − ω(U − Un) + ρ

Inflation expectations are formed by looking at the past andtherefore change only slowly over time. (sticky)

Negative unemployment gap (tight labor market) causes theinflation rate to rise :∆π = π − π−1 = −ω(U − Un) + ρ

U = Un : inflation stops accelerating (changing).NAIRU: non-accelerating inflation rate of unemployment




Aggregate Supply

Aggregate Supply Curve I

U − Un : Unemployment gapY − Yp : Output gap

A.M. Okun (1970), ”The Political Economy of Prosperity”

Okun’s Law :

for each percentage point that output is above potential,the unemployment rate is one-half of a percentage pointbelow the natural rate of unemployment.

U − Un = −0.5× (Y − Yp)




Aggregate Supply

Aggregate Supply Curve II

We get the inflation equation :

π = πe + γ(Y − Yp) + ρ

whereπe = π−1

γ : how inflation respond to the output gap

higher γ → more flexible wages (ω ↑) → steeper PC → steeper AS




Aggregate Supply

The Short-Run and The Long-Run AS Curve




Aggregate Supply

Shifts in AS Curve

The Short-Run : Inflation depends on inflation expectations,output gap and price shocks.

π = πe + γ(Y − Yp) + ρ

The Long-Run : Output is determined by production function.

Y = F (K , L) = AKαLβ




Aggregate Supply

The relationship between the long-run and the short-runAS Curve


Documents

IS-MP-PC : A Short-Run Macroeconomic Model