Positive permanent ShockPositive Shock: Production function moves up.Know: y ↑ c ↑ Unsure: L: income effect ↓ Substitute effect = MPL ↓ Net effect = ?

r ys

y

Permanent increase in Wealth

Suppose your Income rises by £10,000 every year for the rest of your lifeHow much will your consumption rise each year?

Permanent ShockOutput Consumption

Interest rate

Hours worked (L) ? Could go or depending on strength of change in MPl versus wealth effect Empirically for permanent rises L

CASE 2: A Temporary Shock

a) Good/Positive:Good WeatherShort run oil price fall

‘Feel good’ productivity surgeb) Bad/Negative:

Bad Weather - Hurricane/Typhoon

- Flooding/Drought

Strikes / BSE / Gulf War

Short run oil price rise

If the world is constantly subject to positive and negative shocks what do we mean when we draw a production function?

Normal

y

L

Traditionally Macro Primarily concerned about downturns

However, we will start with a positive temporary shock to

allow better comparison with previous case of a positive

permanent shock

Normaly0

L

y0

r0

L0

y1sys

y1Effect of a temporary positive shock on supply

Effect of a temporary positive shock on supply

r0

y0

y1s

ys

yd

Temporary increase in Wealth

Suppose your Income rises by £10,000 just for this year onlyHow much will your consumption rise by?

Go Back to Last Slide

So we get a new equilibrium with lower r and higher output (y)

r0

y0

y1s

yd

ys

C1d= y1

dr1

y1

Temporary Positive ShockOutput Consumption

Supply ………. demand

So Interest Rate ……….

y

L

y=f(L)

Recall any Shift has a Substitution and an Income

Effect

1. Substitution Effect

Normal

y

L

Twist is the pure Substitution EffectMPL Up so real wage (W/P) Up and work more

2. Wealth or Income Effect

Normal

y

L

Shift is the Pure Wealth EffectAnd since you are richer you

work less

But now have 3rd EffectRecall in class derived

Ls for different real wages W/P

W/P

L

Ls

Hours Worked (L) Again Theoretically Uncertain

NOW have 3 Effects

1. Any change in MPl means wages are up and L will go

2. Wealth or income effect means L

3. But now 3rd effect. R has gone down, signal that output is abundant today, incentive to work goes down and L

Overall: Empirically 1 Dominates

Make hay while sun shines!

Normaly0

L

y0

r0

L0ys

y1

Effect of a temporary positive shock on supply

Effect of a temporary positive shock on supply

r0

y0

ys

yd

Negative shock to income is temporary

Therefore agents reduce consumption

-

r0

y0

y1s

ys

yd

C1d= y1

d

So we get a new equilibrium with higher r and lower output (y)

r1

y1

Temporary Negative Shock

Output Consumption

Demand ……… Supply So Price - Interest Rate - ………

Hours Worked (L)

Again Theoretically Uncertain

3 Effects

1. Any change in MPl means wages are down and L will go

2. Wealth or income effect means L

3. R has gone UP, signal that output is scarce today, incentive to work goes up and L

Overall:? Empirically 1 Dominates

How are we doing on the stylised facts?

1. Output fluctuating due to shocks2. Consumption fluctuating also

And remember Cd curve shifts by less than ys when there is a temporary (Business Cycle) shock But is it fluctuating less that output?

3. What about hours worked ?Saw 3 conflicting forces but it is theoretically possible in each case to explain the stylised fact by the dominant force.

r0

y0

y1s

ys

yd

C1d= y1

d

Let’s focus on the shift in cd

r1

y1

So in this model C + Y down by same amount

and Stylised Facts say C by less than y and r

So need something else in this modelIf aggregate C by less than aggregate y then

need aggregate Saving to accommodate

So key is to include investment in the model.

Bluffers Guide to Non-Assessed TestCore TheoryCh2: The Economics of Robinson Crusoe P31 - 47Ch4: Absolutely Essential : P70 - 74 Better P67 - 74 Best P67 - 80Ch5: Basic Market Clearing Model Absolutely Essential P87 - 93

{Ignore bit on Money} P95 - 97 Ideal P85 – 97

See J:\FILES\ECON203\Non-Assessed Tests

Before we consider investment in the model however, we

should very briefly look at what is happening to money here

First notice that the market for goods determines

and the

r0

y0

ys

yd

•So the money market determines the nominal variables in the economy:

•The price level

•Inflation

•Nominal interest rate

That is, the demand for money depends on the level of real income and the NOMINAL interest rate

Why Nominal?

First consider the Demand for Money

First consider the Demand for Money

MD = P L (Y, R)

P

M

For simplicity assume for now that there is no inflation, =0

and thus R=r (that is, there is no distinction)

Money Demand must equal Money supply

Finding Money Market Equilibrium

IF

Then

Money Market Equilibrium

Money Market Equilibrium

MD

P

Money Market Equilibrium

MD

P0

What happens now if there is a Boom?

Money Market Equilibrium

MD

P0

Similarly in a recession

Money Market Equilibrium

MD

0

P0

What happens if the monetary authority increases the money supply