Macroeconomics Theory and Policy Dr Kenneth Creamer kenneth.creamer@wits.ac.za

Overview of Course Course outline: Lecture 1 – 4: AD and AS, imperfect competition and the IS-PC-MR model Lecture 5 – 6: Open economy macroeconomics Lecture 7 and 9 : Fiscal and Monetary Policy Lecture 8, 10 and 11: Financial crises and macroeconomic policy Lectures: Thursdays from 10:00 to 12:00 in SEBS Seminar Suite Email: kenneth.creamer@wits.ac.za Lecture Notes: www.kennethcreamer.co.za Texts: "Macroeconomics - Imperfections, Institutions and Policies" by Wendy Carlin and David Soskice; Published in 2006 by Oxford University Press "Macroeconomics – Institutions, Instability and the Financial System" by Wendy Carlin and David Soskice; Published in 2014 by Oxford University Press Assessments: Mid-term Test 50% (23 March); Exam 50%

Outline of Lecture 1 1.1 Distinguishing short-run and long-run models 1.2 Introducing the short-run IS-PC-MR model 1.3 Aggregate Demand 1.4 Aggregate Supply 1.5 Wage setting – in imperfect competition model 1.6 Price setting – in imperfect competition model 1.7 Labour Market with imperfect competition 1.8 Conclusions – summarising key facts of the model

1.1 Short-run and Long-run models Macroeconomics uses two broad types of models Models for analysing output, unemployment, inflation and the exchange rate (short and medium-run models) Models for analysing growth (long-run models) Focus of this course is short and medium-run models – assisting in an understanding of monetary policy and fiscal policy

Questions that models assist in answering Short and medium-run How are levels of output and employment determined and why do they fluctuate Why does inflation occur and why is it a concern How does government policy affect inflation and unemployment Why is unemployment high for lengthy periods in some countries How do trade and capital flows affect exchange rates and employment and inflation Typical equations: Phillips curve relation: π = π-1 + α(y – ye) Taylor rule: r0 – rs = 0.5(π0 – πT) + 0.5(y0 – ye) Long-run Why are some countries rich and others poor Why is there convergence (catching-up) in some countries but not in others Typical equation: Solow’s growth model: y(t) = K(t)a(A(t)L(t))1-a References: “Why nations fail” Acemoglu and Robinson (2012) “The wealth and poverty of nations” Landes (1999)

What are macro economic models used for? Macroeconomics is the study of the relationship between and among aggregate variables in the economy such as employment, output, inflation, productivity, etc. Models to seek to simplify, clarify and formalise the relationship between macro variables to see you they effect and influence each other Models allow you to analyse (breakdown) and synthesise (bring together) economic concepts with an aim to gaining clarity about economic phenomenon As argued by Dani Rodrik in “Economics Rules” (2015) - Models reveal ‘a’ truth rather than ‘the’ truth about the economy Model selection is very important, as different models explain different phenomena, depending on particular circumstances Eg our 2006 textbook uses the IS-PC-MR model to show how a central bank would operate to keep inflation under control Our 2014 text book, by the same authors, also introduces models to explain asset bubbles, and financial instability, which are not explained by the IS-PC-MR model

1.2 Introducing the IS-PC-MR model A three equation New Keynesian IS-PC-MR model widely used in Central Banks and in modern monetary economics earlier models focused on controlling the money supply, the IS-PC-MR model focuses on the policy rate (or interest rate) as the key instrument IS: y – ye = -a(r – rs) (-ve rels r and y, AD) PC: πE = π-1 + α(y – ye ) (+ve rels y and π, S-side) MR: y – ye = -b(π – πT) (-ve rels π and y, policy rule)

Introducing the IS-PC-MR model The IS curve y – ye = -a(r – rs) models aggregate demand (negative slope - if r up y down) The Phillips curve (PC) πE = π-1 + α(y – ye ) represents the imperfectly competitive supply side of the economy: s-r output and inflation have positive relationship e.g. if inflation rises then short-run increase in output as producers not sure if price increase in general or relative to their own goods (positive sloping short-run PC) l-r output independent of inflation (vertical long-run VPC) The monetary rule (MR) MR: y – ye = -b(π – πT) represents the policy behaviour of an inflation targeting central bank (negative slope because if inflation is up then output must be brought down (through raising r) in order to reduce inflation) i.e. CB reduces inflation by rising r to reduce AD

Questions answered by the model The model must be able to answer the following questions: How is current level of output and employment determined? What determines the medium-run equilibrium level of unemployment (i.e. the level of unemployment at which inflation is stable ye) How does the economy adjust from its current position to medium run equilibrium and what factors influence the speed and smoothness of adjustments. We start by analysing a closed economy version of the model and then in a later lecture extend the model to include open economy factors such as international trade, capital flows and the exchange rate

Defining time-frames in the model Short-run – the period during which output and employment can change, but due to institutional / legal factors prices and wages cannot / are assumed not to respond to changes in output and employment (months rather than years) Medium-run – the period during which it is assumed that wages and prices can respond to changes in output and employment i.e. the supply-side adjusts to a level of equilibrium output (ye,) where inflation is constant again (the NAIRU). The size of capital stock and the labour force are assumed to be fixed i.e. it is about deployment of the existing labour force on the existing capital stock. Long-run – growth theory seeks to explain the impact of growth in the population, the physical capital stock, the human capital stock and changes in knowledge and technology

Market imperfections in the model The IS-PC-MR is a New Keynesian model where there are market imperfections (on the supply side) which are defined broadly to include: the exercise of market power (e.g. where firms are price makers rather than price takers leading to price rigidities) lack of complete information Sticky wages due to contractual periods, efficiency wages, etc. Sticky prices due to strategic pricing, hierachies, menu costs, etc. New Keynesians argue that imperfect market model is a more generally applicable than the “special case” of perfectively competitive markets.

IS-PC-MR model – responding to inflation If AD rises (eg due to fiscal expansion or temporary boost in C or I – IS shifts up) output (y) and employment will rise (and unemployment falls) (to B’ shift in IS curve) workers demand higher wages (there are fewer unemployed workers) price setters will raise prices (as higher wages result in higher costs for firms) i.e. a rise in AD leads to a rise in inflation (move from A to B on PC curve) Policy response: In the IS-PC-MR model the central bank raises interest rates to steer the economy towards lower inflation Move to C’ on IS curve and C on MR line in order to reduce AD, reduce output and employment and reduce inflationary pressure Due to low AD at C inflation will continue to fall and r will be lowered back to rs until the economy returns to desired point at Z (where inflation target πT is achieved at ye)

Diagramatic representation of IS-PC-MR if actual employment = ERU then inflation is constant (no change to r) if employment > ERU then inflation rises (and CB must raise r to bring inflation back to πT) If employment < ERU then inflation falls (and CB must cut r to bring inflation back to πT)

1.3 Aggregate Demand AD is driven by real components C + I + G + X – M (IS curve) and monetary components (LM curve) On the IS side (goods market) one can analyse: Shifts in consumption or investment Changes in fiscal policy eg tax or spending changes On the LM side (money market) one can analyse: Shifts in money demand Changes in monetary policy (changes in money supply) Note: IS-PC-MR model operates without an LM curve, as the key policy instrument is the interest rate, rather than the money supply, essentially: if r rises this is equivalent to a LM contraction, and if r falls this is equivalent to an LM expansion

The IS curve IS curve shows: Combination of interest rates and output at which there is equilibrium in the goods market Where planned expenditure = real output With planned expenditure being made up explicitly of the following components C + I + G (closed economy) Each component is modeled as dependent on other variables: C on income and taxes and wealth (disposable income) I on r and A (interest rates and investor confidence) G on govt fiscal policy