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

2. r ysys y

3. Permanent increase in Wealth Suppose your Income rises by £10,000 every year for the rest of your life How much will your consumption rise each year?

4. Permanent Shock Output Consumption Interest rate Hours worked (L) ? Could go  or  depending on strength of change in MP l versus wealth effect Empirically for permanent rises L 

5. CASE 2: A Temporary Shock a) Good/Positive: Good Weather Short run oil price fall ‘Feel good’ productivity surge b)Bad/Negative: Bad Weather- Hurricane/Typhoon - Flooding/Drought Strikes / BSE / Gulf War Short run oil price rise

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

7. 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

8. Normal y0y0 L y0y0 r0r0 L0L0 y1sy1s ysys y1y1 Effect of a temporary positive shock on supply

9. r0r0 y0y0 y1sy1s ysys ydyd

10. Temporary increase in Wealth Suppose your Income rises by £10,000 just for this year only How much will your consumption rise by? Go Back to Last Slide

11. So we get a new equilibrium with lower r and higher output (y) r0r0 y0y0 y1sy1s ydyd ysys C 1 d = y 1 d r1r1 y1y1

12. Temporary Positive Shock Output Consumption Supply ………. demand So Interest Rate ……….

13. y L y=f(L) Recall any Shift has a Substitution and an Income Effect

14. 1. Substitution Effect Normal y L Twist is the pure Substitution Effect MP L Up so real wage (W/P) Up and work more

15. 2. Wealth or Income Effect Normal y L Shift is the Pure Wealth Effect And since you are richer you work less

16. But now have 3 rd Effect Recall in class derived L s for different real wages W/P W/P L LsLs

17. Hours Worked (L) Again Theoretically Uncertain NOW have 3 Effects 1.Any change in MP l means wages are up and L will go  2.Wealth or income effect means L  3.But now 3 rd 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!

18. Normal y0y0 L y0y0 r0r0 L0L0 ysys y1y1 Effect of a temporary positive shock on supply

19. r0r0 y0y0 ysys ydyd

20. Negative shock to income is temporary Therefore agents reduce consumption -

21. r0r0 y0y0 y1sy1s ysys ydyd C 1 d = y 1 d So we get a new equilibrium with higher r and lower output (y) r1r1 y1y1

22. Temporary Negative Shock Output Consumption Demand ……… Supply So Price - Interest Rate - ………

23. Hours Worked (L) Again Theoretically Uncertain 3 Effects 1.Any change in MP l 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

24. How are we doing on the stylised facts? 1. Output fluctuating due to shocks 2. Consumption fluctuating also And remember C d curve shifts by less than y s 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.

25. r0r0 y0y0 y1sy1s ysys ydyd C 1 d = y 1 d Let’s focus on the shift in c d r1r1 y1y1

27. 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 model If aggregate C  by less than aggregate y then need aggregate Saving to accommodate So key is to include investment in the model.

28. Bluffers Guide to Non-Assessed Test Core Theory Ch2: The Economics of Robinson Crusoe P31 - 47 Ch4:Absolutely Essential : P70 - 74 Better P67 - 74 Best P67 - 80 Ch5: Basic Market Clearing Model Absolutely Essential P87 - 93 {Ignore bit on Money}P95 - 97 Ideal P85 – 97 See J:\FILES\ECON203\Non-Assessed Tests

29. 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 r0r0 y0y0 ysys ydyd

30. So the money market determines the nominal variables in the economy: The price level Inflation Nominal interest rate

31. 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

32. M D = P L (Y, R) P M

33. 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

34. IF Then Money Market Equilibrium

35. MDMD P

36. MDMD P0P0 What happens now if there is a Boom?

37. Money Market Equilibrium MDMD P0P0 Similarly in a recession

38. Money Market Equilibrium MDMD P0P0 What happens if the monetary authority increases the money supply