1. FIN 30220: Macroeconomic Analysis
The Synthesis of Classical and Keynesian Economics

2. Classical economics and the “Long Run”
“The economy is supply driven”
Optimal behavior by individuals
Competitive Markets
All prices are flexible
All markets are in equilibrium
Capital markets determine expenditures
Money markets determine prices
Labor markets determine total production/income

3. In a “classical world”, monetary policy is very simple…
Or, in percentages
Inflation
The Fed takes the “real economy” as a given and chooses money supply to set the inflation rate
Determined in capital markets

4. In a classical world, the Federal Reserve chairman would not be a very newsworthy job…however try to do a Google news search.
Chairman of the Federal Reserve from 1987 to 2006
Chairman of the Federal Reserve from 2006 to 2014
Current Chairman of the Federal Reserve
17,800 Results
57,000 Results
1,150,000 Results
They must be a little more important that the classical world would suggest!

5. It seems that increasing the money supply lowers the interest rate
Real Interest Rate vs. M2
% Deviation from Trend
Correlation = -.20
It seems that increasing the money supply lowers the interest rate

6. It seems that increasing the money supply has a positive effect on GDP
M2 Money Supply vs. GDP
% Deviation from Trend
Correlation = .25
It seems that increasing the money supply has a positive effect on GDP

7. Keynesian economics and the “Short Run”
“The economy is demand driven”
Optimal behavior by (most) individuals
Competitive Markets
The price level is fixed
Not all markets in equilibrium
Money Markets determine the interest rate (price level is fixed)
Capital markets determine output (and employment) via expenditures
Labor markets determine real wages

8. Why are prices fixed in the short run?
For other companies there are strategic reasons for not changing prices continuously
For some companies, it is costly to continually change prices

9. Product Group
Average time between price changes (months)
Cement
13.2
Steel
13.0
Chemicals
12.8
Glass
10.2
Paper
8.7
Rubber Tires
8.1
Petroleum
5.9
Truck Motors
5.4
Plywood
4.7
Non-Ferrous Metals
4.3
Household Appliances
3.6
*Source: Dennis W. Carlton, “The Rigidity of Prices, American Economic Review, September 1986, pp

10. Imagine that we have an initial equilibrium.
Now, suppose that the Fed increases the money supply.

11. Imagine that we have an initial equilibrium.
In a classical world, the price level would increase.

12. In a Keynesian world, the price level is fixed, so the interest rate falls. But, If the interest rate falls to bring the money market into equilibrium, the capital market is out of equilibrium.
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In a Keynesian world, the economy is demand determined. That is, the economy supplies whatever is demanded. In this case higher demand raises production

13. Temporarily higher production has two effects
Temporarily higher production (which means higher income) raises savings
Temporarily higher production (which means higher income) raises money demand =
In a Keynesian world, the economy is demand determined. That is, the economy supplies whatever is demanded. In this case higher demand raises production

14. Note that the current level of output is higher than it would be at the initial equilibrium (i.e. the labor market is out of equilibrium). =
This would be an economy that is overemployed

15. Again, imagine that we have an initial equilibrium.
Now, suppose that we get a random decline in investment (Keynes call this “animal spirits”)

16. The interest rate needs to decline to bring demand back in line with supply
Price level falls
In a Classical world, the economy is supply determined. In this case a decline in prices increases the real value of money which lowers the interest rate

17. In a Keynesian world, the price level can’t adjust.
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Because output is greater than expenditures, output drops

18. Lower output decreases savings and lowers money demand
Because output is greater than expenditures, output drops

19. Note that the current level of output is lower than it would be at the initial equilibrium (i.e. the labor market is out of equilibrium). =
This would be an economy that is underemployed
We need a more compact way of representing this…IS/LM/FE Analysis

20. We need to identify an equilibrium relationship between current GDP and the interest rate in the capital market. All else equal, a rise in current GDP will raise savings which lowers the interest rate.
We call this equilibrium relationship the IS curve

21. We need to identify an equilibrium relationship between current GDP and the interest rate in the money market. All else equal, a rise in current GDP will raise money demand which raises the interest rate.
We call this equilibrium relationship the LM curve

22. Now, we can repeat the previous analysis
Now, we can repeat the previous analysis. Suppose that the Fed increases the money supply. In a classical world, the price level would increase. However, if prices are fixed… =
An increase in the money supply would push down the interest rate for any level of GDP. This moves the LM curve down

23. The new Keynesian (short term) equilibrium has a higher level of GDP (which results in higher savings and higher money demand) =

24. The new classical (long term) equilibrium has a no effect on GDP but has higher prices=
Higher prices lowers the real supply of money which raises the LM curve back to its original position

25. Or, as in the “Animal Spirits” example…a drop in investment demand changes the GDP/interest rate relationship in the capital market =
This drop in investment demand lowers the capital market interest rate…IS shifts down

26. The new Keynesian (short term) equilibrium has a lower level of GDP (which results in lower savings and lower money demand) =

27. The new classical (long term) equilibrium has no effect on GDP but lowers prices=
The fall in prices raises the real supply of money which lowers the interest rate in the money market (LM shifts down)

28. What about labor markets
What about labor markets? We can represent labor markets as the FE (Full Employment) curve. Note that interest rates have no effect on labor supply or demand.

29. Now, lets put it all together…
Now, lets put it all together….suppose that the Federal reserve increases the money supply =

30. Now, lets put it all together…
Now, lets put it all together….suppose that the Federal reserve increases the money supply =
With prices fixed, the rise in money supply lowers the interest rate (LM shifts down)

31. Now, lets put it all together…
Now, lets put it all together….suppose that the Federal reserve increases the money supply =
The new short term (Keynesian) equilibrium has higher GDP and lower interest rates (above equilibrium employment)

32. Now, lets put it all together…
Now, lets put it all together….suppose that the Federal reserve increases the money supply =
The long term (Classical) equilibrium has higher prices (equilibrium employment)

33. Now, lets put it all together…
Now, lets put it all together….suppose we get a drop in investment demand =
With prices fixed, the drop in investment lowers the interest rate (IS shifts down)

34. Now, lets put it all together…
Now, lets put it all together….suppose we get a drop in investment demand =
The new short term (Keynesian) equilibrium has lower GDP and lower interest rates (below equilibrium employment)

35. Now, lets put it all together…
Now, lets put it all together….suppose we get a drop in investment demand =
The long term (Classical) equilibrium has lower prices and lower interest rates (equilibrium employment)

36. What about the productivity shocks from real business cycle theory
What about the productivity shocks from real business cycle theory? Suppose we have a temporary drop in productivity. =

37. The drop in productivity creates a decline in full employment output

38. The drop in GDP (lowering current income) lowers savings while the decline in MPK lowers investment
The drop in savings due to the decline in income would move the economy here
The drop in investment by itself would move the economy here

39. The drop in GDP lowers current income which lowers money demand.=

40. What about the supply shocks from real business cycle theory
What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. =
The new short term (Keynesian) equilibrium has GDP and interest rates falling (above the new equilibrium employment)

41. What about the supply shocks from real business cycle theory
What about the supply shocks from real business cycle theory. Suppose we have a temporary drop in productivity. =
The long term (Classical) equilibrium has higher prices and higher interest rates (equilibrium employment)

42. Suppose we have a permanent drop in productivity.=
The drop in productivity creates a decline in full employment output (FE) and lowers investment (IS)
Its possible for the Classical and Keynesian solutions to coincide with no price change necessary

43. We can also do IS-LM-FE analysis numerically…

44. First, we need to find the long run equilibrium for this economy
First, we need to find the long run equilibrium for this economy. For this, we can temporarily ignore the LM sector…
The FE curve represents long run output…plug this into the IS curve

45. Now that we know the interest rate and output, we can add the money market
Plug in values for output and the interest rate
Now, solve for real money
Now, any value for money supply implies a unique price level

46. So, we have the economy’s long run equilibrium…now, lets give the economy a shock!
Let’s increase the money supply by $10B

47. On impact, this shock only effects the money market…initially, the price level is fixed
Assuming that output remained at 5,000, the interest rate would need to drop to 2.75% to get people willing to hold the extra cash

48. In the short run, we find an interest rate where both money demand = money supply and where demand = supply (for goods & services)
Plug one into the other to solve for r
Now, find Y
This would be the short term equilibrium…

49. Eventually, we need to return to the long run production level given by the FE sector…to accomplish this, a price increase will lower the real value of money and bring interest rates back up
To return demand back to 5,000, r = 4%
Long run output is 5,000
This would be the short term equilibrium…

50. Let’s try another one….suppose FE increases.
Suppose GDP increases by 10%

51. ….again, prices are initially fixed
The interest rate would need to rise to 14% to clear the money market
The interest rate would need to fall to 3.5% to clear the goods market
Now what???

52. In the short run, nothing happens (IS/LM)
An increase in the real value of money will bring the interest rate down
A price level of 1.98 will lower the interest rate to 3.5%

53. Let’s try one more…how about a demand shock.
Consider a shock that (at the initial interest rate), increases expenditures by 10%

54. Let’s try one more…how about a demand shock (for example, a rise in investment demand).
New IS Curve
Given the demand shock, the interest rate would need to rise to 4.5% to keep demand at 5,000

55. Again, in the short run, we look to where IS and LM intersect…
Plug one into the other to solve for r
Now, find Y

56. Again, it will be a change in the price level that returns us to capacity
An decrease in the real value of money will bring the interest rate up to 4.5%
A price level of 2.21 will raise the interest rate to 4.5%