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2. 2 Short run or long run? (full adjustment of capital, expectations, etc.) Classical or non-classical? (sticky wages and prices, rational expectations, etc. Classical or non-classical? (sticky wages and prices, rational expectations, etc. long- run short- run Neo-classical growth model Marxist theories? Behavior growth theories? Malthusian trap models? yes no Real business cycle (RBC); supply-side economics; structural models; misperceptions models Keynesian model (inflexible w and p, Suboptimal behavior, PC, IS-MP, etc.) Schools of Macroconomics

3. 3 REVIEW: IS curve (expenditures) Basic idea: describes equilibrium in goods market. Finds Y where planned I = planned S or planned expenditure = planned output. Basic set of equations: 1. Y = C + I + G 2. C = a + b(Y-T) 3. T = T 0 + τ Y[note assume income tax, τ = marginal tax rate] 4. I = I 0 – dr [note i = r because zero inflation] 5. G = G 0

4. 4 REVIEW: MP curve with the dual mandate The Taylor Rule Begin with a monetary policy equation in the form of a “Taylor rule”: (TR)i = π + r* + b(π-π*) + cy r* is the equilibrium real interest rate, π inflation rate, π* is inflation target, y is log output gap [log(Y/Y p )], b and c are parameters.

5. 5 MP curve with inflation Now add inflation to the MP curve. Assume that inflation is a function of output (this will be covered later): (PC) π = π*+φ y + η (η =inflation shock) (TR)i = π + r* + b(π-π*) + cy So new MP curve is: i = π + r* + b(φ y + η ) + cy or (MP) i = π + r* + (bφ+c) y + bη (MP’) i = π + r* + λy [λ = bφ+c for η = 0]. So adding inflation makes the MP curve steeper, but does not change the basic structure..

6. 6 Algebra of IS-MP Analysis The analysis looks at simultaneous equilibrium in goods market and financial markets (Main St and Wall St). The algebraic solution for equilibrium Y e is: Y e = μ*A 0 – μ* d r* where μ* = μ/(1 + λ μd) = multiplier with monetary policy. μ = simple multiplier > μ* ; A 0 = autonomous spending = a - bT 0 + G 0 + I 0 + demand shocks, Note impacts on output: Positive: G, I 0, NX, demand shocks Negative: risk premium, inflation shocks

7. 7 r = real interest rate Y = real output (GDP) IS(G, T 0, demand shocks …) rere YeYe MP(r*, inflation shocks) IS-MP diagram E

8. 8 Monetary v. fiscal policy Monetary policy: Actions by central bank that affect interest rates and asset prices by balance sheet operations and regulations. -Open market operations, asset purchases, reserve requirements. Do not directly affect incomes. Fiscal policy: Actions by governments that affect incomes and output directly through purchases and taxes. -Government purchases (military, teachers, roads,…) -Taxes (income taxes, corporation taxes, …) -Transfers or negative taxes (social security benefits, UI, …)

9. 9 Important historical examples Monetary policy: Fed raised discount rate in Great Depression to defend gold reserves, and deepened Depression. Fed engaged in forward guidance and asset purchases in Great Recession to stimulate output. Fiscal policy: Huge US military spending in 1941-45 brought economy out of recession. Kennedy-Johnson tax cuts of 1963 were first explicitly Keynesian stimulus policy. Reagan “supply side” tax cuts of 1981 were designed to increase potential output growth. Obama stimulus package in 2009 spurred growth but became highly controversial.

10. 10 1. What are the effects of fiscal policy? Consider a fiscal policy holding monetary policy constant. In normal times, because MP curve slopes upward, expenditure multiplier is reduced due to crowding out.

11. 11 IS shock (as in fiscal expansion) i Y = real output (GDP) IS(G) MP IS(G’)

12. 12 Multiplier Estimates by the CBO Congressional Budget Office, Estimated Impact of the ARRA, April 2010

13. 13 Quizlet in class: Can you explain why the multipliers are different [λ[λ

14. 14 Inflationary shock and stagflation i Y = real output IS MP(η t = 0) Y t ** i t ** MP(η t > 0)

15. 15 Can we understand divergent fortunes EU and US?

16. 16 Dual v single mandate What are MP curves with different mandates? (Dual: Fed) i = π + r* + b(π-π*) + cy (Single: ECB) i = π + r* + b(π-π*) (MP: Fed) i = π + r* + (bφ+c) y + bη (MP: ECB) i = π + r* + (bφ) y + bη So the MP curve of Fed is steeper. This means: -Fed tolerates greater volatility of inflation, but stabilizes unemployment. -ECB tolerates more unemployment but very averse to inflation

17. 17 ECB Single Mandate In accordance with Article 127(1) and Article 282(2) of the Treaty on the Functioning of the European Union, the primary objective of the ESCB shall be to maintain price stability While the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability. The ECB’s Governing Council has announced a quantitative definition of price stability: "Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."

18. 18 Dual v single mandate i Y = real output (GDP) IS ECB Fed IS’ MP(Fed) MP(ECB)

19. 19 What about in the “liquidity trap” or “zero interest rate bound”

20. 20 Liquidity trap in US in Great Depression

21. 21 Japan short-term interest rates, 1994-2012 Liquidity trap from 1996 to today: 16 years and counting.

22. 22 US in current recession Policy has hit the “zero lower bound” five years ago.

23. 23 Conventional monetary expansion in liquidity trap i = nominal interest rate Y = real output (GDP) IS rere MP’ MP

24. 24 Fiscal policy in liquidity trap r = real interest rate Y = real output (GDP) IS rere IS’ MP

25. 25 Can you see why macroeconomists emphasize the importance of fiscal policy in the current environment? “Our policy approach started with a major commitment to fiscal stimulus. Economists in recent years have become skeptical about discretionary fiscal policy and have regarded monetary policy as a better tool for short-term stabilization. Our judgment, however, was that in a liquidity trap-type scenario of zero interest rates, a dysfunctional financial system, and expectations of protracted contraction, the results of monetary policy were highly uncertain whereas fiscal policy was likely to be potent.” Lawrence Summers, July 19, 2009

26. 26 Older approach emphasize the supply of money (Mankiw’s IS analysis). Extreme version is “monetarism,” which holds that demand for money does not depend on interest rate. -Very influential in 1960s through 1983 or so. - When tried, led to very poor predictions Very important tradition, particularly Friedman and Schwartz, A Monetary History of the United States. Deemphasized in Econ 122, but still important in many other views of macro (warning about dissensus) Monetarism

27. 27 Summary on IS-MP Model This is the workhorse model for analyzing short-run impacts of monetary and fiscal policy Key assumptions: - Inflexible prices - Unemployed resources Now on to analysis of - Panics - Great Depression in IS-MP framework.