2. Simple but doesn t deal with stagflation simultaneous presence of inflation and unemployment.

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1 Keynesian Model 1. The Keynesian policy prescription: if there is unemployment, run a deficit on the government account (negative govt savings). If there is inflation, run a surplus. 2. Simple but doesn t deal with stagflation simultaneous presence of inflation and unemployment. 3. Major reason why Keynesian economics is not so popular any more: need both sides supply and demand. 4. Supply side is given by the Solow while the demand side is given by Keynes. 5. Keynes main theoretical contribution: underemployment equilibrium. In classical theory unemployment was impossible because of Say s Law, supply creates its own demand. Thus if there were unemployment, wage would fall and full employment would be restored. 6. Keynes said no: wages and prices in the short run are sticky and don t adjust. 7. Formally the Keynesian model is a fixed price model. Wages and prices are fixed in the short run. 8. Keynesian model has to do with the short run level aggregate demand. Y = C + I + G + C A where Y = GDP, C household consumption, I investment demand for structures, equipment, residential and inventories, an C A the current account or net exports. 9. Each of the variables on the right-hand side is in the SAM, but that is just a snapshot We need a theory of why each behaves the way it does. 10. Keynes most important theoretical contribution is the consumption function. Most economists would say that consumption is a function of price. Keynes broke with what he called the classical economists and said consumption is a function of income, in particular disposable income. 11. This was viewed as a radical thesis: mostly economists believed that income was fixed and prices were variable. Keynes argued that it should be the other way around, at least in the short run. 12. This, said Keynes, is a better description of how a modern capitalist society actually works. Adam Smith had concentrated on a perfectly competitive farmers market and yes, there the quantities were fixed and the price were variable. But a farmers market is not a good basis on which to build a theory of a complex economy with monopolistic competition, that is, large corporations competing with each other. The lack of perfect competition meant that prices were more rigid than Smith had supposed. 13. In labor market, unions made sure that real wages were not flexible. 14. Markets in the Keynesian model are said to be quantity clearing not price clearing. 15. So the Keynesian consumption function does not even mention price! Here it is: 16. C = C + cy d where = C is autonomous consumption and c is the marginal propensity to consume. Disposable income is Y d. 17. The consumption function is calibrated to the SAM. We must know the marginal propensity to consume, c, which is usually given by fitting a regression line through points on a scatter diagram. The slope of the regression line is the marginal propensity to consume. Since the scatter diagram covers many years, not just the year of the SAM, we can use the slope, but not the intercept. 18. Example 19. Calibration: We also know that the MPC or c = 0.7. The consumption function C = C + cy d becomes 80 = C + 0.7(100). This gives C = 10.

2 Table 1: A Social Accounting Matrix Firms Household Investment Total Firms HHolds Savings Total Since there is no government in this SAM of table 1, the model is fully calibrated when the consumption function is done. 21. Here it is written out algebraically Y = C + I C = C + cy or with the parameters inserted. Y = C + 20 C = Y 22. The variable list is V (Y, C) and the parameter list is P (I, C, c). 23. This is a valid models since there are as many entries in the variable list as equations of the model. 24. Formally, a multiplier is the change in the equilibrium values of the variables with respect to a change in one and only one parameter. Hence we have 2 variables and 3 parameters or 6 multipliers, even in this simple model. The multiplier is usually thought as Y C I but logically, we also have I, Y C, C C C and and Y c c. 25. Solving the model is done by substituting upward. Take the second equation and substitute it into the first. Y = C + cy + I this is called the reduced form of the model. It is reduced in that it is only one equation. However, none of the model is lost; it is all inside the one equation. Hence, this is a reduced form of the entire model. 26. To solve for the multiplier write the reduced form twice: Y 1 = C + cy 1 + I 1 Y 0 = C + cy 0 + I 0 and now subtract to get Y 1 Y 0 = c(y 1 Y 0 ) + I 1 I 0 Y = c Y + I 2

3 where Y = Y 1 Y 0 and I = I 1 I 0. so that Y I = 1 1 c This is the multiplier and is a direct consequence of the Keynesian consumption function 27. Here is how it works: income increases directly because of a rise in investment. But then very quickly, rising incomes affect consumption through the consumption function. Now we have a direct and indirect impact on demand. The first is the rise investment and induces an increase in consumption demand. 28. In the Keynesian model, then, there are two types of demand, induced demand and autonomous demand. 29. Note that investment is for Keynes autonomous. Why? Because Keynes believed that the most important determinant of investment demand is animal spirits. 30. Animal spirits means people make investment decisions unaided by mathematical, i.e., rational models. When deciding whether to invest, they don t calculate probabilities and instead are guided by the seat of their pants, hunches, heuristics and gut feelings. 31. None of this, said Keynes, can be put into a formal model. He just took investment as given. 32. Standard or classical economic theory (as we have seen) says that investment and savings are determined by the interest rate, or the intertemporal trade-off between today s and tomorrow s goods. 33. Keynes agreed, but said animal spirits often overwhelm this rational trade-off and even though the model says no go, people will invest anyway. He pointed out that investment is the most volatile component of the aggregate demand and that is generally true. 34. We should not confuse savings and investment. When we speak of the investment function, we have in mind a telephone call by the owner/manager of a firm that says, send over the workers and cement truck, we are going ahead with the project. The factors that determine whether that telephone call is made or not is what determines investment. 35. On thing that may stop the owner/manager from making the call is the interest rate. She must first call the bank and find out how much she is going to have to pay to borrow the money. 36. If the interest rate is high, there is less of a chance the phone call will be made. This is the classical theory. Note that it implies high interest causes low investment. 37. Keynes: yes fine, but there is more too it than that. The main determinant is whether the owner/manager believes that the firm will be able to sell the goods once they are produced in the new factory. This is where the animal spirits comes from. The owner/manage must predict this, and as Neils Bohr said Prediction is very difficult, especially about the future. 38. So investment remains the independent variable in the Keynesian system. For a given level of investment, we can write out a model to determine how the rest of the economy is going to behave. We just can t write out a model to determine investment itself. 39. If we see that investment is too low for full employment we must turn to government to fill in the gap. Adding the government sector 1. For Keynes government spending was a policy variable, in our terms a parameter. It thus has no equation by which it is determined. It is set by the rule above, as to whether there is inflation or unemployment. 2. Again let the MPC =

4 Table 2: A Social Accounting Matrix Firms Household Investment G Total Firms HHolds Taxes Savings Total The tax rate, t, needs to be calibrated. Here it is 30/150 = Here is the model: Y = C + I + G C = C + cy Y d = Y ty + T r where Y d is disposable income and T r is transfers. Y = C C = Y d Y d = Y 0.2Y The variable list is V (Y, C, Y d ) and the parameter list is P (I, C, c, t, T r ). 6. Again we substitute upward. Take the third equation and substitute it into the second equation and the substitute that result into the first. 7. The reduced form is this is the reduced form. Y = C + c(1 t)(y + T r ) + I + G 8. The multiplier is derived in the same way as above: Y 1 = C + c(1 t)(y 1 + T r ) + I 1 + G Y 0 = C + c(1 t)(y 0 + T r ) + I 0 + G where only variable and the one parameter change. Now subtract to get Y = c(1 t)( Y ) + I so that This is the multiplier with government. Y I = 1 1 c(1 t) 4

5 Table 3: A Social Accounting Matrix Firms Household Investment G Foeign Total Firms HHolds Taxes Savings Foreign 0 Total Adding the foreign sector The real exchange rate is written Ep /p where e = nominal exchange rate p =foreign price p =domestic price (GDP deflator of our country) 1. For Keynes the level of exports is given by the real exchange rate, q = EP P, where E is the nominal locals/foreign currency exchange rate, P is the foreign price and P is the domestic price or GDP deflator. X is the level exports. 2. The real exchange rate is a measure of competitiveness. I higher real exchange rate means greater competitiveness, but a weaker currency. We will have more to say about the real exchange rate later in the class. 3. Since the real exchange rate is given, practically speaking, this means that exports, E are given. 4. Imports are given by the marginal propensity to import multiplied by income or M = my. 5. Important: imports and exports in the Keynesian model are determined in fundamentally different ways. 6. If GDP rises because of depreciation in the the real exchange rate, imports change but exports don t. If exports change GDP changes so do imports. Note this lack of symmetry. 7. The marginal propensity to import is must be known; let s say that it is 0.1 To calibrate the current account equation: CA(q, Y d ) = 10 = qx 0.1(140) so that E = 4 8. We now have Y = C + I + G + C A C = C + cy Y d = Y ty + T r Y = C C A C = Y d Y d = Y 0.2Y + 10 C A = 4 0.1Y 9. The variable list is V (Y, C, Y d, C A ) and the parameter list is P (I, C, c, t, T r, m). 5

6 10. The reduced form is Y = C + c(1 t)(y + T r ) + I + G + qx my 11. The multiplier is derived in the same way as above, by subtracting the reduced form for two different time periods. Y 1 = C + c(1 t)(y 1 + T r ) + I 1 + G + qx my 1 Y 0 = C + c(1 t)(y 0 + T r ) + I 0 + G + qx my 0 and thus the multiplier is Y I = 1 1 c(1 t) + m This is the multiplier with government and foreign sectors. 12. The Keynesian cross diagram shows how the model is solved graphically. See the text for an excellent explanation. Investment 1. Investment is made up of structures, equipment, residential and inventories. 2. Investing in bond or stock is not an investment; that is savings. Investment is demand for real goods and services. 3. Investment demand is depends on the interest rate in the form of I = Ī bi where Ī is autonomous investment and b is the interest sensitivity of investment. 4. Can also depend on capacity utilization u = Y/Q. 5. The main link between the financial and real side of the economy is through the interest rate and its effect on investment. 6. Autonomous investment is depends on what Keynes called animal spirits and is the cause of the underlying volatility in investment. 7. Investment demand is satisfied by firms and included structures and equipment, residential and inventory accumulation. 8. Part of the volatility of the market system is due to inventory cycles. As unintended inventory accumulation takes place, retailers cancel orders with producers. Producers respond by laying off workers and inventories build even faster. The reverse happens when inventories fall. To replace them requires that firms hire labor, which in turn causes inventories to fall again. 9. Note that investment responds to lower interest rates, but lower interest rates may not necessarily cause higher investment. 10. This is primarily because the main motivation for investment is profits. Even if the interest rate is low, this does not mean that firms will necessarily invest. 11. The analogy is a date: would you ask someone out just because the price of dinner and a movie happened to fall? Maybe...but since animal spirits governs both investment, as well mating behavior, (says Keynes) it is not necessarily the case that raising the supply of money in order to force interest rates lower will cause investment to rise. 12. If expectations about future profitability are dim, a lower interest rate will not be enough. 6

7 13. On the other hand when the Fed buys bonds from the private sector, it is signaling that it want to lower the interest rate to stimulate the economy. 14. If firms believe that other firms will increase output in response, the Fed s move may be successful, even though the effect on the interest cost is not the primary one. The Fed can alter expectations in this way, through its ability to change the interest rate. This is a subtle but important difference in how Fed policy can work. Disequilibrium Dynamics 1. See the sawtooth diagram spreadsheet 2. We now know from the Keynesian cross model that the equilibrium is determined by the intersection of the 45-degree line with the aggregate demand line. In that case, Y = C + I + G + C A. 3. But what if we are not in equilibrium? In that case, we rely on the inventory adjustment to get us into equilibrium. 4. The owner/manager of a firm knows how much inventory is must keep on hand to support sales. Some firms need a lot, like a grocery store, and some need a little, like a car lot which shows some models, but others have to be special ordered. 5. Inventories cost firms money to hold, so they would like to get by with fewer rather than more. 6. If the interest rate rises, inventory/sales typically falls a bit as firms try to economize on inventory costs. 7. Economize too much however, and sales go down. There is the potential for false economy with inventories and firms know this very well. 8. The government cheats a bit on inventories. They collect data on Y and then on C, G, E and M, imports. Note that I is missing in this list. The bean counters let I be the difference between Y and C + G + C A. 9. In principle this is equal to I but note that it counts all inventories as if they were intended. 10. The government does this because it cannot go inside the minds of the owner/managers and ask if the inventories are desired or not. They have to take the fact that inventories exist at their levels as evidence that they are desired at that level. 11. This is obviously false, at least much of the time. If inventories are low, this could be for one of two reasons (1) either there has been a burst of aggregate demand and firms were caught at the end of the year short-handed on inventories or (2) firms expect a recession in the coming months and are paring back their inventories to get ready for it. 12. Well, which one is it? The government doesn t generally know so it just compromises and takes the inventories as desired. It cops a plea, basically. 13. Consider the first case, that is when inventories fall because of a sudden burst of aggregate demand. 14. First note that before production responds, an increase in aggregate demand must be satisfied by inventories. There is no other source of the goods. 15. When the drop in inventories is unintended firms will scramble to build them back up. This means a telephone call. Send over more goods because are sales seem to be increasing and we need to restock our inventories. 16. Now follow through the logic of the response to this phone call. The factory must produce more of the goods to increase shipments. This means they must increase value added, making payments to households for the factors of production, labor and capital. 7

8 17. Now, the owners of the factors of production have more income. The Keynesian consumption function says they will spend it and they do. 18. Here is the key point. The owner/manager is fighting a losing battle, she thinks. Replacing the inventories generated new income which then turns around and reduces inventories. 19. How does this process ever come to an end? Savings saves the day. Since the owners of the factors of production save some what they earn, the inventories will not go down by as much as their new income from producing them. 20. Hence, the losing battle slowly becomes a winning battle. Eventually enough is produced to close the gap and inventories stop changing. Productions stops changing and we arrive at a new equilibrium. Keynesian disequilibrium dynamics have come to an end. 21. The saw-tooth diagram can be programmed in Excel to see how this works step by step. Download it from the web page and study it. The Four Macroeconomic Markets 1. The circular flow of income is shown in a SAM. Firms use the factors of production owned by households to produce goods, which they then sell to households. 2. This can be represented by a series of markets. 3. There are four markets that interact to give a full macro picture. 4. The DD (or IS) is the goods market. This corresponds to the first row of the SAM, where firms are suppling goods to all the agents. 5. The labor market balances supply and demand for labor. Supply comes from households and demand for labor is derived from firms. The payment made by the firms to the owners of labor are shown in the SAM as wages. 6. The capital market shows demand for capital. Supply comes from households and demand for capital goods is derived from firms. The payments made by the firms to the owners of capital are shown in the SAM as profits (or dividends, interest, etc.) 7. Macroeconomic equilibrium requires that all three markets be in equilibrium simultaneously. 8. The LM (or AA) is the money market shows demand for money from firms and households and supply of money as determined, mostly, by the Federal Reserve (FED). The AA curve shows the equilibrium of the money market and the foreign exchange market. The money market is shown in the financial SAM. The current account is shown in the real SAM. It is just negative of foreign savings. Fiscal Policy 1. Fiscal policy Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth. 2. Multiplier effects stronger for government expenditure than for taxes 3. Not all multipliers are the same. 4. Keynes noted that if the capitalists go on strike the government could fill in for them since the government spending multiplier and the investment multiplier were the same. Y G = Y I 5. This provides a theoretical foundation for the Keynesian model. 8

9 6. The government expenditure multiplier is positive and between 1.5 and The tax multiplier is negative So one question: do they cancel out? Balanced budget multiplier 1. Raise taxes and government expenditure by the same amount and the result is still expansionary. Let GDP: Y = C + I + G Consumption fn: C = C + c(1 t)y Balanced budget condition: G = ty Get reduced form Expand Y = C + c(1 t)y + I + G Y = C + cy cty + I + G Substitute balanced budget condition Y = C + cy cg + I + G Now put time signatures on variables and the one parameter that is going to change and subtract Diving this last equation by G Y 1 = C + cy 1 cg 1 + I + G 1 Y 0 = C + cy 0 cg 0 + I + G 0 Y = c Y c G + G Y G = 1 c 1 c = 1 2. This astonishing result says that if you raise government expenditure by a dollar and then adjusts the tax rate t so that at the new equilibrium ty = G there will still be a net stimulus on the economy equal to one dollar. 3. Reason: some of the increase in taxes comes out of savings. Financing Deficits 1. When a government runs a deficit, it must create a bond. 2. There are three ways government deficits are financed (a) borrow from the private sector (b) borrow from foreigners (c) borrow from the Fed (print money) 3. One of the main reasons poor countries are poor is that their governments cannot borrow from the private sector. 1 This multiplier is a bit more difficult to derive and will be covered in a more advanced class. 9

10 4. Governments are then forced to borrow from the central bank. 5. This creates money and from the quantity equation above, creates inflation. 6. Inflation undermines the society and cause people to have even less faith in their governments. 7. They then invest their savings in US treasury bonds, effectively financing our deficit for us. 8. This is a tragedy. Automatic stabilizers 1. Automatic stabilizers work to prevent aggregate demand from rising or falling as much as it would otherwise. 2. Proportional taxation works as an automatic stabilizer: Let s say there is a drop in investment. This would cause a reduction in output and employment. 3. If taxes were a fixed lump sum, then consumption would fall by a greater amount than if taxes were to fall when income falls. Proportional taxes then stabilize aggregate demand more than lump sum taxes. 4. The same is true of the savings rate. If savings were a fixed sum then consumption would fluctuate more violently. 5. Unemployment insurance is also an automatic stabilizer. When investment falls and people are laid off their jobs, unemployment claims are filed. This causes output not to fall as much as it otherwise would. 6. All forms of the social safety net, such as welfare payments, temporary assistance to needy families and the like tend to stabilize the economy. Foreign Sector 1. How do developing countries get into trouble and have to call on the International Monetary Fund as the lender of last resort? 2. The root of all balance of payment crises is negative government savings. 3. Government savings is T G where T is all forms of taxation and other government revenue and G is government expenditure, including goods and services purchased from firms, government wages, interest payments on government debt, and transfers including welfare and other social safety net items. 4. Most poor countries have difficulty borrowing from their own private sectors, although the situation is improving as inflation is lower throughout the world. Mexico has been able to float debt at very low long-term interest rates recently, for example. 5. If there is a deficit, government saving is negative and G > T. This has an expansionary effect on GDP. 6. Imports increase as GDP increases. If exports don t increase, we have a foreign deficit (positive government savings). 7. We often refer to the twin towers of the government and foreign deficit. A government deficit causes a foreign deficit. 8. The balance of payments crisis can be averted if S g rises, so why don t policymakers simply increase taxes or lower government expenditure. 10

11 9. This is what the IMF recommends. 10. But the policymakers are reluctant, or even powerless, to raise taxes. 11. Many components of G are committed and cannot be changed, for example, interest payments on government debt. The discretionary component of government expenditure may in fact be small. 12. The easiest part of G to cut is transfers, and here is where the IMF gets its bad reputation. 13. Policymakers often blame the IMF for forcing government to make unpopular cuts. The Fund becomes a scapegoat, blamed for problems created by government. 14. In fact governments are fortunate that the IMF exists to bail them out. Otherwise, governments (and states) would fail just as firms do, since no private lender would dare to give the government a loan when it already running a large deficit. 15. Governments can also run out of foreign reserves (dollars) if there is a fixed exchange rate. 16. The central bank makes a market in foreign reserves. On the demand side are importers and those who wish to convert local currency to dollars for capital outflow (capital flight). On the supply side there are importers and foreigners who want to bring money into the country. 17. The foreign investment can take the form of direct foreign investment or portfolio investment. These are financial account entries, where importers and exporters are recorded on the current account of the balance of payments. 18. The central bank buys foreign exchange from exporters and those investing in the country and sells it importers and those who want to take money out of the country. 19. If the two are balanced, then at the end of the day (or any trading period) the supply of dollars in the central bank is constant. 20. If exporters and foreign investors bring in less dollars than importers and capital exporters want then the reserves of the central bank fall. 21. In principal reserves can build up forever, but they cannot decline forever. Once people in the country see that the central bank is struggling to maintain its reserves, there can be a panic, a run on the central bank in which expect that soon the central bank will run out of reserves. This is the beginning of a financial crisis. 22. The solution suggested by the IMF is to move from a fixed exchange rate to a floating exchange rate. 23. In effect the central bank simply closes its foreign exchange window and lets the market set the exchange rate. 24. This is why the IMF is accused of promoting free market orthodoxy. 25. They also support lifting price controls and the privatization of government held assets, such as airlines, energy and basic industry, the Commanding Heights, of the economy. 26. This frees this government from the responsibility for creating a financial or balance of payments crisis and puts the economy on automatic pilot. 27. How does this work? Let s say that the central bank forecasts the demand and supply for reserves and sees there will be a shortage. I can devalue the currency by raising the nominal exchange rate e. 28. This may work fine but the central bank must stay on the job of closely monitoring the exchange rate and adjusting it as needed. 29. The IMF suggest that they move to a floating exchange rate, in which importers, exporters and investors and capital exporters all get together in a market and determine the exchange rate. Now if there is more demand for dollars than is supplied, the exchange rate depreciates. 11

12 30. Exports are then stimulated, imports discouraged, and the balance of payments equilibrium is restored. 31. Argentina is classic example of macroeconomic populism, using the tax and transfer power of the state to achieve political goals. It has frequently blamed the IMF for problems it has created. Exchange rates and competitiveness 1. Exchange rates are analyzed with supply and demand diagrams. See the text for illustration of how exchange rates are determined. 2. Best to think of exchange rate from outside the US. 3. US is a special case since it provides the reserve currency for the world. 4. We have exchange rates with the other major currencies of the world, pound, euro and Japanese yen. 5. We can print our own reserve currency, which no other country in the world can do. 6. Taking hats of the real exchange rate equation q = Ep p we have ˆq = Ê + ˆp ˆp 7. Again up is down meaning that a higher real exchange rate (8 is higher than 6) is a weaker exchanger rate. 8. We could also say that when prices of goods go up domestically that our current is weaker since there is a larger number of dollars required to buy the same good. So there is nothing really weird or new here. The key is to think of the foreign currency, in our examples, the dollar, as just another good. 9. Example: lets say that foreign inflation is 3 percent and domestic inflation is 10 percent. If the nominal exchange rate E remains fixed, then the real exchange rate will appreciate by 7 percent. 10. We use appreciation/depreciation for floating exchange rates and devaluation/revaluation for fixed exchange rates. 11. Appreciation is good for importers (including tourists) and bad for exporters. The latter get fewer units of local currency for their dollars. Hence, IMF always recommends devaluation if there is a balance of payments crisis. This is not evil; it is just logic. Local government resist it however, since they believe that devaluations signal weakness and cause inflation. This is true, but devaluation does help fix the problem. 12. Devaluation does have one major drawback, however; it can spark a financial crisis. Foreign investors will flee the country if they feel that sequence of devaluations is coming. The reason is that when the country devalues its currency it takes more local currency to obtain a USD. This means that foreign investors rate of return is reduced. 13. Example: A US citizen is deciding whether to invest in Mexico or buy a 10-year US treasury, the so-called benchmark financial asset. If the expected rate of return in Mexico is 18 percent but a 11 percent devaluation is expected. The treasury pays 6 percent. Which asset should the US citizen purchase. Solution: The expected rate of return on the Mexican asset is = 7 percent. Now this is greater than 6 percent so the Mexican asset seems more attractive. The US investor may nonetheless go for treasury, however, since the Mexican asset may be more risky (can t be less). If the extra return does not subjectively compensate the investor for the extra risk (here a budget constraint and tangency condition is relevant) then she will go for the treasury and economists can say nothing. 12