Chapter 5 -lecture Notes

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1 Lebanese Amerian University From the SeletedWorks of Ghassan Dibeh 04 Chapter 5 -leture Notes Ghassan Dibeh, Lebanese Amerian University Available at:

2 Chapter 5 IS-L with Variable ries Keynesianism beame the dominant maroeonomi theory espeially in its stati IS-L variant. Shifts in the IS shedule beame the mainstream view on the ause of the business yle. In addition, historial events helped in the fading away of the earlier debate on business yle theory. During the post-w.w.ii period and until the late sixties, the business yle was mild relative to earlier periods in the history of apitalism prompting many to delare the business yle as "dead." The order of the day was the appliation of Keynesian models to the management of the eonomy through the appliation of fisal and monetary poliies to what beame to be known as finetuning the eonomy. And this surely led to less GD volatility ompared to the pre- WWII period. These developments helped reate a onsensus in maroeonomis ame to be known as the neolassial-keynesian synthesis. The synthesis had three main omponents (Sherman, 993: ( Fisal and monetary poliies are needed to ure unemployment. ( One there is full-employment, the eonomy is optimal and (3 the impediments to the apitalist eonomy generating full employment on its own are the prie and wage rigidities in the eonomy. Hene, in the presene of prie and wage flexibility the eonomy moves in the long-run to full employment equilibrium. In the Keynesian model, that we developed up till now (hapters 3 and 4, we did not onsider the determination of the prie level. New post-keynes developments in the field attempted to inlude prie dynamis into the eonomi models that would bring full employment in the long-run. The Neolassial synthesis introdued prie flexibility into the Keynesian system to derive stabilizing fores that operated in the long-run in the apitalist eonomy. In the words of one of the proponents of the neolassial synthesis, Don atinkin "the entral question whih divides lassial and Keynesian

3 eonomis (is: the effiay of an automatially funtioning market system with flexible money wages in eliminating involuntary unemployment. atinkin onsiders that the Keynesian revolution in eonomis put the possibility of disequilibrium on the agenda of eonomi researh. He puts the dihotomy in a lear fashion, "Equilibrium means full employment, or, equivalently, unemployment means disequilibrium. Hene our study of the orretive market fores generated by the presene of involuntary unemployment is a study of the dynami workings of an eonomy in disequilibrium. And the assumption made until now, that granted flexibility, these fores will restore the eonomy to a state of full employment, is an assumption that the eonomy is onsistent and stable; and that, in other words, an equilibrium position always exists and that the eonomy always onverges to it." (atinkin, 965, p. 38. atinkin shows that through a real balane effet, the eonomy an generate a slow, albeit sure, dynami towards full employment again. Eonomi poliy an be effetive in suh an eonomi environment by helping a sluggishly adjusting eonomy pik up speed towards ahieving full employment. In this hapter, we develop the IS-L model that takes into aount the prie level in the eonomy. The effet of hanges in the prie level on aggregate demand and onsequently on output are then developed. The Aggregate Demand Funtion In the simple Keynesian multiplier model and the IS-L model, we have assumed that the general prie level is fixed. The original Keynes formulation of his model assumed that money wages are fixed and hene is fixed. Aording to Keynes, workers are about their relative position in the wage struture and bargain with employers over the money wage. In this view of the labor market as ontratual with nominal wages fixed for a period, the prie level is assumed onstant. In this respet, the lassial assumption that labor markets determine the real wage was onsidered unrealisti by Keynes as workers have no power over the determination of the real wage. Given suh view of the labor market, we add the following losure equation to the IS-L model

4 = ( Now we allow in the IS-L model, the possibility of a hange in. The first step in the onstrution of the new IS-L model is inluding expliitly to deflate the nominal variables in the model. The only nominal variable in the model is money. The money demand funtion then beomes the demand for real money balanes. ( d = L( y, r ( and equilibrium in money markets beomes ( d = (3 or ( = L( y, r (4 This makes the L urve a funtion of (. This an be derived as follows y r = r = y L-urve (5 Graphially, the L urve an be represented as L( with different L urves for different prie levels

5 Figure. L urve as a funtion of For 0 > > > 3, the L urves shift to the right as dereases. The reason is that as the prie level goes down, real money balanes inrease shifting the L to the right (the equivalent of inreasing in the fixed prie model. The hange in the L funtion, given an IS funtion produes a set of points (, that orrespond to equilibrium in money and goods markets. These form the aggregate demand funtion (AD. Figure. Equilibrium points given by IS-L with variable

6 Figure 3. The Aggregate Demand Funtion Algebrai derivation of the aggregate demand funtion We know from hapter 4 that the IS urve is given by C I G ( mp r = y (6 The equilibrium ( r = r gives IS L y = C I G ( mp y ( mp C I G y( = y = ( C I G E mp mp (7 ( ( Equation (0 is the aggregate demand funtion plotted in figure 3. The effet of C, I, G, is to shift the AD urve.

7 Figure 4. Shifts in the AD as a result of Shoks and oliies Algebraially, these an be written for G I,, respetively I mp y E = ( G mp y E = ( mp y E = ( In the AD framework the fixed prie Keynesian model an be represented by the following AD and AS funtions respetively mp G I C mp y E ( ( ( = (8 = (9

8 or graphially, Figure 5. The Keynesian Underemployment Equilibrium. The ondition = is The Neolassial Synthesis equivalent to a horizontal aggregate supply funtion. In the aftermath of Keynes s theory of maroeonomis, the field was divided sharply between the Keynesians and the few outposts of remaining lassial eonomists (espeially after WWII in aademia and government. The division has led as we have seen in hapter one to opposite views on the dynamis of the apitalist eonomy and the role of government poliy. On one side, the Keynesians believed that the apitalist eonomy generated underemployment equilibrium in the normal state of affairs and that government has a role to play in uring reessions through monetary and fisal poliies. On the other side, the lassials believed the eonomy is inherently stable and markets generate full employment and hene governments fisal and monetary poliies are not needed but furthermore are atually harmful. In the 950 s and 960 s a synthesis between the two traditions arose alled the Neolassial synthesis. The synthesis alloated the temporal domains of the appliability of both theories. In the short-run, Keynesian eonomis was valid and in the long-run the lassial model. The synthesis an be summarized as follows:. In the Short run =.. In the Long run, is flexible.

9 Figure 6. aroeonomi Equilibrium (Long run In the SR, Keynesian eonomis applied but as pries adjusted in the long-run, the lassial world dominated. The maroeonomi equilibrium an then be represented as follows. There are two aggregate supply funtions: a short-run aggregate supply (SRAS and a long-run aggregate supply (LRAS. The eonomy in the long run will adjust to y E = y f. The Keynes and igou Effets In the above model, there is in the short-run the possibility that the eonomy due to ertain level of aggregate demand (given by mp, EC and r is in underemployment equilibrium at point A where y < y. E f Figure 7. Underemployment Equilibrium in the Short-run

10 The question is then: How does the eonomy move from point A to point C. The traditional Keynesian approah is through fisal and monetary poliies. The inrease in G or will shift AD to the right until y E = y f. Figure 8. Aggregate Demand Route to Full Employment or, and here omes the Neolassial synthesis, the prie level will adjust downward until the eonomy is again at equilibrium point C where y = y. E f Figure 9. rie Flexibility Route to Full Employment

11 The Neolassial synthesis advaned that there are two mehanisms by whih the eonomy through flexible will move to full employment equilibrium:. The Keynes effet. Keynes in the GT, disussed the possibility that a redution in the prie level leading to an inrease in real money ( would lead to a redution in the interest rate and the movement of the eonomy to full employment. Hene, the redution in is equivalent o an inrease in i.e. the redution in plays the same role as entral bank s monetary poliy. Keynes dismissed this effet as ineffetive due to the liquidity trap (this will be disussed in the next hapter. Graphially, the Keynes effet an be seen in the IS-L model Fig. 0. Keynes Effet The redution in will inrease the real money supply shifting the L urve to the right until y y E = f. Algebraially, this an be seen as y E = ( ( mp. The igou effet. Arthur igou was a major lassial eonomist that was both a friend and a riti of Keynes s ideas. In 943 he published a paper that argued that the effet of a redution of the general prie level was to inrease the real wealth of onsumers and hene would inrease aggregate onsumption. The inrease in C would ure reession and bring the eonomy bak to full employment equilibrium. This is

12 alled the igou effet or the real balane effet. Given the ommunity s wealth as Ψ Ψ then the real wealth is and the onsumption funtion an be written as Ψ C = C mpy µ ( (0 and the IS urve then beomes Ψ C I G µ ( ( mp r = y ( Graphially, the IS urve shifts to the right when the goes down. Hene the falling prie level will lead to an inrease in AD that will push the eonomy to full employment. Fig. The igou Effet ombined with the Keynes Effet Algebraially the AD demand funtion beomes with the igou effet y Ψ E = ( C I G µ mp mp ( ( (

13 The ombined effets would make the adjustment of the eonomy along the AD funtion faster. Solved problem Suppose there is eonomy with the following, 0.75,,, 0.5, 00, 50, 00, Ψ 50, 0.,. a. Write down the equation of the IS urve,.. Y b. Write down the L urve, Calulate equilibrium output and interest rate. IS = L

14 ECO 306 [LECTURES ON ACROECONOICS BY GHASSSAN DIBEH] d. Suppose that the eonomy experiened severe deflation pushing the prie level form to 0.5. How will this deflation affet output? The hange in the prie level will shift both the L urve (Keynes effet and the IS urve (igou effet. The new L beomes and the new IS beomes y The new output is determined by the intersetion of the new IS and L urves

15 roblems. Derive the IS funtion with the igou effet.. Derive the AD funtion with the igou effet. 3. Suppose there is eonomy with the following, 0.8, 0,, 0.05, 00, 50, 00, Ψ 50, 0.3,. a. Write down the equation of the IS urve, b. Write down the L urve,. Calulate equilibrium output and interest rate. d. Suppose that the eonomy experiened sever deflation pushing the prie level form to How will this deflation affet output?