MCh 5 Traditional Keynesian Theories of Fluctuations

CH 5 Traditional Keynesian Theories of Fluctuations 5.1 Review of the Textbook Keynesian Model of AD The AS-AD framework: AS curves slopes upward and the AD curves slopes downward. The IS Curve Planned real expenditure: The IS Curve: : the Keynesian cross From the Keynesian cross to the IS curve: slopes down Explanation: ; The LM Curve: slopes upward The IS-LM assumption: two assets: money and everything else The AD curve The downward-sloping AD curve The slope of AD: Example: the effects of a 5.2 The Open Economy The Real Exchange Rate and Planned Expenditure Nominal exchange rate : price of foreign currency in terms of domestic currency Real exchange rate : price of foreign goods in terms of domestic goods. IS* curve in the open economy: LM curve unaffected as before: Assumptions about the models: the exchange rate regime (floating or fixed), capital mobility (perfect or imperfect), and exchange rate expectations (static or rational). The Mundell-Fleming Model (Mundel, 1968; Fleming, 1962) uncovered interest rate parity( ): (here exchange rate) Perfect capital mobility (no barriers to capital mobility and risk-neutral investors); Static exchange rate expectation: (1) With floating exchange rate LM*: IS*: The Mundell-Fleming model with a floating exchange rate in space The extreme effectiveness of M-policy: The vertical LM* implies that the output for a given price level—that is, the position of AD curve—is determined entirely in the money market. The extreme ineffectiveness of F-policy: Suppose a , IS shift to the right. But at a given level of price this leads only to appreciation of the exchange rate and has no effect on output. Thus AD curve is unaffected. Fig 5.7 (2) With fixed exchange rate LM*: (serves only to determine M, and can therefore be neglected) IS*: Mundell-Fleming model with a fixed exchange rate in the space The extreme ineffectiveness of M-Policy: money supply become endogenous rather than exogenous. The government can not set M independently. Disturbance in the money demand leads only to an increase in money supply, has no real effect on Y. The extreme effectiveness of F-Policy : Suppose a , IS shift to the right. And thus raise output for a given price level. The exchange rate policy: Finally, with a fixed exchange rate, the exchange rate itself is a policy instrument. For example, a devaluation stimulate net exports and thus increase AD. Rational Exchange Rate Expectations and Overshooting With a floating exchange rate, static exchange rate expectations are not rational, and can lead to systematic errors. Rational expectations are needed. Under perfect capital mobility and rational expectation (not static): the return of 1 unit of currency invested in domestic and abroad: derivatives of both sides with respect to valuated at uncovered interest rate parity: under perfect capital mobility, interest rate differences must be offset by expectations of exchange rate movements. The possibility of exchange rate overshooting(Dornbusch, 1976): overshooting refers to a situation where the initial reaction of a variable to a shock is greater than its long run response. The possibility of exchange rate overshooting and undershooting for a Start: , Suppose a at : LM*: IS*: (1) Keynesian models generally imply that in the long run, the nominal shock has no real effect ( ), only causes prices level ( ) and exchange rate to rise ( : depreciated) proportionally with the increase in money. (LM* and IS*) (2) If , then : Investor will hold domestic assets only if they expect the domestic currency to appreciate. (3) means that the domestic currency is worth less now than it will be in the long run; that is, it must have depreciated by so much at the time of the shock that it has overshot its expected long run value. (4) It is possible that in a very short run case, producers can not change output ( ), so that IS equation need not be satisfied at every moment. With both prices and output fixed, the only variable that can adjust to ensure that LM equation is satisfied is the interest rate. Thus i must fall in response to an . When the IS equation is assumed to hold continuously, and increase in no longer necessarily reduces i. Thus in this case there can be either undershooting or overshooting. (Dornbusch, 1976 and Problem 5.10) Imperfect Capital Mobility Barriers to capital movements, risk aversion of the investors, transaction costs and the desire to diversify, etc. : foreigners’ purchases of domestic assets – domestic residents’ purchases of foreign assets and IS**: IS** is flatter than the closed economy IS curve. In the extreme case of perfect capital mobility, the IS** curve is flat at i*. The LM curve is the same as before. In this case, monetary policy is most effective and fiscal policy is absolutely ineffective. Fig 5.9. the case of imperfect capital mobility and a floating exchange rate. Fig 5.10. the effects of an increase in government purchases with imperfect capital mobility and a floating exchange rate. 5.3 Alternative Assumptions about Wage and Price Rigidity---an upward sloping AS Four cases (Incomplete nominal adjustment assumption) : Case 1: Keynes’s Model: sticky wages, flexible prices and competitive goods markets In Keynes’s General Theory (1936) Labor demand: (competitive goods markets) AS: An upward-sloping AS curve. So increase in AD leads to increase in both P and Y Fig 5.11: the labor market with sticky wages, flexible prices, and a competitive goods market. Fluctuations in AD lead to movements of employment and the real wage along the downward sloping labor demand curve: AD down—P declines---W/P increases---employment falls (involuntary unemployment increases) Case 2: Sticky Prices, Flexible Wages, and a competitive Labor markets Often with the case of imperfect competition in the goods markets Wages are flexible (competitive labor market). Workers are on their labor supply curve: Finally, firms meet demand (AD) at the prevailing price as long as it does not exceed the level where marginal cost equals prices: Fig 5.12: AS with rigid goods prices: horizontal at until Fig 5.13: a competitive labor market when prices are sticky and wages are flexible Effective labor demand and labor supply (1) Equilibrium E: there is no unemployment. (2) A procyclical real wage in the face of demand fluctuations: AD decline---Y decline---effective labor demand decline---the real wage W/P decline. (3) A countercyclical markup (ratio of price to marginal cost) in response to AD fluctuations: AD rise --- cost rises (the wage rises and the marginal product of labor declines as Y rise)----the ratio of price to marginal cost falls (price stay fixed) (many references) The reason that incomplete nominal adjustment caused changes in AD to affect Y is quite different in this case than in the previous one: a fall in AD, for example, lowers the amount that firms are able to sell at the prevailing price level. thus they reduce their production; in the previous model, in the contrast, a fall in AD, by raising the real wage, reduces the amount that firms want to sell. This model of AS is important for three reasons (1) It is the natural starting point for models in which nominal stickiness involves prices rather than wages. (2) There is no necessary connection between nominal rigidity and unemployment (3) Models like this often appear in the theoretical literature (easy to use) Case 3: Sticky Prices, Flexible Wages and Real Labor Market Imperfections (modify case 2) suppose that nominal wages are still flexible, but there is some non-Walrasian features of the labor market that cause the real wage to remain above the level that equals demand and supply (details in ch 9; here efficiency wage reasons): *** real wage function the labor supply curve is above that in case 2: Fig 5.14: A non-Walrasian labor market when prices are sticky and nominal wages are flexible (1) AS curve as case 2: horizontal at level until (2) Equilibrium E: the intersection of the effective labor demand and the real wage function. In contrast to the previous case, there is unemployment EA (3) Fluctuations in labor demand leads to movements along the real wage function rather than along the labor supply curve. (4) The elasticity of labor supply no longer determines how real wage responds to AD movements. And if real wage function is flatter than the labor supply curve, unemployment rises when demand falls. Case 4: Sticky Wages, Flexible Prices, and Imperfect Competition in goods market (modify case 1) With imperfect competition in goods market, price is a markup over marginal cost. (as in case 3), we assume that there is a “markup” function: is the marginal cost and is the markup. If is constant, then as in case 1 (1) AS curve slopes up because of the diminishing marginal product of labor (2) The real wage is countercyclical: AD down—P declines---W/P increases---employment falls (involuntary unemployment increases) (3) There is unemployment as long as labor supply is less (larger?) than the level of employment determined by the intersection of AS and AD If is sufficiently countercyclical ( enough )—that is, if the markup is sufficiently lower in booms than in recoveries, the real wage can be acyclical or procyclical even though the nominal rigidity is entirely in the labor market (1) fig 15.5(a) (2) fig 15.5(b) (3) fig 15.5(c) 5.4 Output-Inflation Tradeoff: Phillips curve A Permanent output-inflation tradeoff?: Phillips curve (1958): the strong and relatively stable negative relationship between unemployment and wage (price) inflation in the UK over the previous century If the level at which wages or prices are fixed is determined by the previous period’s wages and prices, the models of the previous section imply a permanent tradeoff between output and inflation. Consider the first model of AS (case 1): fixed wages with , flexible prices, and with a competitive goods market. AS: Fig 5.16: initial : period 1: : short run period 2: ( long run ) thus employment and output would be the same as they were in period 0. that is, goes through : . So the model implies a permanent output inflation tradeoff. The Natural Rates: Friedman (1968) and Phelps (1968) Fig 5.17: unemployment and inflation in the US, 1961-1999: clockwise rotation. The Expectations-Augmented Philips Curves A typical Keynesian AS : core or underlying inflation. : Permanent output-inflation tradeoff With this formulation, there is a tradeoff between output and the changes in inflation, but no permanent output-inflation tradeoff. 5.5 Empirical Application: Money and Output In basic RBC models, purely monetary disturbances have no real effects. In Keynesian models, they have important effects on employment and output. The St. Louis Equation (Leonall Anderson and Jerry Jordan, 1968) Problems of this regression (1) Causation may run from output to money rather than from money to output (King and Plosser, 1984) (2) The determinants of monetary policy (monetary policy to stabilize the economy, Kareken and Solow, 1963; and the effects of fiscal policy) (3) Large shifts in the demand for money (financial innovation and deregulation may lead to a negative relationship between money and output if the FED does not adjust the money supply fully in response to these disturbances) Other Types of Evidence (1) Causation running from money to output rather than in the opposite direction.(independent monetary disturbances) (a) Friedman and Schwartz (1963): by undertaking the historical analysis of the resources of movements in the money stock, they argue that many of the movements in money, especially the largest ones, were mainly the result of developments in the monetary sector of the economy rather than the response of the money stock to real developments. And these monetary movements were followed by output movements in the same direction. (b) C. Romer and D. Romer (1989): evidence of policy shifts designed to lower inflation that were not motivated by developments on the real side of the economy. (2) The impact of monetary changes on relative prices Monetary changes have real effects: Cook and Hahn (1989, section 10.3): the Federal Reserve open market operations are associated with changes in nominal interest rate, and so the real interest rate, with no significant effect on expected inflation, so monetary changes have real effects (since real and Keynesian theories agree that changes in real rates affect real behavior) The nominal exchange rate regime appears to affect the behavior of real exchange rates, and so have real effects (many references) More Sophisticated Statistical Evidence VAR: vector autoregressions: sims, 1980; Hamilton, 1994; Cooley and LeRoy, 1985; Bernanke and Blinder, 1992: measures of monetary policy (the Federal funds rate) other than the money stock Structural VARs: Sims, 1986; Bernanke, 1986; Blanchard and Watson, 1986 Important recent contributions: Sims, 1992; Bernanke and Mihov, 1998; Christiano, Eichenbaum, and Evans, 1996; Leeper, Sims and Zha, 1996; Cochrane, 1998; Barth and Ramey, 2000. Rudebusch, 1998: not clear that modern VARs have in fact solved the difficulties with simpler money output regressions. 5.6 The Cyclical Behavior of the Real Wage The real wage is approximately acyclical or moderately procyclical (Geary and Kennan, 1982) The skill-adjusted aggregate real wage is likely to be more procyclical than the unadjusted aggregate real wage. Bils (1985), the earliest to examine the cyclical behavior of real wages using panel data. Solon, Barsky, and Parker, 1994: the most thorough and careful attempts Two approaches to addressing composition bias (1) Consider only individuals who are employed throughout their sample period and to examine the cyclical behavior of the aggregate real wage for this group (2) Uses more observations : a vector of control variables; : unemployment rate The results of the two approaches are quite similar. 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