KEYNESIAN Flashcards
Dynamic AS/AD model incorporates features from..
Keynesian and new-keynesian
Key feature to Keynesian model
Frictions to adjustment of prices
2 positives of abandoning DSGE setting
- can represent equilibrium in as/ad diagram
2. can show BC shocks by shifts
AS =
the link between output and prices due to the price setting behaviour of firms.
AD =
the link between output and prices due to the demand behaviour of consumers and firms for the final good.
What 2 types of output do keynesian models distinguish between?
Yt bar = potential output
Yt tilda = SR output / output gap
Potential output =
level of output that prevails when FOPs are utilised at their LR level. When shocks have dissipated. Exogenous to this model.
Output gap formula
Yt tilda = Yt - Yt bar / Yt
% deviation of current output from potential output.
The LR =
the time horizon over which effects of temporary shocks have dissipated.
The SR -
the time horizon over which shocks bring the economy away from equilibrium.
In keynesian models, it is important to distinguish between…
NOMINAL AND REAL
especially for IR
Real IR =
the return in terms of the consumption good from investing 1 unit of the final good.
LR Real IR formula
R bar = MPK - d which are steady state quantities.
Why does R≠R bar?
In the SR due to monetary policy,
Nominal IR =
nominal return in terms of money of investing 1 unit of money.
Fisher equation
Rt = it - Pi t
National account identity
Yt = Ct + It + Gt
What does Gt refer to?
Gt = gov purchases
Gt ≠ government spending - it does NOT include transfers.
Formula for Ct
Ct = (ac bar + ac,t) Yt bar
Formula for Gt
Gt = (ag bar + ag,t) Yt bar
What is ac bar?
The constant LR share of potential output that goes to consumption
Does Ct depend on SR output? Why?
NO - only potential output. temporary shocks implicitly assumed to be smoothed by saving/borrowing.
Formula for It
It = (ai bar + ai,t - b(Rt - R bar)) Yt bar
How does It depend on real IR? explain.
It depends negatively on gap between real IR and R bar. If Rt > R bar, this means Rt > MPK so disincentive to invest in K, better to save retained earnings on financial market so It falls.
IS curve shows
The equilibrium relationship between SR output and the real IR, which is negative.
Formula for IS curve
Yt tilda = at - b(Rt - R bar)
where at = ac,t + ag,t + ai,t
ac bar + ag bar + ai bar =
1
at refers to
An AD shock
How can CB control the real IR?
They change nominal IR it by changing interbank lending rate
But since inflation is sticky, they control Rt in effect.
4 reasons for sticky prices
- Sticky wages
- LR contracts between buyers and sellers
- Direct menu costs
- Inattention to monitoring demand conditions.
MP curve shows
SR real IR implied by the nominal IR the CB chooses.
MP rule formula
(Rt - R bar) = m(Pit - Pi bar) + €tM
What is €tM?
Mean zero monetary policy shock = change in monetary policy unrelated to change in inflation.
m bar -
how aggressive CB respond to inflation deviations.
3 advantages of inflation targeting
- predictable environment for It
- Higher inflation distorts prices (adjust at different speeds)
- Direct menu costs if change prices
AD curve is derived from
IS curve + MP curve
AD curve formula
Yt tilda = at - bm(Pit - Pi bar) + b€tM
What do we assume about expectations?
Adaptive expectations
Pi t E = Pi t-1
backwards looking behaviour
SRAS/Phillips curve formula
Pi t = Pit-1 + vYt tilda + Oc
v bar -
sensitivity of prices to change in demand conditions.
Oc =
exogenous shocks to costs of production e.g. oil shock, strikes, weather
How does higher expected inflation lead to higher actual inflation?
Higher expected = workers demand higher wages = higher production costs for firms = it’s optimal for them to raise their prices.
LRAS is given by
Vertical line at Yt tilda = 0
Business cycles for keynesian mean…
Yt tilda ≠ 0
Can we do quantitative analysis with keynesian?
NO - can’t do calibration
If a demand shock at time t+1 is temporary, what does this mean?
At time t+2, ADt+2 = ADt
AD curve back to its original position.
How do CB react to negative demand shock?
Rt+1 < R bar
At time t+2, is the economy now back to its equilibrium?
NO - AD back to normal, but because inflation fell last period, not inflationary expectations have fallen = AS curve shifts down under AE.
How does AS respond from t+3 onwards to the negative demand shock?
Since AS falls at t+2, but inflation higher than in t+1 since AD back to normal = inflation expectations increase relative to t+1 = AS gradually shifts back up to its original.
How to CB respond to negative demand shock in t+2 onwards?
Since the shift in ASt+2 causes positive output gap, CB gradually increase IR back to R bar and cause demand to contract.
Therefore, if a BC is demand driven, inflation is…
PRO-CYCLICAL
Effects of negative demand shock on output
Recession first
Then small expansion before back to equilibrium.
If we have a negative supply shock, how does AS change over the periods?
t+1 = AS shifts left and up t+2 = shock gone but since inflation risen, inflationary expectations rise relative to t, so AS above ASt still. Eventually goes back to ASt.
How to CB respond to negative supply shock over the periods?
Initially increase Rt to curb inflation
But this causes a recession
Gradually reduce Rt back to R bar
Therefore, if a BC is supply driven, inflation is…
COUNTER-CYCLICAL
was the great depression consistent with the model?
YES - demand driven recession and deflation
were the 1970s oil price shocks model consistent?
YES - stagflation
What’s the missing deflation puzzle?
Financial crisis: huge fall in AD, but not many countries experienced deflation.
Possible explanations for missing deflation puzzle.
- AS shifted up at same time
2. Flatter slope of AS
3 reasons why AS may have shifted up
- higher oil prices
- higher inflationary expectations
- higher production costs due to wage rigidity.
3 reasons why slope of AS may have become flatter.
- Higher costs of changing prices
- Increased market power = prices less responsive to demand
- More international trade = prices less responsive to national demand conditions.
If AD falls but AS is very flat, impact on inflation and output
Large fall in output
Very little fall in inflation
What do Coibion & Gorodnichenko (2015) say about deflation puzzle?
Caused by high inflationary expectations
Survey from uni of Michigan: how expect prices to change over next 12 months.
Why were inflationary expectations so high?
expectations reacted strongly to rise in global oil prices. Gasoline prices very salient and frequently observed = disproportionate effect on expectations even though small part of consumption basket. Also rise in production costs due to higher oil prices. So AS shifts up.
Why don’t CB just stimulate the economy forever?
€tM < 0 means Rt falls so expansionary.
AE assumes agents are surprised by shocks.
But if monetary shocks frequent, agents will expect them = inflationary expectations rise = output falls - opposite of intended effect.
2 weaknesses of fiscal policy
- Implementation lags due to gov legislation
2. Large public debts = constrained
benefit of fiscal policy
Useful when MP constrained by ZLB on it.
