ECON 122 Intermediate Macroeconomics

Spring 2018

Lecture 14: The Short-Run Model and the IS Curve

Michael Peters

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 1

The Short Run Model

Consumption

Real interest
Shocks Y=C+I+G
rate r

Investment

Monetary policy Fiscal policy

possible or beneficial or
Is r at the not? not?
“right” level?
Do prices
adjust?
122a - Intermediate Macroeconomics - Fall 15 - Lecture 14 2
Consumption

• Optimal consumption behavior: Euler equation

u0 (c1 ) = (1 + r) u0 (c2 ) c2 = (1 + r) c1
u(c) = ln(c)

• Consumption function:
✓ ◆
1 1 1
c1 = LT W = y1 + y2
1+ 1+ 1+r
✓ ◆
(1 + r) (1 + r) 1
c2 = LT W = y1 + y2
r 1+ 1+ 1+r

r ⇤ A demand shock
reduces the
Demand shock
equilibrium level of
r̂
consumption if
interest rates do not
adjust!
y1
c1
122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 3
Investment
• Investors gain from investing in capital if
K K
Rt+1 pt r+ ⇡t >0

• Investment demand function ⇡tK = 0

I = I Rt+1 pK
t (r + ) with I 0 (.) > 0

• From firm’s capital demand

I = I M P Kt+1 pK
t (r + )

r A shock to investment demand,

e.g. an increase in future MPK

Investment

122a - Intermediate Macroeconomics - Fall 15 - Lecture 12 4

Short-run Fluctuations

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Long-Run versus Short-Run
Long-Run = Prices are flexible (Chapters 1 - 8)
- Output is in steady-state

Yt = Y ⇤ = F (K ⇤ , L)

- Economy at full employment and unemployment at natural rate

⇤ Labor force (constant)

L = N ⇥ (1 u )
Natural rate of
- Evolution of output governed by unemployment

1. Capital accumulation (Solow)

2. Technological progress (Romer)

Long-run model determines potential output and long-run inflation

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 6

Long-Run versus Short-Run
Short-Run = Prices are sticky
• Unemployment fluctuates around u*

• Output fluctuates around its potential (long-run) level

• Fluctuations are driven by shocks

- Technology, labor supply, oil (“supply shocks”)

- Expectation shocks, optimism, financial (“demand

shocks”)

- Gov. spending shocks, monetary shocks (“policy shocks”)

Short-run model determines current output and current inflation

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 7

Business Cycles

• Fluctuations in economic activity around long-run

trend growth

• Decompose output

actual output = long-run trend + |short-run {z

fluctuations}
| {z } | {z }
Yt Ȳt Ỹt

“Solow” - we will take that as

Focus for the rest of the class
exogenous for remainder of
class

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 8

The output gap

Actual output Long-run output

• Output gap
Yt Ȳt Percentage deviation
ŷt ⌘ from long-run output
Ȳt
• Note: ✓ ◆
Yt Yt
ln ⇡ 1 = ŷt
Ȳt Ȳt Note: Jones uses
x-1 Yt Ȳt
Ỹt =
ln(x) Ȳt

“Around x=1, f(x)=ln(x) and

x
1 f(x)=x-1 are very close”
-1
(“Taylor approximation”)

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 9

Business-Cycle

• A Business cycle is a cycle

• Expansion phase: “through to peak”

• Contraction phase “peak to through”

• Empirical regularities

• recurrent, but not periodic

• last from 2 to 10 years

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 10

A schematic business cycle

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Business Cycles in the US

output
gap

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Neo-Classical versus Keynesian Macroeconomics

Neo-Classical View

• Assumption: Prices and wages adjust quickly

• Implications:

‣ Monetary policy has no real effects - it only affects inflation

‣ Business cycles are driven by supply shocks and hence

efficient

‣ Optimal policy: laissez faire

‣ Low money growth to minimize inflation

‣ No fiscal stimulus

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 13

Neo-Classical versus Keynesian Macroeconomics

(New)-Keynesian View

• Assumption: Prices and wages adjust sluggishly

• Implications:

‣ Monetary policy can affect output

‣ Business cycles partly inefficient

‣ Government should try to eliminate inefficient

fluctuations

‣ Optimal policy:

‣ Counter-cyclical monetary and fiscal policy

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 14

Unemployment

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Recessions, Booms and Unemployment

• Empirically: Tight relationship between

unemployment and the state of the economy

Okun’s Law
Stable relationship
between
unemployment and
the output gap

n 1
ut u = ŷt
2

Actual
unemployment Natural rate of Output
rate unemployment gap

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 16

 Roadmap

Three pillars of short-run model:

1. Aggregate Demand: IS-Curve

‣ Relationship between output (Y) and real interest rates (r)

2. Aggregate Supply: Phillips curve

‣ Relationship between output (Y) and inflation (𝜋)

3. Monetary policy

‣ How does the central bank determine real interest rates (r)

122 - Intermediate Macroeconomics - Spring 18 - Lecture 14 17