Positive permanent Shock Positive Shock: Production function moves up. Know: y ↑ c ↑ Unsure: L: income effect ↓ Substitute effect = MP L ↓ Net effect = ?
Positive permanent ShockPositive Shock: Production function moves up.Know: y ↑ c ↑ Unsure: L: income effect ↓ Substitute effect = MPL ↓ Net effect = ?
r ys
y
Permanent increase in Wealth
Suppose your Income rises by £10,000 every year for the rest of your lifeHow much will your consumption rise each year?
Permanent ShockOutput Consumption
Interest rate
Hours worked (L) ? Could go or depending on strength of change in MPl versus wealth effect Empirically for permanent rises L
CASE 2: A Temporary Shock
a) Good/Positive:Good WeatherShort run oil price fall
‘Feel good’ productivity surgeb) Bad/Negative:
Bad Weather - Hurricane/Typhoon
- Flooding/Drought
Strikes / BSE / Gulf War
Short run oil price rise
If the world is constantly subject to positive and negative shocks what do we mean when we draw a production function?
Normal
y
L
Traditionally Macro Primarily concerned about downturns
However, we will start with a positive temporary shock to
allow better comparison with previous case of a positive
permanent shock
Normaly0
L
y0
r0
L0
y1sys
y1Effect of a temporary positive shock on supply
Effect of a temporary positive shock on supply
r0
y0
y1s
ys
yd
Temporary increase in Wealth
Suppose your Income rises by £10,000 just for this year onlyHow much will your consumption rise by?
Go Back to Last Slide
So we get a new equilibrium with lower r and higher output (y)
r0
y0
y1s
yd
ys
C1d= y1
dr1
y1
Temporary Positive ShockOutput Consumption
Supply ………. demand
So Interest Rate ……….
y
L
y=f(L)
Recall any Shift has a Substitution and an Income
Effect
1. Substitution Effect
Normal
y
L
Twist is the pure Substitution EffectMPL Up so real wage (W/P) Up and work more
2. Wealth or Income Effect
Normal
y
L
Shift is the Pure Wealth EffectAnd since you are richer you
work less
But now have 3rd EffectRecall in class derived
Ls for different real wages W/P
W/P
L
Ls
Hours Worked (L) Again Theoretically Uncertain
NOW have 3 Effects
1. Any change in MPl means wages are up and L will go
2. Wealth or income effect means L
3. But now 3rd effect. R has gone down, signal that output is abundant today, incentive to work goes down and L
Overall: Empirically 1 Dominates
Make hay while sun shines!
Normaly0
L
y0
r0
L0ys
y1
Effect of a temporary positive shock on supply
Effect of a temporary positive shock on supply
r0
y0
ys
yd
Negative shock to income is temporary
Therefore agents reduce consumption
-
r0
y0
y1s
ys
yd
C1d= y1
d
So we get a new equilibrium with higher r and lower output (y)
r1
y1
Temporary Negative Shock
Output Consumption
Demand ……… Supply So Price - Interest Rate - ………
Hours Worked (L)
Again Theoretically Uncertain
3 Effects
1. Any change in MPl means wages are down and L will go
2. Wealth or income effect means L
3. R has gone UP, signal that output is scarce today, incentive to work goes up and L
Overall:? Empirically 1 Dominates
How are we doing on the stylised facts?
1. Output fluctuating due to shocks2. Consumption fluctuating also
And remember Cd curve shifts by less than ys when there is a temporary (Business Cycle) shock But is it fluctuating less that output?
3. What about hours worked ?Saw 3 conflicting forces but it is theoretically possible in each case to explain the stylised fact by the dominant force.
r0
y0
y1s
ys
yd
C1d= y1
d
Let’s focus on the shift in cd
r1
y1
So in this model C + Y down by same amount
and Stylised Facts say C by less than y and r
So need something else in this modelIf aggregate C by less than aggregate y then
need aggregate Saving to accommodate
So key is to include investment in the model.
Bluffers Guide to Non-Assessed TestCore TheoryCh2: The Economics of Robinson Crusoe P31 - 47Ch4: Absolutely Essential : P70 - 74 Better P67 - 74 Best P67 - 80Ch5: Basic Market Clearing Model Absolutely Essential P87 - 93
{Ignore bit on Money} P95 - 97 Ideal P85 – 97
See J:\FILES\ECON203\Non-Assessed Tests
Before we consider investment in the model however, we
should very briefly look at what is happening to money here
First notice that the market for goods determines
and the
r0
y0
ys
yd
•So the money market determines the nominal variables in the economy:
•The price level
•Inflation
•Nominal interest rate
That is, the demand for money depends on the level of real income and the NOMINAL interest rate
Why Nominal?
First consider the Demand for Money
First consider the Demand for Money
MD = P L (Y, R)
P
M
For simplicity assume for now that there is no inflation, =0
and thus R=r (that is, there is no distinction)
Money Demand must equal Money supply
Finding Money Market Equilibrium
IF
Then
Money Market Equilibrium
Money Market Equilibrium
MD
P
Money Market Equilibrium
MD
P0
What happens now if there is a Boom?
Money Market Equilibrium
MD
P0
Similarly in a recession
Money Market Equilibrium
MD
0
P0
What happens if the monetary authority increases the money supply