Economics 302 Sec 001 Intermediate Macroeconomic Theory and Policy Spring 2011 3 21 2011 Instructor Prof Menzie Chinn UW Madison 7 4 The Effects of a Monetary Expansion G i Behind Going B hi d the th Scenes S Figure 7 8 The Dynamic y Effects of a Monetary Expansion on Output and the Interest Rate The increase in nominal moneyy initially shifts the LM curve down decreasing the interest rate and increasing output Over time the pprice level increases shifting the LM curve back up until output is back at the natural level of output p 2 of 44 7 4 The Effects of a Monetary Expansion Th Neutrality The N t lit off Money M In the short run a monetary expansion leads to an increase in output a decrease in the interest rate and an increase in the price level In the medium run the increase in nominal money is reflected entirely in a proportional increase in the price level The increase in nominal money has no effect on output or on the h iinterest rate The neutrality of money in the medium run does not mean that monetary policy li cannot or should h ld not be b used d to affect ff output 3 of 44 5 5 How Does the IS LM Model Fit the Facts Figure 5 9 The Empirical Effects of an Increase in the Federal Funds Rate IIn the th short h t run an increase i iin the federal funds rate leads to a decrease in output and to an increase in unemployment but it hhas littl little effect ff t on th the price i level 4 of 33 How Long Lasting Are the Real Effects of Money Figure 1 The Effects of an Expansion in Nominal Money in the Taylor Model Macroeconometric models are larger scale versions of the aggregate supply and aggregate demand model in this chapter They are used to answer questions such as how long the real effects of money last 5 of 44 7 5 A Decrease in the Budget Deficit Figure 7 9 The Dynamic y Effects of a Decrease in the Budget Deficit A decrease in the budget deficit leads initially to a decrease in output Over time however output returns to the natural level of output Note This assumes no portfolio crowding out in effects 6 of 44 7 5 A Decrease in the Budget Deficit Deficit D fi it Reduction R d ti Output O t t and the Interest Rate Since the price level declines in response to the decrease in output the real money stock increases This causes a shift of the LM curve to LM Both output and the interest rate are lower than before the fiscal contraction 7 of 44 7 5 A Decrease in the Budget Deficit Deficit D fi it Reduction R d ti Output O t t and the Interest Rate Figure 7 10 The Dynamic Effects of a Decrease in the B d t Deficit Budget D fi it on Output O t t and the Interest Rate A deficit reduction leads in the short run to a decrease in output and to a decrease in the interest rate In the medium run output returns to its natural level while the interest rate declines further 8 of 44 7 5 A Decrease in the Budget Deficit D fi it Reduction Deficit R d ti Output O t t and d the th Interest I t t Rate R t The composition of output is different than it was before deficit reduction Consider if deficit reduction is due to decrease in G IS relation Yn C Yn T I Yn i G Income and taxes remain unchanged thus consumption is the same as before before Government spending is lower than before therefore investment must be higher g than before deficit reduction higher g by an amount exactly equal to the decrease in G 9 of 44 7 6 Changes in the Price of Oil Figure 7 11 The Real Price of Oil Since 1970 There were two sharp increases in the relative price of oil in the 1970s followed by a decrease until the 1990s 1990s and a large increase since then 140 120 Real price of oil in 2010 100 80 60 40 20 0 1970 Nominal price of oil bbl 1975 1980 1985 1990 1995 2000 2005 Each of the two large price increases of the 1970s was associated with a sharp recession and a large increase in inflation a combination macroeconomists call stagflation to capture the combination of stagnation and inflation that characterized these episodes 10 of 44 2010 7 6 Changes in the Price of Oil Eff t on th Effects the N Natural t lR Rate t off U Unemployment l t P W 1 P 1 W a PE 1 a W 1 W P 1 PE 1 a 1 W 1 PE 1 a 1 W 1 PE 1 a For PE PE Figure 7 12 The Effects of an Increase in the Price of Oil on the h Natural N l Rate R of Unemployment An increase in the price of oil leads to a lower real wage and a higher natural rate of unemployment Note this is a slightly different 11 of 44 treatment from in the textbook 7 6 Changes in the Price of Oil Th Dynamics The D i off Adjustment Adj t t P 1 W P a 1 a E P 1 P F u z P e a 1 a E An An increase in the price of energy results in an increase in the price level at any level of output Y The aggregate supply curve shifts up In addition Yn falls and un rises 12 of 44 7 6 Changes in the Price of Oil Th Dynamics The D i off Adjustment Adj t t After the increase in the price off oil il th the new AS curve goes through point B where output equals the new lower natural level of output Y n and the price i llevell equals l P e The economy moves along the AD curve from A to A Output decreases from Yn to Y 13 of 44 7 6 Changes in the Price of Oil Th Dynamics The D i off Adjustment Adj t t Figure 7 13 The Dynamic Effects of an Increase in the Price of Oil An iincrease in A i th the price i off oilil leads in the short run to a decrease in output and an increase in the price level O titime output Over t t ddecreases further and the price level increases further 14 of 44 7 6 7 6 Changes in the Price of Oil Eff t on th Effects the N Natural t lR Rate t off U Unemployment l t Figure 7 14 Oil Price Increases and Inflation in the United States Since 1970 The oilil price Th i increases i off th the 1970s were associated with large increases in inflation But this has not been the case for th recentt oilil price the i iincreases 15 of …