Lecture Note # 8 Econ 303 - Macroeconomic Equilibrium

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Dec 15, 2024

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Econ 303Intermediate MacroeconomicsFall 2024University of Illinois at Urbana-ChampaignDepartment of EconomicsProf. Ricardo BebczukLecture Note # 81

MacroeconomicEquilibrium2

TopicsOur macroeconomic equilibrium model puts together everything we have studied so far in class into an aggregate demand (AD) and aggregate (AS) system:✓Introduction: IS-LM model✓Aggregate demand (AD)✓Aggregate supply (AS) ✓Macroeconomic equilibrium and shifts in the DA curveSource (suggested textbook): Abel, Bernanke and Croushore. Most introductory and intermediate macroeconomic textbooks also cover this topic in great detail.3

iYThe Origins of the AD-AS Model: The IS-LM ModelIS Curve (Goods Market Equilibrium)Yd = C + I + GC=C (Y-T, i)+ -C= a (Y-T) - b iI= I (VMPk, i)+ -I= c VMPk- d iYd =[a (Y-T) - b i] +[c VMPk- d i] + GEquilibrium: Yd = YWhy the IS name? Y- C - G = SI = SISY=[a (Y-T) - b i] + [c VMPk- d i] + GY= [a/(1-a)] (-T) –[(b+d)/(1-a)] i+ [c/(1-a)] VMPk+ [1/(1-a)] GAssumptions of the basic IS-LM model (Hicks, 1937, based on Keynes, 1936):✓Closed economy✓Fixed prices (no inflation)✓Aggregate demand-driven (no supply side modeling)4

iYM/P=L (Y, i)+ -M/P = v Y - f ii= -(1/f) M/P + (v/f) YLMThe Origins of the AD-AS Model: The IS-LM ModelLM Curve (Money Market Equilibrium)5

ii*Y= [a/(1-a)] (-T) –[(b+d)/(1-a)] i+ [c/(1-a)] VMPk+ [1/(1-a)] GY= [a/(1-a)] (-T) –[(b+d)/(1-a)] [-(1/f) M/P + (v/f) Y] + [c/(1-a)] VMPk+ [1/(1-a)] GY*= [a/(1-a)z] (-T) + [(b+d)/(1-a)z] [(1/f) M/P] + [c/(1-a)z] VMPk+ [1/(1-a)z] Gwhere z= {1-[(b+d)/(1-a)](v/f)}YY*M/P=L (Y, i)+ -M/P = v Y - f ii= - (1/f) M/P + (v/f) YThe Origins of the AD-AS Model: The IS-LM ModelMacroeconomic Equilibriumi* = -(1/f) M/P + (v/f) Y*LMIS6

Aggregate Demand, Aggregate Supplyand Macroeconomic Equilibrium7

Price Level (P)Output (Y)Long-run ASYFE(full employment, long-runequilibrium)The equilibrium between AD and ASAD = C + I + G + XNP*(equilibrium)ADShort-run ASY*(short-runequilibrium)8

PYThe aggregate demand (AD) curve Why does the AD curve is downward-sloping?(not the usual micro explanation!)1. Wealth Effect↑P→ ↓(M/P)→ ↓AD → ↓Y2. Interest Rate Effect↑P → ↓(M/P)→ ↑r → ↓AD → ↓Y3. RER EffectRER = NER ×P* / P↑P→ ↓RER→ ↓XN → ↓AD → ↓YEach point along the AD curve reflects an equilibrium point (Y*) from the IS-LM model, that is, a point at which both the goods market and the money market are in equilibrium9

The Aggregate Supply (AS) CurveProducers maximize their profit:Profit = P ×Y(L) –W ×L where: P = Price, Y = Output, L = Employment, W = Nominal wageQuestion:Why doesn’t physical capital K appear in the equation? Because K is assumed to be fixed in the short-run, so the producer only needs to make employment decisions.This standard microeconomic problem yields the following maximization condition, which can be written in two equivalent forms:Value of the marginal productivity of labor = Nominal wageP ×MPL= WMarginal productivity of labor = Real wageMPL= W / P = w10

W/P=wLLabor Demand [MPL]w*L*Labor Supply Labor Market11Labor supplyshows the minimumreal wage a worker would accept to provide his/her services and labor demandis the maximumreal wage a firm would pay for such services

W/P=wLw*L1Digression: The effect of unions and social security contributions (SSC) on wages and employment w1Market wages increase, but formal employment drops, potentially leading to more informal (union and SSC-free) employment with very negative social consequencesL*Labor Supply Labor Demand [MPL]12

Source: World Bank (2020), https://documents1.worldbank.org/curated/en/799701589552654684/pdf/Costs-and-Trade-Offs-in-the-Fight-Against-the-COVID-19-Pandemic-A-Developing-Country-Perspective.pdf13

Source: OECD (2023), https://www.oecd.org/tax/double-blow-for-workers-as-inflation-drives-real-wages-down-and-labour-taxes-up.htm14

PYMPL= W / P = w↑P→ ↓w→ ↑ Profits (MPL>w)→ ↑ Output ↑P→↑ YAggregate Supply (AS) Curve: The Intermediate Case15

What determines the slope of the AS curve?The slople depends en how the nominal wage W reacts to a change in P:1.If P and W are directly proportional (they go up by the same percentage), then output does not change: →AS is vertical (Classical Case)2. If P goes up but W goes up by a smaller percentage, then output goes up: →AS is upward-sloping (Intermediate Case, the most common in practice)3. If P goes up but W stays the same, then output increases the most: →AS is horizontal (Keynesian Case)16

PYAggregate Supply (AS) Curve: The Three Possible Cases17KeynesianClassicalIntermediate

W/P=wLExcess Demand (LD> LS)LS2wFEw2(↑P)LFull EmploymentExcess Supply (LS> LD)w1 (↓P)LD2LD1LS1Unemployment and real wage in the classical caseLabor Supply Labor Demand18

PYYFull EmploymentAggregate supply (AS) in the classical case19

WL[P0× MPL]W (Reservation wage)LFull EmploymentInvoluntaryunemploymentLObserved[P1× MPL][P2× MPL]P0 < P1 < P2Unemployment and wage in the Keynesian caseLabor Supply 20

PYObservedYYFEOutput GapAggregate supply (AS) in the Keynesian case21

PYYFull EmploymentAggregate supply (AS) in the classical case22

PYObservedYYFEOutput GapAggregate supply (AS) in the Keynesian case23

The Equations behind the AD-AS Model:The Equilibrium in a Closed EconomyFrom the IS-LM equilibrium:Y*= [a/(1-a)z] (-T) –[(b+d)/(1-a)z] [(1/f) M/P] + [c/(1-a)z] VPMGk+ [1/(1-a)z] Gwhere z = {1-[(b+d)/(1-a)](v/f)}In order to obtain a linearized solution, assume that: M/P = M –P w/P = w –P [this is a valid assumption when M, P and w are close to 1. Alternatively, you can work with a log model, as log (M/P) = log M –log P]24

Given the IS-LM equilibrium Y*, the three cases can be represented as follows:(1) Y*= YFEThis is the classic case. Plugging this value, the IS-LM solution can be solved for P to show that AD does not affect output but only prices and that M and P have a one-to-one relationship.(2) P = ഥ𝑷This is the extreme Keynesian case. Plugging this value for P, the IS-LM solution can be solved to show that AD changes fully affect output without changing prices, as expected in the basic IS-LM model with fixed prices.(3) Ys = - h (w –P)This is the intermediate case. Here the AS depends negatively on the real wage, defined here as (w –P). Setting Ys = Y*, the equilibrium price level P* can be solved, and then P* can be used to solve for Ysabove. In this case, AD changes will affect both output and prices. The Equations behind the AD-AS Model:The Equilibrium in a Closed Economy25

PYFEAggregate Supply: Reconciling the Keynesian and the Classical CasesYAn example: US economy since 2021, https://thehill.com/policy/finance/549536-summers-says-inflation-indicators-flashing-red-alarmWhat explains the lack or partial wage adjustment to prices when there’s an output gap?The fact that, in the face of a high unemployment rate, workers (and their unions) prioritize employment over wage.26

From Aggregate Demand to Inflation in the intermediate case: Connecting the Dots↓ AD →↓ Y → ↓ Employment →↑ Unemployment → ↓ Wages → ↓ PricesWage Phillips CurvePhillips CurveOkun’s LawAD-AS ModelSources: Own elaboration, based on Abel, Bernanke and Croushore (2023, recommended textbook) or any macroeconomic textbook.Also: ILO (2020), https://www.ilo.org/wcmsp5/groups/public/---ed_emp/documents/publication/wcms_761967.pdf Fed (2020), https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattenedRecall: P = (1 + m) [(w×L) / Q]27

Okun’s Law: Evidence for 75 advanced and emerging countries, 1991-2017Source: https://www.ilo.org/wcmsp5/groups/public/---ed_emp/documents/publication/wcms_761967.pdfOn average, when the GDP growth ratedrops by 1 percentage point(for example, from 4% to 3%), the unemployment rateincreases 0.2 percentage points (for example, from 5% to 5.2%). 28

Source: https://www.nbc.ca/content/dam/bnc/en/rates-and-analysis/economic-analysis/special-report-15sept2017.pdfWage Phillips Curve: US Evidence, 1998-201729

Source: Fed (2020), https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattenedhttps://www.sltrib.com/opinion/commentary/2023/09/13/paul-krugman-how-goldilocks-came/30

FRED GraphSource: Federal Reserve (Nov. 2023), https://fred.stlouisfed.org/graph/?g=x8Q1Read: Fed (2020), https://www.stlouisfed.org/open-vault/2020/january/what-is-phillips-curve-why-flattened#:~:text=The%20Phillips%20curve%20is%20named,(i.e.%2C%20wage%20inflation).https://www.brookings.edu/articles/the-hutchins-center-explains-the-phillips-curve/https://www.clevelandfed.org/publications/economic-commentary/2023/ec-202313-postpandemic-nominal-wage-growth-inflation-passthrough-or-labor-market-imbalanceHowever, the Phillips Curve is not stable: 2012-2019 vs 2020-2023InflationUnemployment

Nominal Wage Drivers: Evidence for 28 European Union Countries, 1995-2017Explanatory VariablesEstimated coefficientsUnemployment rate-0.371***Inflation rate0.906***Labor productivity (GDP per worker) growth0.836**Country fixed effectsYesYear fixed effectsYesObservations582R-squared0.69Note: *** Significant at 1%, ** Significant at 5%, * Significant at 10%Source: Kiss and Van Herck (2019), https://docs.iza.org/pp144.pdf32

Newspaper articles (October 30, 2023): https://www.washingtonpost.com/business/2023/10/30/gm-uaw-tentative-agreement/https://www.reuters.com/business/autos-transportation/gm-reaches-tentative-deal-with-uaw-source-says-2023-10-30/#:~:text=The%20UAW%20won%20from%20GM,payments%20to%20retirees%20through%202028.After a six-week strike, auto industry union has agreed on a 25 percent raise over 4½ years.The union had agreed to give up on cost-of-living adjustments in the wake of the 2008 Great Recession, but such adjustment has now been reinstated.The new contract adds some $900 per vehicle in labor costs and so higher car prices.A recent real-world example: Unemployment and wage demands33

FRED GraphSource: https://fred.stlouisfed.org/series/UNRATEUnemployment Rate in the US, 2005-2023

8008509009501,0001,0501,10020132014201520162017201820192020202120222023Employment in the Auto Industry in the US, 2013-2023Source: Own elaboration based on https://data.bls.gov/timeseries/CES3133600101?amp%253bdata_tool=XGtable&output_view=data&include_graphs=trueNote: In thousand workers35

Short-run Macroeconomics:Aggregate Demand Shifts36

PYASY’ADP’YPAD and AS ShiftsY’AD’AS’37

PYASADYPAD Shifts38AD = C + I + G + XNso anything that changes the AD components above will shift the AD curve to the right or left.That’s precisely what we have been learning since day 1.

If this variable increases...... the AD curve shifts to the:because of the following effect on this AD component:Theoretical backgroundFuture expected disposable income (or permanent income)RightMore private consumption CPermanent income theory (key assumptions: forward-looking behavior and perfect financial markets)Current disposable incomeRightMore private consumption CKeynesian theory (key assumption: imperfect financial markets and/or myopia in the face of unknown future)Future expected business profitability (expectedVMPK, or Tobin’s q)RightMore investment I (*)Investment theory, Tobin’s q in particular (key assumption: forward-looking behavior)Current and recent profitabilityRightMore investment I (*)Keynesian theory (key assumption: imperfect financial markets and/or myopia in the face of unknown future)(*) Recall that in fact the variable I (from Y=C+I+G+TB) comprises not only private investment (business plus household) but also government investment. Business investment is the one most directly affected by the changes described in the table.Some AD Shifters (I)39

If this variable increases...... the AD curve shifts to the:because of the following effect on this AD component:Theoretical backgroundUncertainty (I)LeftLess private consumption Precautionary savingUncertainty (II)LeftLess investment Investment irreversibility Autonomous (independent of disposable income) consumption, investment and exportsRightMore private consumption, more investment and/or more exports Keynesian theoryMarginal propensity to consume and investSome AD Shifters (II)40

If this variable increases...... the AD curve shifts to the:because of the following effect on this AD component:Theoretical backgroundGovernment spending (*) (or lower taxes)RightMore private consumption and/or investmentFiscal multiplier Interest rate (through changes in policy interest rate)LeftLess private consumptionSubstitution effect (assuming no income effect)LeftLess investmentInvestment theory (through higher costs of external funds and higher opportunity cost of internal funds)Nominal exchange rate (in case CB intervenes in foreign currency market)RightMore exports and less importsElasticities approach (key assumption: NER increase leads to RER increase. See next slide)(*) Recall that government spending includes government consumption G, investment and transfers. See textbook or, among many sources, https://www.bea.gov/help/faq/552 and https://www.bea.gov/resources/methodologies/primer-government-accountsSome AD Shifters (III): Fiscal, monetary and exchange rate policies41

If this variable increases...... the AD curve shifts to the:because of the following effect on this AD component:Theoretical backgroundInternational interest rate (and/or sovereign spread)LeftLess private consumption and investmentSee previous slide on the effect of interest rate hikes.International export prices p*RightMore exportsElasticities approach (key assumption: p* increase leads to RER increase. Recall that RER = NER× p*/p)International import prices p*RightLess importsElasticities approach (key assumption: p* increase leads to RER increase. Recall that RER = NER× p*/p)Nominal exchange rateRightMore exports and less importsElasticities approach (key assumption: NER increase leads to RER increase. See above)Some AD Shifters (IV): International variables in open economies42