The New Keynesian Model ECON 30020: Intermediate Macroeconomics

Total Page:16

File Type:pdf, Size:1020Kb

The New Keynesian Model ECON 30020: Intermediate Macroeconomics The New Keynesian Model ECON 30020: Intermediate Macroeconomics Prof. Eric Sims University of Notre Dame Fall 2016 1 / 38 New Keynesian Models I At risk of oversimplification, New Keynesian models are the leading alternative to the neoclassical / RBC model I \New" Keynesian: neoclassical backbone to these models. Just a twist on neoclassical model, not a fundamentally different framework. In the \medium run"/\long run" models are the same I Basic difference: nominal rigidities. Wages and/or prices are imperfectly flexible I Means: 1. Money is non-neutral 2. Demand shocks matter 3. Equilibrium of the model is inefficient 4. There is therefore scope for policy to improve outcomes in short run 2 / 38 Demand and Supply I The demand side of the neoclassical and New Keynesian models are the same I Differences arise on the supply side I Two basic variants (or mixture of the two): wage stickiness and/or price stickiness I Mathematically, what we are going to assume is that either the nominal wage or price level are predetermined (i.e. exogenous) I This will require some change in the labor market { either the firm (price stickiness) or household (wage stickiness) is off its demand or supply schedule I Because it works out to be a bit simpler, we will focus on the sticky price model in class, though book covers both 3 / 38 Review: Neoclassical Model: I Equilibrium conditions: d Ct = C (Yt − Gt , Yt+1 − Gt , rt ) s Nt = N (wt , qt ) d Nt = N (wt , At , Kt ) d It = I (rt , At+1, qt , Kt ) Yt = At F (Kt , Nt ) Yt = Ct + It + Gt d Mt = Pt M (it , Yt ) e rt = it − pt+1 I Pt is endogenous I Nominal wage, Wt , is Wt = wt Pt , and is also therefore endogenous 4 / 38 New Keynesian Model I Sticky price model: I Pt = P¯t is now exogenous, rather than endogenous I Extreme form of price stickiness: price level completely pre-determined I Replace labor demand curve with Pt = P¯t . Firm (which sets price), has to hire labor to meet demand at P¯t rather than to maximize its value I Sticky wage model: I Wt = W¯ t is now exogenous, rather than endogenous I Extreme form of wage stickiness: wage set \in advance," worker has to supply as much labor as is demanded at this wage I This means that we replace the labor supply curve with the condition wt = W¯ t /Pt 5 / 38 Graphing the Equilibrium I We will use the AD (aggregate demand) and AS (aggregate supply) curves to summarize the equilibrium I AD: stands for aggregate demand. Summarizes the following conditions: d Ct = C (Yt − Gt , Yt+1 − Gt , rt ) d It = I (rt , At+1, qt , Kt ) Yt = Ct + It + Gt d Mt = Pt M (it , Yt ) e rt = it − pt+1 I Differently than before, AD curve summarizes both real demand (the first three equations) and nominal demand (the last two) I Classical dichotomy will no longer hold, so cannot separately analyze real and nominal sides of the economy 6 / 38 The IS and LM Curves I The IS curve is identical to before: set of (rt , Yt ) pairs where the first three of the conditions hold I LM curve (liquidity = money) plots combinations of (rt , Yt ) where last two equations hold I LM curve is upward-sloping in (rt , Yt ) space. Basic idea: holding Mt and Pt fixed, if rt goes up, Yt must go up for money demand to equal money supply I Go through graphical derivation e I LM curve will shift if Mt , Pt , or pt+1 change I Rule of thumb: LM curve shifts in the same direction as real balances, Mt Pt 7 / 38 Deriving the LM Curve , + , , = , + , , �0 +1 0 � , 1 1 � +1 � 1 , , ( , + , , ) 0 0 0 +1 1 , , , 0 0 1 8 / 38 The AD Curve I The AD curve is the set of (Pt , Yt ) pairs where the economy is on both the IS and LM curves I Basic idea: Pt determines position of LM curve, which determines a Yt where the LM curve intersects the IS curve. A higher Pt means the LM curve shifts in, which results in a lower Yt I Hence, the AD curve is downward-sloping I Go through graphical derivation 9 / 38 Deriving the AD Curve ( , , , ) 2 0 ( , , , ) 0 0 ( , , , ) , 1 0 2 , 0 , 1 , 2 , 0 , 1 10 / 38 Shifts of the AD Curve I The AD curve will shift if either the IS or LM curves shift (for reason other than Pt ) I This means that the AD curve will shift right if: e I At+1, qt , or Gt increase (IS shifts); Mt or pt+1 increase (LM shifts) I Gt+1 decreases (IS shift) I Note: we could use the AD curve to summarize the demand side of the neoclassical model as well I Was just convenient to not since this emphasized classical dichotomy in the neoclassical model 11 / 38 The Supply Side I Generically, the AS curve is the set of (Pt , Yt ) pairs (i) consistent with the production function, (ii) some notion of labor market equilibrium, and (iii) any exogenous restriction on nominal price or wage adjustment I Can use the AS curve to summarize the neoclassical model as well as the New Keynesian model: s Nt = N (wt , qt ) d Nt = N (wt , At , Kt ) Yt = At F (Kt , Nt ) I Since Pt does not appear in these equations, the AS curve would be vertical in the neoclassical model 12 / 38 The Neoclassical AS Curve ( , ) , 2 , 0 , 1 ( , , ) = ( , ) , , 0 0 13 / 38 Neoclassical IS-LM-AD-AS Equilibrium ( , , ) 0 , 0 ( , ) , 0 ( , , ) = ( , ) , , 0 0 14 / 38 Sticky Price Model I In sticky price model, assume that Pt = P¯t is predetermined and hence exogenous (think something like menu costs) I Replace labor demand with this condition: firm has to meet demand at Pt , cannot optimally choose labor conditional on this I Conditions: s Nt = N (wt , qt ) Pt = P¯t Yt = At F (Kt , Nt ) I The AS curve will just be horizontal at P¯t . Can only shift if P¯t changes exogenously 15 / 38 The Sticky Price AS Curve ( , ) � = = ( , ) 16 / 38 Sticky Price IS-LM-AD-AS Equilibrium ( , , ) 0 , 0 ( , ) , , 0 �0 = ( , ) , , 0 0 17 / 38 Increase in Mt I Whereas in the neoclassical model Yt is supply determined, in the New Keynesian model output is demand determined I First, figure out what Yt is, and then figure out what Nt must be to support that I In an increase in Mt shifts the LM curve to the right, and hence the AD curve to the right as well I With a horizontal (as opposed to vertical) AS curve, this results in a higher Yt and lower rt I The lower rt stimulates It ; lower rt plus higher Yt means Ct is higher I To support higher Yt , Nt must rise I To induce workers to work more, wt must rise 18 / 38 Increase in Mt: Graphically ( , , , ) 0 0 Original ( , , , ) Post-shock 1 0 , 0 subscript: original 0 1 subscript: post-shock , 1 , ( , ) 1 , , 0 �0 ′ = ( , ) , , , , 0 1 0 1 19 / 38 Increase in Mt: Graphically in Neoclassical Model , , , = ( , , , ) �0 0 � 1 1 Original ( , , , ) Post-shock 1 0 Post-shock, indirect effect of on LM , 0 0 subscript: original 1 subscript: post-shock ( , ) , 1, 0 ′ ( , , ) = ( , ) , , 0 0 20 / 38 IS Shock I Increase in qt , At+1, Gt , or decrease in Gt+1: shifts IS curve to the right I Results in AD curve shifting to the right, which means higher Yt I Higher Yt means that Nt must rise I Again, compare results to neoclassical model 21 / 38 Sticky Price Model: IS Shock ( , , ) Original 0 Post-shock , , 1 0 0 subscript: original 1 subscript: post-shock ′ ( , ) , 1 , , 0 �0 ′ = ( , ) , , , , 0 1 0 1 22 / 38 Increase in At I Since P¯t doesn't change, in the sticky price model an increase in At has no effect on Yt I Mechanically, this means that Nt must fall 23 / 38 Increase in At: Graphically ( , , ) 0 Original Post-shock , 0 subscript: original 0 1 subscript: post-shock ( , ) , , 0 �0 , 1 = ( , ) , 1 , ( , ) 0 , , , 0 1 0 24 / 38 Comparing Neoclassical and New Keynesian Models I Useful rule of thumb: demand shocks have bigger effects in New Keynesian model and supply shocks smaller effects relative to neoclassical model I For productivity shock in particular, it is \contractionary" in sense of lowering hours worked I Some empirical debate on this: I Gali (1999) and Basu, Fernald, and Kimball (2006): positive productivity shock lowers hours in the short run (i.e. the New Keynesian model) and raises hours in the medium run (i.e. the neoclassical model) I Nevertheless, there is some debate about these empirical findings 25 / 38 Increase in P¯t I This is the only exogenous variable which will shift the AS curve in the sticky price model I Real world interpretation: increase in prices of intermediate inputs (e.g. price of oil) I Results in AS shifting up, Yt falling, and Pt rising. Sometimes called “stagflation” { prices (inflation) rising and output (employment) declining 26 / 38 Graphical Effects: Increase in P¯t ( , , ) ( , , ) 1 0 Original , Post-shock 1, Post-shock, indirect effect 0 of on LM 0 subscript: original 1 subscript: post-shock ( , ) , �1 , ′ , 0 �0 , 1 = ( , ) , , , , 0 1 1 0 27 / 38 Summarizing Qualitative Effects in the Sticky Price Model Exogenous Shock Variable " Mt " IS curve " At " qt " P¯t Yt + + 0 0 - Nt + + - 0 - wt + + - + - rt - + 0 0 + it - + 0 0 + Pt 0 0 0 0 + 28 / 38 Dynamics I The New Keynesian model is a special case of the neoclassical model { we simply swap labor demand with a fixed nominal price f I Call Yt the “flexible price" level of output { the level of output which would emerge in the neoclassical model I If firm could adjust price, it would do so that it is on its labor f demand curve, which would entail
Recommended publications
  • Calculating the Output Gap
    ECONOMIC AND MONETARY DEVELOPMENTS AND PROSPECTS Appendix 2 Calculating the output gap The output gap is an important concept in the preparation of inflation forecasts and assessments of the economic outlook. However, the output gap is difficult to measure and subject to great uncertainty in practice. The techniques used by the Central Bank of Iceland and elsewhere to calculate the output gap, which have previously been described in Monetary Bulletin (2000/4 pp. 14-15), will be recapitulated here taking particular account of investments in the aluminium and power sectors, since these have a substantial impact on both the level of production and output potential in the economy, not only during the construction phase but also when the investments 1 have been completed. 2005•1 MONETARY BULLETIN Definition of the output gap The output gap is defined as the difference between actual and potential GDP as a per cent of potential GDP, i.e.: (1) P where GAPt is the output gap, Yt is GDP in real terms and Y t is the potential output of the economy, all during the year t. Potential output is defined as the level of GDP that is consistent with full utilisation of all factors of production under conditions of stable inflation. Thus potential output is determined on the supply side of the economy, i.e. by capital stock, labour use and available technology. Potential output in the long term is determined by how effici- ently the available factors of production can be utilised for a given level of productivity. In the short run, however, aggregate demand can drive the level of production beyond long-term potential output.
    [Show full text]
  • Output Gaps and Robust Monetary Policy Rules
    SVERIGES RIKSBANK WORKING PAPER SERIES 260 Output Gaps and Robust Monetary Policy Rules Roberto M. Billi MARCH 2012 WORKING PAPERS ARE OBTAINABLE FROM Sveriges Riksbank • Information Riksbank • SE-103 37 Stockholm Fax international: +46 8 787 05 26 Telephone international: +46 8 787 01 00 E-mail: [email protected] The Working Paper series presents reports on matters in the sphere of activities of the Riksbank that are considered to be of interest to a wider public. The papers are to be regarded as reports on ongoing studies and the authors will be pleased to receive comments. The views expressed in Working Papers are solely the responsibility of the authors and should not to be interpreted as reflecting the views of the Executive Board of Sveriges Riksbank. Output Gaps and Robust Monetary Policy Rules Roberto M. Billiy Sveriges Riksbank Working Paper Series No. 260 March 2012 Abstract Policymakers often use the output gap, a noisy signal of economic activity, as a guide for setting monetary policy. Noise in the data argues for policy caution. At the same time, the zero bound on nominal interest rates constrains the central bank’sability to stimulate the economy during downturns. In such an environment, greater policy stimulus may be needed to stabilize the economy. Thus, noisy data and the zero bound present policymakers with a dilemma in deciding the appropriate stance for monetary policy. I investigate this dilemma in a small New Keynesian model, and show that policymakers should pay more attention to output gaps than suggested by previous research. Keywords: output gap, measurement errors, monetary policy, zero lower bound JEL: E52, E58 I thank Tor Jacobson, Per Jansson, Ulf Söderström, David Vestin, Karl Walentin, and seminar participants at Sveriges Riksbank for helpful comments and discussions.
    [Show full text]
  • Mind the Output Gap: the Disconnect of Growth and Inflation During Recessions and Convex Phillips Curves in the Euro Area
    Working Paper Series Marco Gross, Willi Semmler Mind the output gap: the disconnect of growth and inflation during recessions and convex Phillips curves in the euro area Task force on low inflation (LIFT) No 2004 / January 2017 Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. Task force on low inflation (LIFT) This paper presents research conducted within the Task Force on Low Inflation (LIFT). The task force is composed of economists from the European System of Central Banks (ESCB) - i.e. the 29 national central banks of the European Union (EU) and the European Central Bank. The objective of the expert team is to study issues raised by persistently low inflation from both empirical and theoretical modelling perspectives. The research is carried out in three workstreams: 1) Drivers of Low Inflation; 2) Inflation Expectations; 3) Macroeconomic Effects of Low Inflation. LIFT is chaired by Matteo Ciccarelli and Chiara Osbat (ECB). Workstream 1 is headed by Elena Bobeica and Marek Jarocinski (ECB) ; workstream 2 by Catherine Jardet (Banque de France) and Arnoud Stevens (National Bank of Belgium); workstream 3 by Caterina Mendicino (ECB), Sergio Santoro (Banca d’Italia) and Alessandro Notarpietro (Banca d’Italia). The selection and refereeing process for this paper was carried out by the Chairs of the Task Force. Papers were selected based on their quality and on the relevance of the research subject to the aim of the Task Force. The authors of the selected papers were invited to revise their paper to take into consideration feedback received during the preparatory work and the referee’s and Editors’ comments.
    [Show full text]
  • Unemployment, Aggregate Demand, and the Distribution of Liquidity
    Unemployment, Aggregate Demand, and the Distribution of Liquidity Zach Bethune Guillaume Rocheteau University of Virginia University of California, Irvine Tsz-Nga Wong Federal Reserve Bank of Richmond February 13, 2017 Abstract We develop a New-Monetarist model of unemployment in which distributional considerations matter. Households who lack commitment are subject to both employment and expenditure risk. They self- insure by accumulating real balances and, possibly, claims on firms profits. The distribution of liquidity is endogenous and responds to idiosyncratic risks and monetary policy. Despite the ex-post heterogeneity our model can be solved in closed form in a variety of cases. We show the existence of an aggregate demand channel according to which the distribution of workers across employment states, and their incomes in those states, affects the distribution of liquid wealth and firms’ profits. An increase in unemployment benefits or wages has a positive effect on aggregate demand and can lead to higher employment. Moreover, an increase in productivity has a multiplier effect on firms’ revenue. JEL Classification Numbers: D83 Keywords: unemployment, money, distribution. 1 Introduction We develop a New-Monetarist model of unemployment in which liquidity and distributional considerations matter. Our approach is motivated by the strong empirical evidence that household heterogeneity in terms of income and wealth, together with liquidity constraints, affect aggregate consumption and unemployment (e.g., Mian and Sufi, 2010?; Carroll et al., 2015). There is a recent literature that formalizes search frictions and liquidity constraints in goods markets that reduce the ability of firms to sell their output, their incentives to hire, and ultimately the level of unemployment (e.g., Berentsen, Menzio, and Wright, 2010; Michaillat and Saez, 2015).
    [Show full text]
  • AS-AD and the Business Cycle
    Chapter AS-AD and the Business Cycle CHAPTER OUTLINE 1. Provide a technical definition of recession and describe the history of the U.S. business cycle and the global business cycle. A. Dating Business-Cycle Turning Points B. U.S. Business-Cycle History C. Recent Cycles 2. Explain the influences on aggregate supply. A. Aggregate Supply Basics 1. Why the AS Curve Slopes Upward a. Business Failure and Startup b. Temporary Shutdowns and Restarts c. Changes in Output Rate 2. Production at a Pepsi Plant B. Changes in Aggregate Supply 1. Changes in Potential GDP 2. Changes in Money Wage Rate and Other Resource Prices 3. Explain the influences on aggregate demand. A. Aggregate Demand Basics 1. The Buying Power of Money 2. The Real Interest Rate 3. The Real Prices of Exports and Imports B. Changes in Aggregate Demand 1. Expectations 2. Fiscal Policy and Monetary Policy 3. The World Economy C. The Aggregate Demand Multiplier 4. Explain how fluctuations in aggregate demand and aggregate supply create the business cycle. A. Aggregate Demand Fluctuations B. Aggregate Supply Fluctuations C. Adjustment Toward Full Employment 710 Part 10 . ECONOMIC FLUCTUATIONS CHAPTER ROADMAP What’s New in this Edition? Chapter 29 is now the first chapter in which the students en‐ counter the AS‐AD model. This chapter now uses some of the material from the second edition’s Chapter 23 introduc‐ tion to AS‐AD to explain the beginning about aggregate supply and aggregate demand. The connection between the AS‐AD model and business cycle has been rewritten and made even more straightforward for the students.
    [Show full text]
  • Some Answers FE312 Fall 2010 Rahman 1) Suppose the Fed
    Problem Set 7 – Some Answers FE312 Fall 2010 Rahman 1) Suppose the Fed reduces the money supply by 5 percent. a) What happens to the aggregate demand curve? If the Fed reduces the money supply, the aggregate demand curve shifts down. This result is based on the quantity equation MV = PY, which tells us that a decrease in money M leads to a proportionate decrease in nominal output PY (assuming of course that velocity V is fixed). For any given price level P, the level of output Y is lower, and for any given Y, P is lower. b) What happens to the level of output and the price level in the short run and in the long run? In the short run, we assume that the price level is fixed and that the aggregate supply curve is flat. In the short run, output falls but the price level doesn’t change. In the long-run, prices are flexible, and as prices fall over time, the economy returns to full employment. If we assume that velocity is constant, we can quantify the effect of the 5% reduction in the money supply. Recall from Chapter 4 that we can express the quantity equation in terms of percent changes: ΔM/M + ΔV/V = ΔP/P + ΔY/Y We know that in the short run, the price level is fixed. This implies that the percentage change in prices is zero and thus ΔM/M = ΔY/Y. Thus in the short run a 5 percent reduction in the money supply leads to a 5 percent reduction in output.
    [Show full text]
  • Aggregate Demand and the Dynamics of Unemployment
    Aggregate Demand and the Dynamics of Unemployment Edouard Schaal Mathieu Taschereau-Dumouchel New York University The Wharton School of the University of Pennsylvania June 3, 2016 Abstract We introduce an aggregate demand externality into the Mortensen-Pissarides model of equi- librium unemployment. Because firms care about the demand for their products, an increase in unemployment lowers the incentives to post vacancies which further increases unemploy- ment. This positive feedback creates a coordination problem among firms and leads to multiple equilibria. We show, however, that the multiplicity disappears when enough heterogeneity is introduced in the model. In this case, the unique equilibrium still exhibits interesting dynamic properties. In particular, the importance of the aggregate demand channel grows with the size and duration of shocks, and multiple stationary points in the dynamics of unemployment can exist. We calibrate the model to the U.S. economy and show that the mechanism generates ad- ditional volatility and persistence in labor market variables, in line with the data. In particular, the model can generate deep, long-lasting unemployment crises. JEL Classifications: E24, D83 1 1 Introduction The slow recovery that followed the Great Recession of 2007-2009 has revived interest in the long-held view in macroeconomics that episodes of high unemployment can persist for extended periods of time because of depressed aggregate demand. The mechanism seems intuitive: when firms expect lower demand for their products, they refrain from hiring and unemployment increases. In turn, as unemployment rises, aggregate income and spending decline, effectively confirming the low aggregate demand. In this paper, we propose a theory of unemployment and aggregate demand to investigate this mechanism.
    [Show full text]
  • Aggregate Supply and Unemployment
    Aggregate Supply Explain why the elasticity of the aggregate supply curve for an economy varies between infinity and zero (12) Are supply-side policies likely to be more effective than demand-side policies in reducing unemployment? (13) Aggregate supply (AS) measures the output of goods and services than an economy can supply at a given price level in a given time period. The output potential of the economy depends on (a) the stock of factor inputs available (b) the productivity of factor inputs (c) the pace of technological progress. The elasticity of aggregate supply is a measure of how responsive output is to changes in demand. Supply elasticity normally depends on (a) the degree of spare capacity in the economy (b) the time period involved (c) the amount of stocks that can be used to meet changes in demand There is a continuing debate about the elasticity of aggregate supply. Standard Keynesian theory assumes a perfectly elastic aggregate supply curve. Changes in aggregate demand lead to changes in the equilibrium level of national output - prices are assumed to be constant in the injections and withdrawals framework. Neo- classical economists argue that aggregate supply in independent of the price level. The AS curve is assumed to be vertical in the long run - and can shift following increases in the stock and productivity of factors of production. A synthesis view shows the elasticity of aggregate supply changing at different levels of output. These views are shown in the diagrams below. Price Level (P) SRAS1 AD1 AD2 Y1 Y2 Real National Output (Y) In the diagram above the short run aggregate supply curve is drawn as perfectly elastic.
    [Show full text]
  • Aggregate Demand by RENEE HALTOM
    JARGONALERT Aggregate Demand BY RENEE HALTOM hat determines how much the economy pro- cycles but as a workable prescription for how policymakers duces in any given period? One way to think should respond to them. This backfired when attempts to Wabout it is through the concept of aggregate continually boost aggregate demand worked a little too well, demand, along with a partner concept, aggregate supply. resulting in inflation. The lesson was that the economy can’t An aggregate demand curve displays the quantity of goods be pushed beyond its sustainable level of supply for long. and services that are demanded at every possible price level in But many economists continue to argue that economists the economy. The aggregate quantity of goods and services should counteract demand shortfalls in recessions. This is demanded generally is high when prices are low and low when what the 2009 fiscal stimulus law tried to do. And in the prices are high (the opposite being true for aggregate supply, aftermath of the Great Recession, Christina Romer, then which slopes upward). Where the two intersect is, in theory, head of the President’s Council of Economic Advisers, at the current level of gross domestic product (GDP). noted the presence of factors that Keynes might have agreed This theoretical framework can help economists think would be harmful to aggregate demand: a fall in wealth fol- through the causes of business cycles. For example, four com- lowing the 2007-2008 financial crisis, disruptions of credit, ponents of aggregate demand cause the aggregate demand shrinking government spending, and cautious spending from curve to shift outward when they increase: the amounts nervous consumers.
    [Show full text]
  • Measuring Potential Output and Output Gap and Macroeconomic Policy: the Ac Se of Kenya Angelica E
    University of Connecticut OpenCommons@UConn Economics Working Papers Department of Economics October 2005 Measuring Potential Output and Output Gap and Macroeconomic Policy: The aC se of Kenya Angelica E. Njuguna Kenyatta University and KIPPRA Stephen N. Karingi United Nations Economic Commission for Africa Mwangi S. Kimenyi University of Connecticut Follow this and additional works at: https://opencommons.uconn.edu/econ_wpapers Recommended Citation Njuguna, Angelica E.; Karingi, Stephen N.; and Kimenyi, Mwangi S., "Measuring Potential Output and Output Gap and Macroeconomic Policy: The asC e of Kenya" (2005). Economics Working Papers. 200545. https://opencommons.uconn.edu/econ_wpapers/200545 Department of Economics Working Paper Series Measuring Potential Output and Output Gap and Macroeco- nomic Policy: The Case of Kenya Angelica E. Njuguna Kenyatta University and KIPPRA Stephen N. Karingi United Nations Economic Commission for Africa Mwangi S. Kimenyi University of Connecticut Working Paper 2005-45 October 2005 341 Mansfield Road, Unit 1063 Storrs, CT 06269–1063 Phone: (860) 486–3022 Fax: (860) 486–4463 http://www.econ.uconn.edu/ This working paper is indexed on RePEc, http://repec.org/ Abstract Measuring the level of an economy.s potential output and output gap are essen- tial in identifying a sustainable non-inflationary growth and assessing appropriate macroeconomic policies. The estimation of potential output helps to determine the pace of sustainable growth while output gap estimates provide a key bench- mark against which to assess inflationary or disinflationary pressures suggesting when to tighten or ease monetary policies. These measures also help to provide a gauge in the determining the structural fiscal position of the government.
    [Show full text]
  • Macro-Economics of Balance-Sheet Problems and the Liquidity Trap
    Contents Summary ........................................................................................................................................................................ 4 1 Introduction ..................................................................................................................................................... 7 2 The IS/MP–AD/AS model ........................................................................................................................ 9 2.1 The IS/MP model ............................................................................................................................................ 9 2.2 Aggregate demand: the AD-curve ........................................................................................................ 13 2.3 Aggregate supply: the AS-curve ............................................................................................................ 16 2.4 The AD/AS model ........................................................................................................................................ 17 3 Economic recovery after a demand shock with balance-sheet problems and at the zero lower bound .................................................................................................................................................. 18 3.1 A demand shock under normal conditions without balance-sheet problems ................... 18 3.2 A demand shock under normal conditions, with balance-sheet problems ......................... 19 3.3
    [Show full text]
  • Working Paper No. 563 Whither New Consensus Macroeconomics? the Role of Government and Fiscal Policy in Modern Macroeconomics
    Working Paper No. 563 Whither New Consensus Macroeconomics? The Role of Government and Fiscal Policy in Modern Macroeconomics by Giuseppe Fontana* May 2009 * University of Leeds (UK) and Università del Sannio (Benevento, Italy). Correspondence address: Economics, LUBS, University of Leeds, Leeds LS2 9JT, UK. E-mail: [email protected]; tel.: +44 (0) 113 343 4503; fax: +44 (0) 113 343 4465. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. The Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. The Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levy.org Copyright © The Levy Economics Institute 2009 All rights reserved. ABSTRACT In the face of the dramatic economic events of recent months and the inability of academics and policymakers to prevent them, the New Consensus Macroeconomics (NCM) model has been the subject of several criticisms. This paper considers one of the main criticisms lodged against the NCM model, namely, the absence of any essential role for the government and fiscal policy. Given the size of the public sector and the increasing role of fiscal policy in modern economies, this simplifying assumption of the NCM model is difficult to defend.
    [Show full text]