Dynamics of the ShortRun Model

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Dynamics of the Short-Run Model
ECO 105 Lecture 4.5 19 November 2008
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Quick Reivew

• Wages are the largest
• Wages are sticky, making
• Wages tend to rise
• When
• When
• When the labor market

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Unemployment and Wage Increases

• Think of un as the Non-Accelerating Inflation
  Rate
• When u falls below un
• Firms attempt to bid
• Workers demands for higher wages

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Effect of Higher Wages

• Increases in wages (not matched by increases in
  labor productivity) increase the
• Firms price on a
• Firms
• The SRAS curve

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Price Adjustment Process

• AD increases, pushing
• u falls below
• Wages begin
• Firms raise prices
• Y demanded falls
• Demand for labor falls
• Pressure for wage increases

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Price-Adjustment Process
LRAS
PI
SRAS1
PI1
SRAS0
PI0
AD1
AD0
Y
Yn
Y1
Y2
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Cost-Based Pricing and Inflation

• An increase in AD affects prices
• Increased demand in retail markets affects
  wholesale, manufacturing, and factor markets
• Wages dont adjust for months
• Thus, increased AD affects Y in the

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Inflation Process

• Once underway, inflation
• Cost increases are transmitted from factor
  markets
• Even if AD has fallen,
• This causes Y to
• So . . . better not

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Inflation Process
LRAS
PI
SRAS2
PI2
SRAS1
PI1
SRAS0
PI0
AD1
AD0
,2
Y
Yn
Y1
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Important Points

• Although cost increases cause prices to rise in
  this model, an increase in
• U.S. workers are not organized to push wages
  upward
• The only possible source of cost-push inflation
  is
• Even this requires money growth

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Macroeconomic Response to Large Oil-Price Shocks
LRAS0
LRAS1
PI
If the Fed doesnt increase the money supply, AD
remains constant and PI falls.
PI1
SRAS1
PI2
SRAS2
SRAS0
PI0
AD0
Y
Yn0
Yn1
Y1
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From Theory to Policy

• Weve constructed the AD/SRAS/LRAS model of
  economic activity.
• Now its time to consider policy issues.

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How the Fed Influences the Economy

• The Fed cannot
• The Fed has no direct control
• The Fed can influence aggregate demand by
  altering

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Loanable Funds Model (II)

• We used the LF model to determine
• Augmented for changes in bank lending, it can be
  used to determine
• DLF is still determined
• SLF depends on

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How the Fed Affects Interest Rates

• The Fed works through the federal funds market
  the
• When the Fed buys bonds on the open market, it
  increases the
• The federal funds rate - the rate charged on

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Federal Funds Market
iff
SR
SR1
iff0
iff1
DR
Reserves
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From the Funds Rate to the Market Rate

• A lower federal funds rate reduces banks
  marginal
• Banks reduce their
• The interest rate on loans declines as banks

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Determining the Interest Rate
SLF S
Interest
SLF1 S DMS1
Rate
i0
i1
DLF
Loanable Funds
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Nominal and Real Interest Rates

• The reduction in i reduces the expected real
  interest rate if
• So long as market participants dont believe the
  lower interest rate will generate

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Monetary Policy and Shifts in the AD Curve

• The Fed affects AD primarily through
• OM purchase injects reserves into the banking
  system,

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Federal funds market
iff
SR
SR1
iff0
iff1
DR
Reserves
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...

• Banks increase
• If expected inflation remains constant,

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Loanable funds market
SLF S
Interest
SLF1 S DMS1
Rate
i0
i1
DLF
Loanable Funds
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...

• Lower r e encourages more
• AD increases, and in the short run

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Aggregate output market
Price Level
PI0
SRAS
ADo
AD1
Y
Y0
Y1