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  • Short Run FluctuationsDavid Romer

    University of California, BerkeleyJanuary 2013

    Notes by Eran Yashiv, Tel Aviv UniversityJanuary 8, 2014

    ROMER (JAN 2013) () JANUARY 9, 2014 1 / 28

  • IS-MP MODEL

    IS-MP MODEL

    IS as usual

    MP is a consequence of Taylor Rule behavior

    i = ei+ 1( ) + 2(YY) (1)i = r = ei 1 2Y| {z }

    a

    + (1 1)| {z }b

    + 2|{z}c

    Y

    r = a+ b + cY

    r = r(, Y)+

    (2)

    ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

  • IS-MP MODEL

    IS-MP MODEL

    IS as usualMP is a consequence of Taylor Rule behavior

    i = ei+ 1( ) + 2(YY) (1)i = r = ei 1 2Y| {z }

    a

    + (1 1)| {z }b

    + 2|{z}c

    Y

    r = a+ b + cY

    r = r(, Y)+

    (2)

    ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

  • IS-MP MODEL

    IS-MP MODEL

    IS as usualMP is a consequence of Taylor Rule behavior

    i = ei+ 1( ) + 2(YY) (1)i = r = ei 1 2Y| {z }

    a

    + (1 1)| {z }b

    + 2|{z}c

    Y

    r = a+ b + cY

    r = r(, Y)+

    (2)

    ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

  • IS-MP MODEL

    IS-MP MODEL

    IS as usualMP is a consequence of Taylor Rule behavior

    i = ei+ 1( ) + 2(YY) (1)i = r = ei 1 2Y| {z }

    a

    + (1 1)| {z }b

    + 2|{z}c

    Y

    r = a+ b + cY

    r = r(, Y)+

    (2)

    ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

  • IS-MP MODEL

    ROMER (JAN 2013) () JANUARY 9, 2014 3 / 28

  • IS-MP MODEL

    MECHANISM

    Money market in initial equilibrium

    M0P0

    = L(i0, Y0)

    = L(r0 + e0, Y0)

    Now M0 rises to M1Thus P and e rise so

    M1P1> L(r0 + e1, Y0)

    ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

  • IS-MP MODEL

    MECHANISM

    Money market in initial equilibrium

    M0P0

    = L(i0, Y0)

    = L(r0 + e0, Y0)

    Now M0 rises to M1Thus P and e rise so

    M1P1> L(r0 + e1, Y0)

    ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

  • IS-MP MODEL

    MECHANISM

    Money market in initial equilibrium

    M0P0

    = L(i0, Y0)

    = L(r0 + e0, Y0)

    Now M0 rises to M1

    Thus P and e rise so

    M1P1> L(r0 + e1, Y0)

    ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

  • IS-MP MODEL

    MECHANISM

    Money market in initial equilibrium

    M0P0

    = L(i0, Y0)

    = L(r0 + e0, Y0)

    Now M0 rises to M1Thus P and e rise so

    M1P1> L(r0 + e1, Y0)

    ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

  • IS-MP MODEL

    MECHANISM

    Money market in initial equilibrium

    M0P0

    = L(i0, Y0)

    = L(r0 + e0, Y0)

    Now M0 rises to M1Thus P and e rise so

    M1P1> L(r0 + e1, Y0)

    ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

  • IS-MP MODEL

    For equilibrium r falls and/or Y rises according to

    ROMER (JAN 2013) () JANUARY 9, 2014 5 / 28

  • IS-MP MODEL

    For equilibrium r falls and/or Y rises according to

    ROMER (JAN 2013) () JANUARY 9, 2014 5 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.

    Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.

    In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.

    Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.

    That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.

    Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.

    In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • IS-MP MODEL

    CLASSICAL MODEL CASE

    If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

    ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

  • AD-IA MODEL

    AGGREGATE DEMAND

    AD curve is downward sloping in Y space and not PYspace

    When inflation rises, the CB raises the interest rate and shifts theMP curve

    ROMER (JAN 2013) () JANUARY 9, 2014 7 / 28

  • AD-I