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International macroeconomics
Thomas Lagoarde-Segot, PhD, HDR
Policy and economic fluctuation
Economic activity fluctuates one year to the next. 
 While economic output increases most years, occasionally firms are unable to sell all their products. This leads to lay offs, unemployment and a drop in GDP. Economists call this phenomenon a recession.
What drives short term fluctuations in economic activity? What can governments do in order to prevent recessions and mitigate their effects on unemployment? These are the questions addressed in this chapter.
We will analyze how different policy instruments affect the value of GDP, unemployment, and inflation in the short run in a closed economy
We will rely on the most standard macroeconomic model: the aggregate supply/aggregate demand (AS/AD) model
Introduction
The AS/AD model explains two macroeconomic variables:
The production of goods and services (i.e. real GDP)
The level of macroeconomic prices (i.e. the GDP deflator, or CPI)
.
The AS/AD model is based on the analysis of aggregate supply and aggregate demand:
The aggregate demand curve (AD) links prices to the amount of goods and services desired
The aggregate supply curve (AS) links prices to quantities produced
Introduction
Aggregate supply (AS) and aggregate demand (AD)
Aggregate supply (AS)
Real GDP
Prices
The macroeconomic price index is on a vertical axis. Real output is on a horizontal axis. Production and prices adjust to reach the intersection point between aggregate supply and aggregate demand.
Aggregate demand (AD)
Equilibrium output
Equilibrium
 prices
The aggregate demand curve (AD)
The aggregate demand curve
To understand why the AD curve has a negative slope, remember the four components of GDP:
Y = Gross Domestic Product
C = Private consumption 
I = investment
G = Government
CA = trade balance (exports X – imports M)
Each of these 4 components contributes to the level of aggregate demand and is negatively correlated to prices
Aggregate demand
Aggregate supply
The aggregate demand curve
To understand why the AD curve has a negative slope, remember the four components of GDP:
Three effects kick in following a decrease in prices decrease:
The ‘wealth effect’
Following a decrease in prices, the nominal value of money holdings remains the same, but the real value of these holdings increase: one euro allows to purchase more good and services. In other words a decrease in prices make households wealthier which makes them consume more. This increase in consumption expenditure makes aggregate demand and production increase.
The aggregate demand curve
To understand why the AD curve has a negative slope, remember the four components of GDP:
Three effects kick in following a decrease in prices decrease:
2. The ‘interest rate effect’
Following a decrease in prices, households will need less money to maintain their consumption level constant. Therefore, when prices decrease, the money holdings of households decrease. Household decrease their money holdings by lending their money: e.g. by purchasing bonds or by putting their money on an interest-bearing bank account (in which case the bank use the proceeds to give out loans). The increase in the supply of funds decrease the interest rate. As a result, firms and households can borrow funds at a cheaper cost which increases investment expenditure and production.
The aggregate demand curve
To understand why the AD curve has a negative slope, remember the four components of GDP:
Three effects kick in following a decrease in prices decrease:
3. The ‘exchange rate effect’
A decrease in prices lower the interest rate. As a result, domestic financial market investors invest abroad in order to yield a higher return on their assets. For instance if the interest rate of European bonds decrease, an investment fund might sell these bonds to purchase US Treasury bonds. As the funds converts euros in dollars in order to purchase the US Treasury bonds, the supply of euros increase in the foreign exchange market. Therefore the euro depreciates against other currencies. This means that each euro purchases less units of foreign currency. As a result non European goods (imports) become more expensive for Europeans consumers and European goods (exports) become cheaper for foreign consumers. As a result the current account balance – and production- increases.
Prices and aggregate demand (AD)
Real GDP
Prices
A decrease in macroeconomic prices (P1 to P2) increases the demand for goods and services Y due to a simultaneous an increase in consumption (wealth effect), investment (interest rate effect) and net exports (exchange rate effect)
Aggregate demand (AD)
P1
P2
Y1
Y2
The aggregate demand curve
Any change in the level of consumption (C), investment (I), government expenses (G) and net exports (CA) will affect demand regardless of the initial price level
This will result in a change in the position of the demand curve (AD)
We need to study the determinants of consumption, investment, government expenditure and net exports
Position of the aggregate demand curve (AD)
Real GDP
Prices
Other things equal, an increase in private consumption, investment, government expenses or net exports leads to an upwards shift of the AD curve (AD to AD’). 
Other things equal, a decrease in private consumption, investment, government expenses or net exports leads to a downward shift of the AD curve (AD to AD’’) 
(AD)
P
Y’’
Y
(AD’)
(AD’’)
Y’
Private consumption
 
 
Explanatoryvariable
Causalitymechanism
Y = GDP
Wealtheffect
Yp=Expectedlifetimeincome
Expectations
W =wealth
Assets/Socialstatus
T =taxes
Disposableincome
Tr=transferincome
Disposableincome
Rc= shortruninterestrates
Costofcredit
Π= inflation
Realvalue ofsavings
u=unemployment
Precautionarysavings
Private investment
 
 
Explanatoryvariable
Causalitymechanism
q=profitabilityoffirms
CostofinvestmentExpectations
rl= longruninterestrates
Costofcredit
ΔY= changes inglobaldemand
Expectations
Government expenditure
 
 
Explanatoryvariable
Causalitymechanism
POL=Political
National budget
Y= GDP
Taxrevenue
Tr
Expenses
Rl=longruninterestrates
Costofcredit
Π= inflation
Realvalue ofsavings
The demand function 
 
 
Position of the aggregate demand curve (AD)
Real GDP
Prices
Other things equal, an increase in private consumption, investment, government expenses and net exports lead to an upwards shift of the AD curve (AD to AD’). 
A decrease in private consumption, investment, government expenses and net exports lead to a downward shift of the AD curve (AD to AD’’) 
(AD)
P
Y’’
Y
(AD’)
(AD’’)
Y’
The aggregate supply curve (AS)
The aggregate supply curve (AS)
The aggregate supply (AS) curve shows how many goods and services are produced each year for any given price level
One important difference with the AD curve is that the slope of the AS curve depends on the time horizon
The slope of the AS curve is vertical in the long run and positive in the short run
The shape of the AS curve explains why short term fluctuations are different from long term fluctuations
The long term aggregate supply curve (AS)
In the long term, production does not depend on prices, but on the economy’s factor endowments
 Endowments include the stock of labour, stock of capital, natural resources, technologies. These are determined by factors such as the quality of educational system, the stability of institutions...
This is the classical assumption of the ‘neutrality of money’: real economic variables are not related of nominal variables
Given that the level of prices does not affect factor endowments, the long term AS curve is vertical
Ofcourse at the micro economic level, supply of a particular good depends on prices. However this is due to substitution across goods (i.e. relative prices). Given that we are considering the macroeconomic level, there is no substitution effect.
In the long term, price movements do not affect production
The long term aggregate supply curve (AS)
Real GDP
Prices
In the long term, production depends on the stock of labour, capital, natural assets and technologies. Price movements leave supply unchanged. The aggregate supply curve is vertical and reached the natural production level Y*
(AS)
Y*
P1
P2
The long term aggregate supply curve (AS)
Only changes in factor endowments can modify the position of the long term AS curve. Such changes include:
Labour migration: if the active population grows (immigration), so does the labour force and the long term supply. The AS curve shifts to the right. (reciprocally, emigration has the opposite effect).
Capital movements: if the stock of capital (including physical capital, human capital and land) increases, so does the long term supply. The AS curve shifts to the right.
Technology: innovations allow for a better use of capital and labour resources. This increases long term supply. The AS curve shifts to the right.
The long term aggregate supply curve (AS)
Real GDP
Prices
Long term changes in the stock of labour, capital, and technologies shift the AS curve to the right, resulting in a higher long term production level (Y to Y*), which is uncorrelated to the level of prices.
(AS)
Y
Y*
(AS*)
P
The short term aggregate supply curve (AS)
In the short term (1 – 2 years), production is sensitive to prices as lower prices decrease output. 
This is due to the fact that markets are imperfect: the observed price level deviates from the expected price level. 
The complementary theories are used to explain why expectation errors generate a positive short-run relationship between prices and output:
The rigid wages theory: when aggregate prices decrease, real wages increase. This increases production costs and leads to lower output.
The rigid prices theory: when aggregate prices decrease, individual prices remain the same due to menu costs. This deteriorates competitiveness and decreases output.
The theory of perception errors: variations in aggregate prices can lead producers to misinterpret the situation of their specific market.
 Ex: in case of a ‘pure deflation’, farmers may expect that their profits will decrease as they observe a drop in the price of wheat. They mistakenly decrease output. However, their relative profits would have been unchanged given that the prices of all goods decrease simultaneously.
The short term aggregate supply curve (AS)
Real GDP
Prices
v
In the short term, a decrease in prices (P1 to P2) has a negative impact on aggregate supply (Y1 to Y2). Economists explain mechanism due to expectation errors that generate wage rigidities, price rigidities and perception errors. 
(AS)
Y2
P2
P1
Y1
The short term aggregate supply curve (AS)
Production deviates from the natural level only when observed price levels deviate from price expectations
This can be expressed with the following formula:
Production = Natural production + α (Observed Prices – Expected Prices)
Where α expresses the reaction of production to unexpected price movements
The value of α depends on the impact of wage rigidities, price rigidities and perception errors
As economic agents adjust their expectations, production converges back to the natural level
The short term aggregate supply curve (AS)
The position of the short term aggregate supply curve depends on the gap between observed prices and expected prices
In the long term, agents make accurate price predictions. Following a deflation:
Employers decreases nominal wages in order to maintain real wages constant - offsetting the wage rigidities effect
Firms decrease their prices in order to maintain their competitiveness -offsetting the price rigidities effect
Agents make less perception errors and adjust their behaviour accordingly - offsetting the perception errors effect
In the long term the assumption of neutrality of money holds and production converges towards the long run level
The long term equilibrium
Real GDP
Prices
The economy’s reaches long term equilibrium when aggregate demand meets long run aggregate supply (AS’). At this point, wages, prices and expectations have adjusted so that the short term aggregate supply curve (AS) goes through the equilibrium point as well.
(AS)
Long term aggregate supply (AS’)
(AD)
P*
Y*
Long term economic growth and prices
Real GDP
Prices
As the economy’s production capacity increases over time, the long run aggregate supply curve shifts to the right. In the mean time, the aggregate demand curve shifts to the right as more income is distributed. The Central Bank responds by increasing money supply, so that production and prices increase over time. 
(AS’1980)
(AD1980)
P1980
Y1980
(AS’1990)
(AS’2000)
(AD1990)
(AD2000)
P1990
P2000
Y1990
Y2000
Analyzing economic fluctuations
Scenario 1: a recession
Assume that all economic agents suddenly become pessimistic (due to a financial crisis, a political scandal, a war...)
 Households reduce their expenses, firms delay their investments.
This causes a shift the AD curve to the left: aggregate demand decreases
Given that the short run AS curve is positive, real GDP decreases
Effects of a recession
Real GDP
Prices
In a recession, aggregate demand decreases and the AD curve shifts to the left (AD to AD’). This leads to a new temporary equilibrium characterized by lower production (Y* to Y1) and lower prices (P1 to P2). 
Short run(AS)
(AD’)
(AD)
Y1
P2
P1
Y*
Long run (AS)
Price expectations ‘natural end’ of recessions
Recessions being with a drop in aggregate demand
 Households reduce their expenses, firms delay their investments.
Lower aggregate demand decreases prices
In the short run: lower prices decrease production due to higher real wages, price expectation errors and market imperfections
In the long run, price expectations adjust and production goes back to its equilibrium level
 Employers lower nominal wages and lower final prices. Perception errors also disappear
The short run AS curve shifts to the right 
Prices are strongly deflated but production goes back to its long run level : ‘money is neutral’
The natural end of recessions
Real GDP
Prices
In a recession, aggregate demand decreases and the AD curve shifts to the left (AD to AD’). This leads to a new equilibrium characterized by lower prices (P1 to P2) and lower production (Y1 to Y2). As firms gradually incorporate lower prices into their decisions, the AS curve shifts to the right (AS to AS’) equalizing output with long run output (Y1 to Y*). Prices decrease to P3.
(AS’)
(AD’)
(AD)
Y*
P2
P1
Y1
(AS)
P3
Policy response
‘In the long run, we will all be dead’ (J.M. Keynes): income is lost during the adjustment phase
Economic policy can shift AD to the right and bring back output to its original level (stimulus programs)
This accelerates economic recovery 
Effects of a recession
Real GDP
Prices
In a recession, aggregate demand decreases and the AD curve shifts to the left (AD to AD’). This leads to a new temporary equilibrium characterized by lower production (Y* to Y1) and lower prices (P1 to P2). 
Short run(AS)
(AD’)
(AD)
Y1
P2
P1
Y*
Long run (AS)
Policy response to a recession
Real GDP
Prices
In a recession, aggregate demand decreases and the AD curve shifts to the left (AD to AD’). This leads to a new equilibrium characterized by lower production (Y1 to Y2) and lower prices (P1 to P2). Governmentcan react though a stimulus policy (increasing C, I, G, or CA) which shifts AD to the right (AD’ to AD’’), and production and prices towards their initial level.
(AS)
(AD’)
(AD)
Y2
P2
P1
Y1
(AD’’)
Long run (AS)
Example 2: an inflationary shock
Assume that geopolitical turmoil in the Middle East slows down oil production and increases production costs for all firms
 Prices are higher for each level of national output
The AS curve shifts to the left and aggregate supply decreases
As a result, GDP decreases while inflation increases: the economy is in stagflation
Effect of an oil shock
Real GDP
Prices
The oil shock increases production costs. The AS curve to the left (AS to AS’): prices are higher for each supply level. This leads to a new equilibrium characterized by lower production (Y* to 12) and higher prices (P1 to P2). The economy is in stagflation.
(AS’)
(AD)
Y*
P2
P1
Y1
(AS)
Natural adjustment after an oil shock
The oil shock triggers a period of stagflation: lower GDP growth and higher inflation
In the long run, wages and prices adjust:
Nominal wages decrease due to higher unemployment rate and lower negotiation power (WS curve)
Corporations decrease prices in order to keep the same profit margin and increase volumes
The aggregate supply curve shifts to the right and production converges back to its natural level
Natural adjustment after an oil shock
Real GDP
Prices
The oil shock increases production costs. The AS curve shifts to the left (AS to AS’). This leads to a new equilibrium characterized by lower production (Y* to Y1) and higher prices (P1 to P2). The economy is in stagflation. Unemployment decreases wages, so that output and prices move back to their initial levels in the long run (P2 to P1, Y1 to Y*)
(AS’)
(AD)
Y*
P2
P1
Y1
(AS)
Policy response to an oil shock
The oil shock induces a period of stagflation: lower output and higher prices 
What happens if economic policy stimulates the economy, shifting AD to the right?
The recessionary effects of the oil shock are eliminated
A higher rate of inflation is observed
Stimulus after an oil shock
Real GDP
Prices
The oil shock increase production costs, leading to a shift of the AS curve to the left (AS to AS’). This leads to a new equilibrium characterized by lower production (Y* to Y1) and higher prices (P1 to P2). The economy is in stagflation. The government can accelerate recovery through a stimulus program (AD to AD’). This brings back output to its long run level, but generates a permanent price increase (P2 to P3)
(AS’)
(AD)
Y*
P2
P1
Y1
(AS)
(AD’)
P3
Assignment