Thursday, December 11, 2008

Confessions

Perhaps, being a PhD student in economics, I should know the answer to this question. But I don't.

In a Y=C+I economy, suppose a negative shock creates an output gap, i.e. the economy produces less than it could, i.e. a recession. How does the economy return to potential? Unfortunately, I do not own any intro macro texts. And I have an exam tomorrow. So if someone could provide...

Also, a particularly interesting map.

1 comment:

Gabriel said...

In the long run markets clear because prices unstick. Badabing!

Think about the following model:

I = (a_i - b (R - MPK)) Y_potential
C = a_c Y_potential

Y = I + C

Y = (a_i + a_c - b (R - MPK)) Y_potential

Output gap = (Y - Y_potential) / Y_potentia;

output gap = a - b (R - MPK)

a = a_i + a_c - 1
(demand shock = investment demand shock + consumption demand shock - 1)

R = real interest rate

Assume prices are sticky in the short run. Then the central bank can set the real interest rate, by setting the nominal interest rate.

when central bank increases R above MPK then an output gap appears and its negative (actual below potential).

When there's a negative demand shock, creating a negative output gap, the central bank can decrease the interest rate and return the economy to potential.

Alternatively, we could wait until prices unstick and the real interest rate is again equal to the MPK.

If you're interesting in inflation in this setup, think of this Philips curve with adaptive expectations:

delta pi_t+1 = v output_gap + cost-push shock
(and pi_0 given)

You can also do Okun's Law:

u = NAIRU - x output_gap

Finally, you can start with Y = C+I+G+NX and then put NX in I and split G into C and I components, and then you can do the RBC thing and model the entire economy as C+I, so that's not a problem.

I hope this helps. This is largely based on the Charles I. Jones Intermediate Macro textbook I use in my TA job.