Economic Shocks in the Short Run

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 1 / 12

 Figure: Initial General Equilibrium

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 2 / 12

A temporary adverse supply shock

Suppose productivity drops temporarily

,! IS curve is not aected, since future MPK is unchanged
,! MPN falls and labour demand curve shifts down
,! the FE line shifts left

Short-run, temporary equilibrium

,! at original intersection of IS and LM

General equilibrium
,! since Y > Y , P starts to rise and M/P falls
,! the LM curve shifts up until Y = Y

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 3 / 12

 Figure: Temporary TFP shock: Short run

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 4 / 12

 Figure: Temporary TFP shock: GE

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 5 / 12

The eects of a monetary expansion

Central bank raises M

,! the LM curve shift down and the interest rate drops

Short-run, temporary equilibrium

,! drop in r stimulates aggregate demand
,! rms respond by increasing production
General equilibrium
,! since Y > Y , P rises and M/P falls
,! LM curve shifts up until Y = Y

The change in M causes P to change proportionally.

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 6 / 12

 Figure: Monetary expansion: Short run

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 Figure: Monetary expansion: GE

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 8 / 12

The eects of a scal expansion

Suppose the government choses to increase government purchases

,! national savings declines
,! the IS curve shifts up and the interest rate increases

Short-run, temporary equilibrium

,! rms respond to increased demand by increasing production
General equilibrium
,! since Y > Y , P rises and M/P falls
,! LM curve shifts up until Y = Y

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 9 / 12

 Figure: Fiscal expansion: Short run

Macroeconomic Theory I (ECON222) General Equilibrium Fall 2017 10 / 12

Short-run adjustment to scal expansion reects:

The Multiplier Eect

,! initial change in G stimulates aggregate demand
,! may generate increased consumption spending

The Crowding-out eect

,! the resulting increase in the interest rate
,! crowds out private investment.

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 Figure: Fiscal expansion: GE

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