Transcript Chapter 14

Chapter 13
Business Fluctuations:
Aggregate Demand
and Supply
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline




The Aggregate Demand Curve
The Long-Run Aggregate Supply Curve
Real Shocks
Aggregate Demand Shocks and the Short-Run
Aggregate Supply Curve
 Shocks to the Components of Aggregate Demand
 Understanding the Great Depression: Aggregate
Demand Shocks and Real Shocks
2
Introduction
 Economic growth is not a smooth process.
 Real GDP in the United States has grown at an
average rate of 3.2% per year over the past 60
years.
 The economy rarely grew at an average rate.
 Growth fluctuated from -5% to over 8%.
 Recessions are of special concern to
policymakers and the public because
unemployment typically increases.
3
Definition
Business fluctuations:
fluctuations in the growth rate of real
GDP around its trend growth rate.
Recession:
a significant, widespread decline in real
income and employment.
4
Introduction
Bureau of Economic Analysis
Quarterly Growth Rate in Real GDP, 1947–2013
5
Introduction
Bureau of Labor Statistics; National Bureau of Economic Research
U.S. Civilian Unemployment Rate, 1948–2013
6
Introduction
 To understand booms and recessions, we are
going to develop a model of aggregate demand
and aggregate supply (AD/AS), with 3 curves:
• Aggregate demand curve (AS)
• the long-run aggregate supply curve (LRAS or
Solow)
• the short-run aggregate supply curve (SRAS).
 The AD/AS model shows how unexpected
economic disturbances or “shocks” can
temporarily increase or decrease the rate of
growth.
7
Definition
Aggregate demand curve:
shows all the combinations of inflation
and real growth that are consistent with
a specified rate of spending growth,
M v .
8
The Aggregate Demand Curve
 We can derive the AD curve using the quantity
theory of money in dynamic form,
M    P  YR
Where:
M

P
= growth in velocity
YR
= growth rate of real GDP
= growth rate of the money supply
= growth rate of prices (inflation)
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The Aggregate Demand Curve
 We can also write the equation as:
M    Inflation  Real Growth
 So if money growth = 5%, velocity = 0%, and
real growth is 0%, the inflation rate must = 5%.
 In other words, if the money supply is growing,
velocity is constant, and there are no additional
goods, then prices must go up.
10
The Aggregate Demand Curve
 Another example: if money growth = 5%,
velocity = 0%, and real growth is 3%, the
inflation rate must = 2%.
 An AD curve tells us all the combinations of
inflation and real growth that are consistent with
a specified rate of spending growth, M   .
 In our example, any combination of inflation and
real growth that adds up to 5% is on the same
AD curve.
11
The Aggregate Demand Curve
Inflation
Rate (p)
If spending and real growth
increases, then inflation will
fall down.
5%
5% + 0% = 5%
2%
2% + 3% = 5%
AD (spending growth = 5%)
0%
-2%
0%
3%
5%
7%
Real GDP
growth rate 12
Self-Check
equals:
a. Real growth.
b. Inflation + nominal growth.
c. Inflation + real growth.
Answer: c : M    Inflation  Real Growth
13
Shifts in Aggregate Demand
 Increased spending must flow into either a
higher inflation rate or a higher growth rate.
 If spending growth increases, either because of
an increase in money supply or an increase in
velocity, then the AD curve shifts up and to the
right.
 A decrease in spending growth shifts the AD
curve inward.
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Shifts in Aggregate Demand
Inflation
Rate (p)
7%
7% + 0% = 7%
1. Increases in spending growth,
 M and/or  
shift the AD curve to the right.
2. Decreases in spending growth,
 M and/or  
shift the AD curve to the left.
5%
2%
2% + 5% = 7%
AD (spending growth = 7%)
0%
-2%
0%
3%
5%
7%
Real GDP
growth rate 15
Long Run Aggregate Supply
 Every economy has a potential growth rate
determined by:
• Increases in the stocks of labor and capital.
• Increases in productivity.
 The rate of growth, as given by these real
factors of production, is called the “Solow”
growth rate.
 The long-run aggregate supply curve is a
vertical line at the Solow growth rate,
independent of the inflation rate.
16
Long Run Aggregate Supply
Inflation
Rate (p)
LRAS
Potential growth does not
depend on the rate of inflation.
The Solow
growth rate
Real GDP
growth rate
17
Definition
Solow growth rate:
an economy’s potential growth rate, the rate of
economic growth that would occur given flexible
prices and the existing real factors of production.
The long run aggregate supply curve
(LRAS):
is vertical at the Solow growth rate.
18
Shifts in the LRAS Curve
 When we put the AD and LRAS curve together,
we can see how business fluctuations can be
caused by real shocks.
 In this model, the equilibrium inflation rate and
growth rate are determined by the intersection
of the AD and LRAS curves.
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AD and LRAS Curves
LRAS
Inflation
Rate (p)
If M   is 10% and
real growth is 3%,
then the inflation rate
will be 7%.
7%
AD (M  v  10%)
3%
Real GDP
growth rate 20
Self-Check
An economy’s potential growth rate is called:
a. The Solow growth rate.
b. Aggregate supply.
c. Aggregate demand.
Answer: a – the potential growth rate is called
the Solow growth rate.
21
AD + LRAS: Real Business Cycle Model
(RBC)
 RBC – Real Business Cycle Model
 Pre-Keynesian model
 Prices assumed to be flexible, markets auto
adjust to changes in agg demand
 Consists of just the AD and LRAS curve
 A supply side model
 Shifts in the AD curve only causes changes in
inflation rate, not real growth rates
 Real growth rate changes only when there are
real shocks
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Shifts in the LRAS Curve
 Real shocks are rapid changes in economic
conditions that increase or diminish the
productivity of capital and labor.
 Economies are continually hit by real shocks,
which shift the Solow growth rate.
 This in turn influences GDP and employment.
 Possible shocks include wars, terrorist attacks,
major new regulations, tax rate changes, mass
strikes, and new technologies.
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AD and LRAS Curves
LRAS
Inflation
Rate (p)
Negative
shock
Positive
shock
1. A positive shock results
in a higher real growth
rate and lower inflation.
11%
2. A negative shock
results in a lower real
growth rate and higher
inflation.
7%
3%
AD (M  v  10%)
-1%
3%
7%
Real GDP
growth rate 24
Real Shocks
 Agricultural output depends on the quantity and
quality of the inputs of capital and labor.
 It also depends on the weather.
 If farmers struggle, many other sectors of the
economy suffer as well.
 When the weather fluctuates, so does output
and therefore so does GDP, especially in
agricultural economies.
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Real Shocks: Weather
26
Real Shocks
 In an economy with a large manufacturing
sector, a reduction in the oil supply reduces
GDP.
 Oil and machines are complementary - they
work together with labor to produce output.
 When the oil supply is reduced, capital and
labor become less productive.
 The first OPEC oil shock came in late 1973, and
the price of oil more than tripled in two years.
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Real Shocks
 Since oil is an important input in many sectors,
high oil prices—or oil shocks—hurt many
American industries.
 In each of the last six U.S. recessions, there
was a large increase in the price of oil just prior
to or coincident with the onset of recession.
 A 10% increase in the price of oil lowers the
GDP growth rate for just over two years.
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Real Shocks
The Price of Oil and U.S. Recessions
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Real Shocks
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Self-Check
Higher business taxes will shift the long run
aggregate supply curve:
a. To the left.
b. To the right.
c. Higher taxes will not shift the LRAS curve.
Answer: a – higher taxes will decrease LRAS,
shifting the curve to the left.
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Introduction to the AD/AS Model
 Next model: AD-AS (New Keynesian)
• Explains the business cycle in terms of both
real shocks and/or aggregate demand shocks
• Both supply-side shocks and demand side
shocks are incorporated
 This is a model for the economic short run,
not the long run
• Trying to explain the “business cycle”
• Hence the need for the SRAS
 AD-AS is primarily a Demand Side model
32
John Maynard Keynes
 John Maynard Keynes (1883-1946)
• The General Theory of Employment, Interest, and
Money, 1936.
 Wrote in the context of the Great Depression.
 Explained that when prices are not perfectly
flexible (sticky), deficiencies in aggregate
demand could cause recessions
Key to the model: when prices are
sticky, the economy can grow
faster or slower than the Solow
growth rate.
33
Keynesianism
Keynesian economic philosophy:
The economy must be managed.
The economy is unstable, tends to fall into recessions
Government spending and money printing are the
solutions to “manage” the economy
(even if it means digging holes and then filling them up!)
Economic corrections by themselves take too long
“In the Long Run, we’re all dead.”
Can not rely on the economy to correct itself
34
Keynesianism
 Utilizes big aggregated concepts/explanations
• – too aggregated, not enough information
 Became “intellectual cover” for big government
spending, collectivism
 If WWII spending ended the Great Depression, why
didn’t the huge reduction in government spending
cause another recession/depression? Many
predicted this.
 Regime uncertainty may be a better explanation
 Discredited in the early 1970’s but was resurrected
big time in 2009 with the massive stimulus bill
35
Short Run Aggregate Supply (SRAS)
The short run aggregate
supply curve:
shows the positive relationship between
the inflation rate and real growth during
the period when prices and wages are
sticky.
36
Short Run Aggregate Supply (SRAS)
37
Short Run Aggregate Supply (SRAS)
 The SRAS show the pathway of the economy in the
short run
 The short run macroeconomic equilibrium is at the
intersection of the AD curve and the SRAS curve
 The intersection of these two curves indicates the
rate of economic growth and the inflation rate
(actual inflation)
 In the short run, an increase in AD will increase
both inflation and real growth.
• Increase in AD is split between growth & inflation
 i.e. a decrease in demand will decrease both the
inflation rate and the growth rate.
38
Short Run Aggregate Supply (SRAS)
 The position of the SRAS curve is anchored by
expected inflation E(p), and changes in E(p) will shift
SRAS. Such shifts occur only in the long run.
 Changes in actual inflation (p) cause a movement
along the SRAS curve. Such movements occur only
in the short run.
 Each SRAS curve is associated with a specific rate of
expected inflation - E(p)
39
Why does the SRAS slope upwards?
 Given:
M    P  YR
 When spending increases, the “stickiness” of
prices means that changes in the growth rate of
P can not change enough to compensate
 Therefore, real GDP growth rate must change to
balance both sides of the equation (in the short
run only)
 In the SR, output can change (temporarily)
 In the LR, prices can fully adjust (flexible)
40
Sticky Prices
 Prices can be sticky (not fully flexible) due to
uncertainty, “menu costs,” and other factors
 There may be confusion as to whether price
changes are real or nominal.
 Firms may not respond immediately to
changes in AD/inflation
 “Menu costs” – represent the costs of
changing prices
 Changing prices may create mistrust among
the firm’s customers
 The “profit story” illustrates sticky prices
41
Self-Check
The costs associated with changing the prices of
goods and services are called:
a. Inflation costs.
b. Inflationary expectations.
c. Menu costs.
Answer: c – menu costs.
42
Sticky Wages
 Another form of sticky prices
 Wages are the major expense for many firms
 Wages can be slow to adjust due to labor contracts,
uncertainty, human factors, etc
 When inflation falls, wages may remain high,
making labor expensive
 Firms may choose to do layoffs rather than wage
cuts
 Workers often become upset when there are
reductions to their nominal wages, morale drops
 Wages will change more slowly than actual inflation
in the short run
43
Definition
Nominal wage confusion:
occurs when workers respond to their
nominal wage instead of to their real
wage, that is, when workers respond to
the wage number on their paychecks
rather than to what their wage can buy
in goods and services (the wage after
correcting for inflation).
44
The “Profit” Story
45
Short Run Aggregate Supply (SRAS)
 The SRAS is drawn with a steeper slope to the
right of the LRAS – reflects capacity limitations
in the economy
 Since wages are sticky downwards, a slowdown
in nominal spending growth results in more
unemployment than if wages/prices were
perfectly flexible (RBC model)
 With a negative AD shock, the ultimate effect of
sticky wages results in more unemployment
 This is reflected in the shape of the SRAS curve
46
Check It
If p > p e :
a) firms' profits will increase.
b) money growth will cause the short-run
aggregate supply curve to shift.
c) firms' profits will decrease.
d) there will be no change in real GDP
growth because it is determined by real
factors.
SRAS Shifts
• What shifts the SRAS curve?
• Whenever the LRAS moves left or right, the
SRAS moves with it, staying with the “anchor”
point
• Changes in expected inflation rate
 When exp infl increases, SRAS shifts left
 When exp infl decreases, SRAs shifts right
• Whenever exp infl does not equal actual inflation,
the SRAS shifts in the appropriate direction
48
Short-Run Aggregate Supply
Inflation
Rate (p)
LRAS
SRAS (E(p) = 2%)
2%
AD (M  v  5%)
3%
Real GDP growth rate
49
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve

Inflation
Rate (p)
Solow growth
curve
d
6%
4%
2%
(SRAS2)
(E(p) = 4%)
c
(SRAS1)
(E(p) = 2%)
b
then p = 4% and E(p) = 2%,
and real growth ↑ to 7%
When p = 4% and E(p) = 4%,
SRAS shifts up and economy
moves to point c.
If economy moves to d
then p = 6% and E(p) = 4%,
and real growth ↑ to 7%
a
3%
At p = 2% and E(p) = 2%,
economy is at point a.
If economy moves to b (due to
an AD shift)
7%
Real GDP growth rate
Equilibrium in SR/LR
 Equilibrium:
 Long Run • When all three curves intersect at the same point (the
anchor point)
• Expected inflation always equal actual inflation
 Short Run –
• Wherever the SRAS and AD curve intersect
 Determines actual inflation rate and economic
growth rate
• Does not necessarily have to be in LR equilibrium
51
Aggregate Demand Shocks
Aggregate demand shock:
a rapid and unexpected shift in the AD
curve (spending).
52
Aggregate Demand Shocks
 A positive shock to spending must either
increase inflation or the real growth rate.
 In the short run, an increase in spending will be
split between increases in inflation and
increases in real growth.
 In the long run, the real growth rate is equal to
the Solow rate, which is not influenced by
inflation. (“money is neutral’)
 In the long run, therefore, an increase in
spending will increase only the inflation rate.
53
An Increase in Aggregate Demand
Inflation
Rate (p)
If there is an unexpected ↑ in M ,
both inflation and the growth rate
increase in the short run (a → b).
LRAS
SRAS (E(p) = 2%)
b
4%
2%
AD (M  v  10%)
a
AD (M  v  5%)
3%
6%
Real GDP growth rate
54
An Increase in Aggregate Demand
 Workers initially mistake the nominal wage
increase for a real increase.
 Prices also don’t move instantly because it is
costly to change prices (“menu costs”).
 Firms may also hold off on price changes
because they are not sure whether the change
in market conditions is temporary or permanent.
 As prices increase throughout the economy,
workers demand even higher wages to catch up
to the higher inflation rate.
55
An Increase in Aggregate Demand
Inflation
Rate (p)
Eventually, inflation expectations
adjust, wages are unstuck and
the growth rate returns to the
Solow rate (b → c).
LRAS
SRAS (E(p) = 7%)
c
7%
SRAS (E(p) = 2%)
b
4%
2%
AD (M  v  10%)
a
AD (M  v  5%)
3%
6%
Real GDP growth rate
56
A Decrease in Aggregate Demand
 When AD falls due to a fall in the money supply:
• The economy shifts to a new short run
equilibrium point.
• The inflation rate decreases a little.
• Real growth is reduced a lot (recession).
 Prices and wages are especially sticky in the
downward direction.
 It can take the economy a long time to move out
of a recession.
57
A Decrease in Aggregate Demand
Inflation
Rate (p)
LRAS
(SRAS)
(E(p) = 7%)
a
7%
5%
b
A decrease in AD can
induce a lengthy
recession.
AD1 (M  v  10%)
AD2 (M  v  5%)
-1%
3%
Real Growth
58
A Decrease in Aggregate Demand
Inflation
Rate (p)
LRAS
(SRAS)
(E(p) = 7%)
a
7%
5%
b
c
3%
In the long run, wages
become unstuck and
the economy moves to
a new equilibrium at c.
AD1 (M  v  10%)
AD2 (M  v  5%)
-1%
3%
Real Growth
59
A Decrease in Aggregate Demand
 In the previous graph, a negative AD shock
results in moving from A to B to C
 i.e. the economy will eventually recover to its
long run Solow growth rate
 Keynesian say that this process takes too long,
resulting in various social problems
 Rather than wait for this process (3 years?), the
government should actively manage the
economy via policies that increase aggregate
demand
 To be covered in Fiscal Policy chapter
60
Shocks to Components of AD
 Changes in  are the same as changes in the
spending rate, holding M constant.
 If  increases, the growth rate of C, I, G, or NX
must increase.
 Changes in  tend to be temporary.
 The shares of GDP devoted to C, I, G, and NX
have been quite stable over time.
61
A Shock to the Growth Rate of Spending
Consumers’ fears →
LRAS
temporary decrease
in AD
 Short-run
(SRAS)
• Wages are
(E(p) = 7%)
sticky
• Real growth ↓
 Long-run
• AD returns
a
• Real growth ↑
Inflation
Rate (p)
7%
6%
b
AD1 (M  v  10%)
AD2 (M  v  5%)
-1%
3%
Real Growth
62
Factors That Shift AD
63
Self-Check
A slower growth in the money supply will:
a. Decrease AD.
b. Increase AD.
c. Not affect AD.
Answer: a – decrease AD.
64
The Great Depression
 The Great Depression was due primarily to a
large fall in aggregate demand.
 In 1929, the U.S. stock market crashed.
 Common belief - “Capitalism is inherently
unstable and goes through regular panics and
recessions.”
 World finances were a mess as a result of WWI.
The US economy boomed during the “Roaring
20s” fueled by easy money from the recently
created Federal Reserve.
65
The Great Depression
 The boom was largely due to too much credit
and when the brakes were put on in the late
1920’s, the stock market crashed (just like 20082009).
 Few supporters of the “common” belief
recognize or mention the sharp depression
experienced in 1920-21.
 GDP fell by over 10% though the economy
recovered quickly within 18 months
 How did the US get out of the 1920-1921
depression so quickly?
66
The Great Depression
 The government largely did nothing.
 Many people believe that monetary flows from Europe
energized spending and economic growth in the US.
 In 1922, the “Roaring 20s” began.
 High flying tech stocks like RCA (radio) led the frenzied
creation of a stock market bubble.
 Until the crash of October 1929 - where 25% of the
market value was lost over two days.
• Many stocks down 90%
• Loss of confidence in the system
 In the October 1989 crash, market down 25% in one day
67
The Great Depression
 People felt poorer and decreased spending,
reducing aggregate demand.
 In 1930, depositors lost confidence in the banks.
 From 1930 to 1932, there were four waves of
banking panics.
 By 1933, more than 40% of all American banks
had failed.
 The fear and uncertainty also reduced
investment spending.
 The U.S. capital stock was lower in 1940 than it
had been in 1930.
68
The Great Depression
 In 1931, instead of increasing the money supply
to boost the economy, the Federal Reserve
allowed the money supply to contract even
further.
 There was an additional monetary contraction
during 1937–1938.
• This was the infamous “Depression within a
depression.”
• Much of the previous economic gains were gone.
 At the time of Pearl Harbor, the unemployment
rate was still 14%
69
The Great Depression
Inflation
Rate (p)
LRAS
SRAS
C
0%
I
M
AD(M  v  4%)
-10%
AD( M  v  - 23%)
-13%
4%
Real GDP growth rate
70
The Great Depression
 Real shocks also played a role in the Great
Depression.
 Bank failures not only reduced the money supply
and spending (AD), but they also reduced the
efficiency of financial intermediation.
 Economic policy mistakes also impeded
recovery; government agencies tried to increase
prices by reducing supply.
 The Smoot–Hawley Tariff of 1930 raised tariffs
on imports; other countries retaliated.
71
The Great Depression
 A severe drought and decades of ecologically
unsustainable farming practices turned millions
of acres of farmland into a “dust bowl”.
 The shocks
compounded
one another
and made a
desperate
situation even
worse.
NOAA GEORGE E. MARSH ALBUM
72
Video Links for Ch 13
 Business Cycle –

https://www.youtube.com/watch?v=O-IZB0Ndl8s&index=22&list=PLJqCyb18paTjIoFpfHVwOj6dI5WJmmH2
 Real Business Cycle

https://www.youtube.com/watch?v=rcezRoO7xfA&index=23&list=PLJqCyb18paTjIoFpfHVwOj6dI5WJmmH2
 AS-AD model - Intro

https://www.youtube.com/watch?v=-DvANk24ge0&list=PLJqCyb18paTjIoFpfHVwOj6dI5WJmmH2&index=24
 More on AS-AD model (Part 1)

https://www.youtube.com/watch?v=ZWbyZtmyNj4&index=25&list=PLJqCyb18paTjIoFpfHVwOj6dI5WJmmH2
 More on AS-AD model (Part 2)

https://www.youtube.com/watch?v=sGcIoqK80YU&index=26&list=PLJqCyb18paTjIoFpfHVwOj6dI5WJmmH2
73
Takeaway
 The aggregate demand and supply model can
be used to analyze fluctuations in the growth
rate of real GDP.
 Real shocks are analyzed through shifts in the
LRAS curve, while aggregate demand shocks
are analyzed using shifts in the AD curve.
 Nominal wage and price confusion, sticky
wages and prices, menu costs, and uncertainty
create an upward-sloped short run aggregate
supply curve.
74
Takeaway
 The Great Depression resulted from an
unfortunate, concentrated, and interrelated
series of aggregate demand and real shocks.
 It can be illustrated using the AD/AS model.
75