DYNAMIC POWERPOINT SLIDES BY SOLINA LINDAHL CHAPTER 30 Business Fluctuations: Aggregate Demand and Supply
CHAPTER OUTLINE The Dynamic Aggregate Demand Curve The Solow Growth 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 For applications, click here To Try it! questions To Video
Food for Thought. Some good blogs and other sites to get the juices flowing:
Introduction Economic Growth is Not a Smooth Process Real GDP grew at an average rate of 3% over the past 50 years. Growth wasn t smooth. A business fluctuation is a fluctuation in the growth rate of real GDP around its trend growth rate.
Introduction Economic Growth is Not a Smooth Process What causes the deviations from the average: booms and recessions A recession is a significant, widespread decline in real income and employment. (Shaded blue areas)
The Model To understand booms and recessions, we use the dynamic aggregate demand framework. Ultimately the model will have 3 curves: 1. Dynamic aggregate demand curve 2. Solow growth curve 3. Short-run aggregate supply curve
The Dynamic Aggregate Demand Curve Aggregate Demand Curve: A curve showing all the combinations of inflation and real growth that are consistent with a specified rate of spending growth. Deriving the Dynamic Aggregate Demand Curve from the quantity theory in dynamic form: Where represents total spending growth.
The Dynamic Aggregate Demand Curve The rate of spending growth = so that: Spending growth = Inflation + Real Growth Important: For a given level of spending growth the AD curve shows the combinations of inflation and real growth that add up to that spending growth.
The Dynamic Aggregate Demand Curve Plotting inflation against real growth gives a dynamic AD curve for each level of spending growth.
The Dynamic Aggregate Demand Curve Inflation Rate (p) AD curve when spending growth = 5% Note: The sum of inflation and real growth will always equal spending growth, which equals money growth plus the growth of velocity. e.g. 7% 5% 2% 0% -2% 5% + 0% = 5% 2% + 3% = 5% AD (spending growth = 5%) 0% 3% 5% 7% Real GDP growth rate
The Dynamic Aggregate Demand Curve Inflation Rate (p) AD curve when spending growth = 7% Conclusion: Increases in spending growth, 7% shifts the AD curve to the right. 2.Decreases in spending growth, 5% shifts the AD curve to the left. AD (spending growth = 7%) 2% 0% -2% AD (spending growth = 5%) 0% 3% 5% 7% Real GDP growth rate
Building the Model Moving on to the next piece of the model: 1. Dynamic aggregate demand curve 2. Solow growth curve 3. Short-run aggregate supply curve
The Solow Growth Curve Solow growth rate: is an economy s potential growth rate, the rate of economic growth that would occur given flexible prices and existing real factors of production. Important point: If markets are working well and prices are perfectly flexible, the economy will grow at the potential growth rate.
The Solow Growth Curve The Solow Growth Curve Inflation Rate (p) Solow growth curve Why is the Solow Growth Curve vertical? Potential growth does not depend on the inflation rate. 3% Real GDP growthback rate TO
What causes the Solow Growth Curve to Shift? Inflation Rate (p) Solow growth curve Real shocks ( Productivity Shocks ) which increase or decrease the potential growth rate. Positive productivity shocks Negative shock Positive shock increase the ability of the economy to produce. Negative productivity shocks decrease the ability of the economy to produce. -1% 3% 7% Real GDP growth rate
Try it! An increase in inflation will cause the Solow growth curve to: a)shift inward. b)shift outward. c)not shift at all. d)shift randomly. To next Try it!
Try it! Solow growth rates fluctuate over time because of: a)real shocks. b)monetary shocks. c)changes in the rate of inflation. d)all of the answers are correct. To next Try it!
Try it! Which of the following choices can explain the shift of the Solow growth curve from A to B in the figure above? a)development of new technology b)negative supply shock c)war To next Try it! d)oil crisis
The Solow Growth Curve and AD Putting the AD and the Solow growth curve together. Inflation Rate (p) Solow growth curve Equilibrium 7% AD 3% Real GDP growth rate
The Solow Growth Curve and AD Putting the AD and the Solow growth curve together. Solow growth curve Inflation Rate (p) Negative shock Positive shock 11% 7% Conclusions: A positive shock results in a higher real growth rate, 7%, and lower inflation, 3%. 2. A negative shock results in a lower real growth rate, -1%, and higher inflation, 11%. 3% AD -1% 3% 7% Real GDP growth rate
Take a look.. Besides co-authoring this text, Tyler Cowen writes the most popular Economics blog, he has written a book called The Great Stagnation. Here is clip of Paul Solman s (PBS Newshour) interview which focuses on the question, Why Hasn't Recent Technology Created More Jobs? (8:56 minutes) http://www.youtube.com/watch?v=yxaiwfwafuc
Real Shocks If there are rapid changes in economic conditions that affect the productivity of capital and labor then the economy s growth rate will change. Rainfall Shocks in India Correlate Well with Agricultural Output and GDP Source: Reserve Bank of India and Indian Institute of Tropical Meteorology
Real Shocks: The Price of Oil and U.S. Recessions Note: Real price of oil per barrel in $2000.
Real Shocks: The Price of Oil and U.S. Recessions Real Output Growth Response to a 10 Percent Increase in Oil Price Source: Stylized graph based on results in Sill, Keith. 2007. The Macroeconomics of Oil Shocks. Federal Reserve Bank of Philadelphia, Business Review Q1: 21 31. Oil shocks create disruptions, bottlenecks and recessions- and impact growth for two years.
Real Shocks: Examples & Analysis
Building the Model Moving on to the next piece of the model: 1. Dynamic aggregate demand curve 2. Solow growth curve 3. Short-run aggregate supply curve
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve To understand why aggregate demand (AD) shocks matter, we need to look at the behavior of prices and short-run aggregate supply (SRAS). An aggregate demand shock is a rapid and unexpected shift in the AD curve (spending).
SEE THE INVISIBLE HAND 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.
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve The Short-Run Aggregate Supply Curve If wages are not as flexible as prices Inflation will result in higher profits. Result: higher profits lead to increased output, or, real GDP growth. Two reasons why there can be a positive relationship between the inflation rate and the growth rate of real GDP in the short-run: 1.Sticky wages 2.Sticky prices
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve 1.Sticky Wages Expected inflation is built into labor contracts. What happens if inflation is higher or lower than expected? Inflation higher that expected Result: Inflation lower that expected Prices increase faster than wages Prices An increase upward slower than wages Profits increase sloping SRAS Profits decrease Firms increase Output and real GDP growth increases Firms decrease curve. Output and real GDP growth decreases
Try it! If prices are perfectly flexible, the economy will always be growing: a)at its potential rate. b)below its potential rate. c)above its potential rate. d)near its potential rate. To next Try it!
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve The short-run aggregate supply curve (SRAS) shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky.
Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Inflation Rate (p) Solow growth curve Short Run aggregate supply (SRAS)(E(p) = 2%) Conclusions: Sticky wages result in an upward sloping SRAS. 2.There is a different SRAS for every level of expected inflation, E(p). 2% AD 3% Real GDP growth rate
Try it! If the growth rate of money is 3%, and the growth rate of velocity is 1%, the growth rate of nominal GDP is: a)4%. b)1%. c)0%. d)2%. To next Try it!
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 If p = 2% and E(p) = 2%, economy stays at point a. If p = 4% and E(p) = 2%, economy moves to b. and real growth to 7% If p = 4% and E(p) = 4%, SRAS shifts up and economy stays at point c. a If p = 4% and E(p) = 6%, economy moves to d. and real growth to 7% 3% 7% Real GDP growth rate
Try 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. To next Try it!
Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Nominal Wage Confusion Menu Costs Uncertainty Nominal wage confusion: when workers respond to their nominal wage instead of to their real wage, 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).
Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Menu costs: the costs of changing prices. Printing costs and the desire not to upset consumers with rapid price changes keep firms from changing prices frequently.
Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Uncertainty causes firms to hold off changing prices. They can be unsure about whether: A shock is permanent or temporary. Increases in demand are nominal, caused by inflation, or real. Sticky prices cause upward sloping SRAS
In the Long Run, Real Growth Eventually Returns to the Solow Rate An Unexpected increase in Inflation Rate (p) Solow growth curve 7% c 4% (SRAS2) (E(p) = 7%) (SRAS1) (E(p) = 2%) b Short-run: a b Real growth to 6% p to 4% Long-run: b c Real growth to 3% p to 7% AD2 2% a AD1 3% 6% Real GDP growth rate
A Fall in Aggregate Demand Could Induce a Lengthy Recession Sometimes the adjustment (and pain) takes a while. Inflation Rate (p) Solow growth curve (SRAS1) (E(p) = 7%) 7% Short-run: a b Real growth to -1% p to 6% Long-run: b c Real growth to 3% as prices become unstuck a b 6% AD1 c AD2-1% 0% 3% Real GDP growth rate
Shocks to the Components of Aggregate Demand Other Factors that Shift the AD Curve 1. Fear and confidence also affect growth of investment spending,, as well as. Fear about the future will cause business people to put off large investments in capital. Confidence about the future will result in greater investment spending by businesses. 2. Wealth shocks can also increase or decrease AD. Negative wealth shock Positive wealth shock
Shocks to the Components of Aggregate Demand 3. Taxes also shift and. ( ) in taxes can ( ). Taxes targeted at investment (i.e. investment tax credit) will have a similar effect on. 4. Changes in government spending,, shift AD. ( ) shift the AD to the right (left). 5. Changes in the growth of net exports, NX. Other countries spending on our goods AD. We our spending on foreign goods AD.
Shocks to the Components of Aggregate Demand Changes in the rate of growth of velocity. It is easier to think of changes in working through. Example: A reduction in working through a reduction in. Workers may become fearful of losing their jobs and reduce consumption.
A Temporary Shock to the Aggregate Demand and the Adjustment A temporary reduction in Inflation Rate (p) working through a reduction in Solow growth curve (SRAS1) (E(p) = 7%) 7% Short-run: a b Real growth to -1% p to 6% Long-run: b a Real growth to 3% p to 7% a 6% b AD1 AD2-1% 0% 3% Real GDP growth rate
Shocks to the Components of Aggregate Demand What did we learn from this example? A negative spending shock reduces the real growth rate and inflation in the short-run only. Why?: Changes in spending growth are temporary. Shares of GDP devoted to C, I, G, and NX have been stable over time. This implies that their growth rates must also be stable. Changes in the growth rates of spending do not change the long-run rate of inflation.
Shocks to the Components of Aggregate Demand A final important point: We know now that changes in spending growth,, shift the AD curve. A fundamental difference between and is that can be set at any permanent rate Changes in are temporary. Conclusion: Sustained inflation requires continuing increases in the money supply.
Shocks to the Components of Aggregate Demand
Understanding the Great Depression The Great Depression (1929-1940) Most catastrophic economic event in the history of the United States. GDP plummeted by 30 percent. Unemployment rates exceeded 20 percent. Stock market fell by more than two thirds. It was a worldwide event. Germany: Led to a totalitarian regime. The Great Depression became Great because policy makers allowed aggregate demand to collapse.
Understanding the Great Depression Shocks to AD and the Great Depression October 1929: the stock market crashed. Caused in part by tight monetary policy aimed at limiting a stock market bubble. Created a wealth shock. Along with the tight monetary policy AD curve shifted to the left. 1930: Depositors lost confidence in their banks and they withdrew their deposits. 1929-1933: Four waves of bank panics. By 1933, 40% of all American banks failed.
Crowd at New York's American Union Bank during a bank run early in the Great Depression. The Bank opened in 1917 and went out of business on June 30, 1931.
Understanding the Great Depression Shocks to Aggregate Demand and the Great Depression Between 1929 and 1933 investment spending fell by nearly 75%. Spending on new capital was not enough to replace depreciated capital. By 1940 the U.S. capital stock was lower than it was in 1930. The Fed allowed the money supply to fall by 1/3. This is the largest negative shock in U.S. history.
Understanding the Great Depression Shocks to Aggregate Demand and the Great Depression What should the Fed have done? Increase the money supply To drive up AD and output. Increase reserves of banks to stop panics. 1937-1938: The Fed caused another monetary contraction. Contracted the economy and unemployment increased. Prolonged the Great Depression.
Understanding the Great Depression The Great Depression and the Great Fall in AD Solow growth curve Inflation Rate (p) SRAS 1. 2. 0% 3. -10% AD AD -13% 4% Real GDP growth rate
Understanding the Great Depression Real Shocks and the Great Depression Real shocks played a role in the failure of the economy to recover more quickly. We will look at three: 1. Bank failures reduced the efficiency of financial intermediation. The bridge between savers and investors collapsed. Small businesses were especially harmed because they couldn t get credit.
Understanding the Great Depression 2. Smoot-Hawley Tariff of 1930 Intent: increase demand for domestic goods. What really happened: Other countries retaliated with tariffs and exports fell. This reduced AD. A tariff is a negative productivity shock (shifts LRAS to the left). Pushes capital and labor into lower productivity sectors.
Understanding the Great Depression 3. The Dust Bowl: natural disasters are negative real shocks Severe drought turned millions of acres of farmland to dust. The Dust Bowl: a real shock
Try it! Discuss the 2008 Financial Crisis and identify what type of shock hit the economy: a real shock or a demand-side shock? If you like, look at www.bls.gov and www.bea.gov for a look at inflation and GDP for evidence.