Chapter 12 Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model

1. Chapter 12 Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model

2. 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.

3. Introduction Economic Growth is Not a Smooth Process (cont.) We now turn to deviations from the average: booms and recessions.

4. A Skeleton Model • 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 next two slides show the Solow growth curve and how it shifts.

5. A Skeleton Model • The Solow Growth Curve (cont.) Solow growth curve Inflation Rate (p) • Why is the Solow Growth • Curve vertical? • Potential growth does not • depend on the inflation rate. 3% Real GDP growth rate

6. A Skeleton Model • The Solow Growth Curve (cont) Solow growth curve Inflation Rate (p) • What causes the Solow Growth • Curve to shift? • Positive productivity shocks • Factors that increase the • fundamental ability of the economy to produce goods and services. • Negative productivity shocks • Factors that decrease the • fundamental ability of the economy to produce goods and services. Negative shock Positive shock -1% 3% 7% Real GDP growth rate

7. A Skeleton Model • To understand booms and recessions, we develop two models: • The Real Business Cycle (RBC) model • The New Keynesian model • Both models will be placed within the dynamic aggregate-demand-aggregate supplyframework. • Ultimately the AD-AS framework will have three curves: • Solow growth curve • Dynamic aggregate demand curve • Short-run aggregate supply curve

8. A Skeleton Model • The Dynamic Aggregate Demand Curve • Definition: A curve showing 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.

9. A Skeleton Model • The Dynamic Aggregate Demand Curve (cont.) • 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. • This is shown in the following table.

10. A Skeleton Model • The Dynamic Aggregate Demand Curve (cont.) • Plotting inflation against real growth gives a dynamic AD curve for each level of spending growth.

11. A Skeleton Model • The Dynamic Aggregate Demand Curve (cont.) • AD curve when spending growth = 5% Inflation Rate (p) Note: The sum of inflation and real growth will always equal spending growth, which equals money growth plus the growth of velocity. i.e., 7% 5% 2% 5% + 0% = 5% 2% + 3% = 5% AD (spending growth = 5%) 0% -2% 0% 3% 5% 7% Real GDP growth rate

12. A Skeleton Model • The Dynamic Aggregate Demand Curve (cont.) • AD curve when spending growth = 7% Inflation Rate (p) • Conclusion: • Increases in spending growth, • , • shifts the AD curve to the right. • Decreases in spending growth, • , • shifts the AD curve to the left. 7% 5% AD (spending growth = 7%) 2% AD (spending growth = 5%) 0% -2% 0% 3% 5% 7% Real GDP growth rate

13. If inflation is 2 percent and the Solow growth rate is 5 percent what, if anything, happens to the Solow growth rate when inflation increases to 5 percent? • If we have a dynamic aggregate demand curve with = 7 percent and = 0 percent, what will inflation plus real growth equal? If we find out that real growth is 0 percent, what is inflation? • Increased spending growth shifts the dynamic aggregate demand curve which way: inward or outward?

14. The RBC Model: The Solow Growth Curve • Putting the AD and the Solow growth curve together. Solow growth curve Inflation Rate (p) Equilibrium 7% AD Real GDP growth rate 3%

15. The RBC Model: The Solow Growth Curve • Putting the AD and the Solow growth curve together (cont.) Solow growth curve • Conclusions: • A positive shock results in a higher real growth rate, 7%, and lower inflation, 3%. • A negative shock results in a lower real growth rate, -1%, and higher inflation, 11%. Inflation Rate (p) Negative shock Positive shock 11% 7% 3% AD -1% 3% 7% Real GDP growth rate

16. The RBC Model: The Solow Growth Curve • Shocks to Aggregate Demand in the RBC Model Solow growth curve • Conclusions: • A positive demand shock, • , • results in higher inflation. • A Negative demand shock, • , • results in lower inflation. Inflation Rate (p) 7% b 2% a AD2 AD1 3% Real GDP growth rate

17. The RBC Model: The Solow Growth Curve • Final thoughts on the RBC Model • Shifts in AD do not influence real growth. • This is what is meant when we say that money is neutral. • Results from a key assumption of the RBC model: prices are perfectly flexible. • Most economists believe that changes in the growth rate of money will change real growth in the short run. • What if prices are not perfectly flexible? • This requires a new model, the New Keynesian model.

18. In what direction would a technological innovation such as the internet or cheap fusion power shift the Solow growth curve? • In the real business cycle model, what effect does a large fall in aggregate demand have on real growth?

19. The New Keynesian Model • 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. • New Keynesian model is based on Keynes’s original work. • Key to the model: when prices are sticky, the economy can grow faster or slower than the Solow growth rate.

20. The New Keynesian Model • 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: • Sticky wages • Sticky prices • Let’s look at both of these in turn.

21. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) • Sticky Wages • Expected inflation is built into labor contracts. • What happens if inflation is higher or lower than expected? • Result: An upward sloping SRAS curve. Prices increase faster than wages Firms increase Output and real GDP growth increases Inflation higher that expected Profits increase Prices increase slower than wages Firms decrease Output and real GDP growth increases Inflation lower that expected Profits decrease

22. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) Solow growth curve • Conclusions: • Sticky wages result in an upward sloping SRAS. • There is a different SRAS • for every level of expected inflation, pe. Inflation Rate (p) Short-Run aggregate supply (SRAS)(pe = 2%) 2% AD Real GDP growth rate 3%

23. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) • Shifting the SRAS Curve • An increase in the expected inflation rate will shift the SRAS up and to the left. • A decrease in the expected inflation rate will shift the SRAS down and to the right. • It is easier to see this if we use the model.

24. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) Inflation Rate (p) Solow growth curve (SRAS2) (pe = 4%) • If p = 2% and pe = 2%, • economy stays at pt. a. • If p = 4% and pe = 2%, • economy moves to b. • and real growth ↑ to 7% • If p = 4% and pe = 4%, • SRAS shifts up. • economy stays at pt. c • If p = 6% and pe = 4%, • economy moves to d. • and real growth ↑ to 7% d (SRAS1) (pe = 2%) 6% 4% b c 2% a Real GDP growth rate 3% 7%

25. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) • The SRAS is flatter to the left of the Solow growth curve. • Because prices and wages are especially sticky in the downward direction. • This is due to the endowment effect. • People attach special importance to their starting point. • Have a strong dislike for losing that position.

26. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) • The SRAS is steeper to the rightof the Solow growth curve. • Reasons: • Wages are less sticky in the upward direction. • The SRAS must turn vertical at some point because there is a limit to how fast the economy can grow.

27. The New Keynesian Model • The Short-Run Aggregate Supply Curve (cont.) • What causes sticky prices? • Menu costs: the costs of changing prices. • Printing costs • Loss of consumer trust • If prices are always changing, how do buyers know when they are getting a good deal? • Waste due to uncertainty about whether: • a shock is permanent or temporary. • increases in demand are nominal, caused by inflation, or real. • Again, sticky prices → upward sloping SRAS

28. Contrast wage and price flexibility in the real business cycle and new Keynesian models. Which model assumes significant price and wage stickiness? • The Solow growth curve is vertical, the short-run aggregate supply curve is not. What explains the difference? • What happens to the short-run aggregate supply curve when people expect inflation to increase from 2 percent to 3 percent?

29. Shocks to AD in the New Keynesian Model • In the Real Business Cycle model, changes in AD have no effect on real growth. • Because prices are assumed to be perfectly flexible. • We will now use the New Keynesian model with sticky prices to examine how shocks to aggregate demand can change real growth.

30. Shocks to AD in the New Keynesian Model • An Unexpected Increase In Inflation Rate (p) Solow growth curve (SRAS2) (pe = 7%) • Short-run: a → b • Real growth ↑ to 6% • p↑ to 4% • Long-run: b → c • Real growth ↓ to 3% • p↑ to 7% (SRAS1) (pe = 2%) 7% c 4% b 2% a AD1 AD2 Real GDP growth rate 3% 6%

31. Shocks to AD in the New Keynesian Model • 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. • We will use the New Keynesian model to work through this.

32. Shocks to AD in the New Keynesian Model • A reduction in working through a reduction in Inflation Rate (p) Solow growth curve • Short-run: a → b • Real growth ↓ to -1% • p↓ to 6% • Long-run: b → a • Real growth ↑ to 3% • p↑ to 7% (SRAS1) (pe = 7%) 7% a 6% b AD1 AD2 Real GDP growth rate -1% 0% 3%

33. Shocks to AD in the New Keynesian Model • A reduction in working through a ↓(cont.) • 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.

34. Shocks to AD in the New Keynesian Model • A reduction in working through a ↓(cont.) • 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.

35. Shocks to AD in the New Keynesian Model • Other Factors that Shift the AD Curve • 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. • Wealth shocks can also increase or decrease AD. • Negative wealth shock→ , • Positive wealth shock → ,

36. Shocks to AD in the New Keynesian Model • Other Factors that Shift the AD Curve (cont.) • Tax changes shift and • ↑ (↓) in taxes can ↓ (↑) . • Taxes targeted at investment • ↑ Capital gains) → ↓ • Investment tax credit → ↑ • Changes in government spending, • ↑ (↓) → shift the AD to the right (left). • Changes in the growth of net exports, • ↑↓Growth of exports → ↑↓AD • ↑↓Growth of imports → ↓↑AD • The next table gives a useful summary…

37. Shocks to AD in the New Keynesian Model • Other Factors that Shift the AD Curve (cont.)

38. What always happens to unexpected inflation in the long run? • Show what happens to the dynamic aggregate demand curve if consumers fear a recession is coming and cut back on their expenditures

39. Understanding the Great Depression • 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 (National Socialism, or, Nazis). • The Great Depression became “Great” because policy makers allowed aggregate demand to collapse.

40. 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. • This along with the tight monetary policy → shifted AD curve 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.

41. Understanding the Great Depression • Shocks to AD and the Great Depression (cont.) • Between 1929 and 1933 investment spending fell by nearly 75 percent. • 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.

42. Understanding the Great Depression • Shocks to AD and the Great Depression (cont.) • 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”. • Let’s use the model again…

43. Understanding the Great Depression • The Great Depression and the Great Fall in AD Solow growth curve Inflation Rate (p) SRAS Narrative: 1. 2. 3. 0% AD -10% AD Real GDP growth rate -13% 4%

44. 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: • 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.

45. Understanding the Great Depression • Real Shocks and the Great Depression (cont.) • Smoot-Hawley Tarrif of 1930 • Intent was to boost demand for domestic goods. • What really happened: • Other countries retaliated with tarrifs 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.

46. Understanding the Great Depression • Real Shocks and the Great Depression (cont.) • The Dust Bowl: natural disasters are negative real shocks • Severe drought turned millions of acres of farmland to dust. The Dust Bowl was a real shock

47. What happened to the U.S. money supply in the early 1930s? Did this primarily or initially affect aggregate demand or the Solow growth curve, and in which direction? • If, as was said earlier in this chapter, real shocks hit the economy all of the time, should we ignore them in explaining the Great Depression?

48. Takeaway • We have used the framework of dynamic aggregate demand and short-run aggregate supply to analyze business fluctuations. • Business fluctuations refers to the fact that the growth rate of real GDP is volatile in the short run. • The aggregate demand curve slopes downward and the short-run aggregate supply curve slopes upward.

49. Takeaway • Changes in AD can be broken up into changes in and changes in . • Changes in can be broken down into changes in . • You should know what makes wages and prices sticky • menu costs • uncertainty • confusion between nominal and real values

50. Takeaway • You should know and understand how… • menu costs • uncertainty • confusion between nominal and real values Make wages and prices sticky. • We applied the models to the Great Depression. • The Great Depression resulted from concentrated and interrelated series of aggregate demand and real shocks.