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## Macroeconomics of Business Cycles

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Growth rates of real GDP, consumption

Real GDP growth rate

Consumption growth rate

Average growth rate

Percent change from 4 quarters earlier

Growth rates of real GDP, consumption, investment

Real GDP growth rate

Investment growth rate

Consumption growth rate

Percent change from 4 quarters earlier

Unemployment

Percent of labor force

Okun’s Law

Percentage change in real GDP

1966

1951

1984

2003

1971

1987

2008

1975

2001

1991

1982

Change in unemployment rate

Facts about the business cycle

GDP growth averages about 3 percent per year over the long run with large fluctuations in the short run.

Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.

Unemployment rises during recessions and falls during expansions.

Okun’s Law: the negative relationship between GDP and unemployment.

Index of Leading Economic Indicators

Published monthly by the Conference Board.

Aims to forecast changes in economic activity 6-9 months into the future.

Used in planning by businesses and govt, despite not being a perfect predictor.

Components of the LEI index

Average workweek in manufacturing

Initial weekly claims for unemployment insurance

New orders for consumer goods and materials

New orders, nondefense capital goods

Vendor performance

New building permits issued

Index of stock prices

M2

Yield spread (10-year minus 3-month) on Treasuries

Index of consumer expectations

Time horizons in macroeconomics

Long runPrices are flexible, respond to changes in supply or demand.

Short runMany prices are “sticky” at a predetermined level.

The economy behaves much differently when prices are sticky.

AD/AS Model

The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy

Shows how the price level and aggregate output are determined

Shows how the economy’s behavior is different in the short run and long run

Aggregate demand

- We use a simple theory of AD based on the quantity theory of money.
- Recall the quantity equation

M V = P Y

- For given values of M and V, this equation implies an inverse relationship between P and Y:

Y = (M V) / P

The downward-sloping AD curve

An increase in the price level causes a fall in real money balances (M/P),

causing a decrease in the demand for goods & services.

P

AD

Y

Aggregate supply in the long run

Recall from Chapter 3: In the long run, output is determined by factor supplies and technology

is the full-employment or natural level of output, at which the economy’s resources are fully employed.

“Full employment” means that unemployment equals its natural rate (not zero).

Long-run effects of an increase in M

An increase in M shifts AD to the right.

LRAS

P

P2

In the long run, this raises the price level…

AD2

AD1

Y

…but leaves output the same.

P1

The short-run aggregate supply curve

The SRAS curve is horizontal:

The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

P

SRAS

Y

Short-run effects of an increase in M

…an increase in aggregate demand…

In the short run when prices are sticky,…

P

SRAS

AD2

AD1

Y

…causes output to rise.

Y2

Y1

From the short run to the long run

Over time, prices gradually become “unstuck.” When they do, will they rise or fall?

In the short-run equilibrium, if

then over time, P will…

rise

fall

remain constant

The adjustment of prices is what moves the economy to its long-run equilibrium.

The SR & LR effects of M>0

A = initial equilibrium

LRAS

P

P2

SRAS

AD2

AD1

Y

Y2

B = new short-run eq’m after Fed increases M

C

B

A

C = long-run equilibrium

The effects of a negative demand shock

AD shifts left, depressing output and employment in the short run.

LRAS

P

P2

SRAS

AD2

AD1

Y

Y2

A

B

Over time, prices fall and the economy moves down its demand curve toward full-employment.

C

Supply shocks

A supply shock alters production costs, affects the prices that firms charge (also called price shocks)

Examples of adverse supply shocks:

Bad weather reduces crop yields, pushing up food prices

Workers unionize, negotiate wage increases

New environmental regulations require firms to reduce emissions

Favorable supply shocks lower costs and prices

CASE STUDY: The 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in the supply of oil

Oil prices rose 11% in 1973 68% in 1974 16% in 1975

CASE STUDY: The 1970s oil shocks

The oil price shock shifts SRAS up, causing output and employment to fall.

LRAS

P

SRAS2

SRAS1

AD

Y

Y2

B

In absence of further price shocks, prices will fall over time and economy moves back toward full employment.

A

A

CASE STUDY: The 1970s oil shocks

Predicted effects of the oil shock:

inflation

output

unemployment

…and then a gradual recovery.

CASE STUDY: The 1970s oil shocks

Late 1970s:

As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

CASE STUDY: The 1980s oil shocks

1980s:

A favorable supply shock--a significant fall in oil prices.

As the model predicts, inflation and unemployment fell:

Stabilization policy

def: policy actions aimed at reducing the severity of short-run economic fluctuations.

Example: Using monetary policy to combat the effects of adverse supply shocks…

Stabilizing output with monetary policy

LRAS

P

SRAS2

SRAS1

AD1

Y

Y2

The adverse supply shock moves the economy to point B.

B

A

Stabilizing output with monetary policy

LRAS

P

SRAS2

AD2

AD1

Y

Y2

But the Fed accommodates the shock by raising agg. demand.

B

C

A

results: P is permanently higher, but Y remains at its full-employment level.

Aggregate Demand I:The IS-LM Model

The IS-LM model determines income and the interest rate in the short run when P is fixed

The Big Picture

KeynesianCross

IScurve

IS-LMmodel

Explanation of short-run fluctuations

Theory of Liquidity Preference

LM curve

Agg. demandcurve

Model of Agg. Demand and Agg. Supply

Agg. supplycurve

The Keynesian Cross

A simple closed economy model in which income is determined by expenditure.

Notation:

I = planned investment

PE = C + I + G = planned expenditure

Y = real GDP = actual expenditure

Difference between actual & planned expenditure = unplanned inventory investment

Elements of the Keynesian Cross

consumption function:

govt policy variables:

for now, plannedinvestment is exogenous:

planned expenditure:

equilibrium condition:

actual expenditure = planned expenditure

The equilibrium value of income

Equilibrium income

PE

planned

expenditure

PE =Y

PE =C +I +G

income, output,Y

An increase in government purchases

PE

At Y1, there is now an unplanned drop in inventory…

PE =C +I +G2

PE =C +I +G1

G

Y

PE1 = Y1

PE2 = Y2

Y

PE =Y

…so firms increase output, and income rises toward a new equilibrium.

Solving for Y

Solve for Y :

equilibrium condition

in changes

because I exogenous

because C= MPCY

Collect terms with Yon the left side of the equals sign:

The government purchases multiplier

Definition: the increase in income resulting from a $1 increase in G.

In this model, the govt purchases multiplier equals

Example: If MPC = 0.8, then

An increase in G causes income to increase 5 times as much!

Why the multiplier is greater than 1

Initially, the increase in G causes an equal increase in Y:Y = G.

But Y C

furtherY

furtherC

furtherY

So the final impact on income is much bigger than the initial G.

An increase in taxes

PE

PE =Y

PE =C1+I +G

PE =C2+I +G

At Y1, there is now an unplanned inventory buildup…

C = MPC T

Y

PE2 = Y2

PE1 = Y1

Y

Initially, the tax increase reduces consumption, and therefore PE:

…so firms reduce output, and income falls toward a new equilibrium

The tax multiplier

def: the change in income resulting from a $1 increase in T :

If MPC = 0.8, then the tax multiplier equals

The IS curve

def: a graph of all combinations of r and Y that result in goods market equilibrium

i.e. actual output = planned expenditure

The equation for the IS curve is:

J.R. Hicks

Shifting the IScurve: G

At any value of r,

G PE Y

PE

Y

r

Y

Y

PE =Y

PE =C +I(r1)+G2

PE =C +I(r1)+G1

…so the IS curve shifts to the right.

Y1

Y2

The horizontal distance of the IS shift equals

r1

IS2

IS1

Y1

Y2

The Theory of Liquidity Preference

Due to John Maynard Keynes

A simple theory in which the interest rate is determined by money supply and money demand

Equilibrium

The interest rate adjusts to equate the supply and demand for money:

r

interest

rate

r1

L(r)

M/P

real money balances

How the Fed raises the interest rate

To increase r, Fed reduces M

r

interest

rate

r2

r1

L(r)

M/P

real money balances

The LM curve

Now let’s put Y back into the money demand function:

The LMcurve is a graph of all combinations of r and Y that equate the supply and demand for real money balances.

The equation for the LMcurve is:

Deriving the LM curve

r

r

LM

L(r,Y2)

L(r,Y1)

Y

M/P

Y1

Y2

(a) The market for real money balances

(b) The LM curve

r2

r2

r1

r1

How M shifts the LM curve

r

r

LM2

LM1

L(r,Y1)

Y

M/P

Y1

(a) The market for real money balances

(b) The LM curve

r2

r2

r1

r1

The short-run equilibrium

The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets:

LM

r

IS

Y

Equilibrium

interest

rate

Equilibrium

level of

income

Policy analysis with the IS-LM model

We can use the IS-LM model to analyze the effects of

fiscal policy: G and/or T

monetary policy: M

LM

r

r1

IS

Y1

Y

An increase in government purchases

1. IS curve shifts right

LM

r

r2

r1

IS2

IS1

Y1

Y2

Y

2.

3.

1.

causing output & income to rise.

2. This raises money demand, causing the interest rate to rise…

3. …which reduces investment, so the final increase in Y

A tax cut

LM

r

r2

1.

2.

r1

1.

IS2

IS1

Y1

Y2

Y

2.

2.

Consumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G…

and the IS curve shifts by

…so the effects on rand Y are smaller for T than for an equal G.

Monetary policy: An increase in M

1. M > 0 shifts the LM curve down(or to the right)

LM1

r

LM2

r1

r2

IS

Y2

Y1

Y

2. …causing the interest rate to fall

3. …which increases investment, causing output & income to rise.

The Fed’s response to G > 0

Suppose Congress increases G.

Possible Fed responses:

1.hold M constant

2.hold r constant

3.hold Y constant

In each case, the effects of the Gare different…

Response 1: Hold M constant

LM1

r

r2

r1

IS2

IS1

Y1

Y2

Y

If Congress raises G, the IS curve shifts right.

If Fed holds M constant, then LM curve doesn’t shift.

Results:

Response 2: Hold r constant

LM1

r

LM2

IS2

IS1

Y3

Y1

Y2

Y

If Congress raises G, the IScurve shifts right.

To keep r constant, Fed increases Mto shift LM curve right.

r2

r1

Results:

Response 3: Hold Y constant

LM2

LM1

r

r3

r1

IS2

IS1

Y1

Y2

Y

If Congress raises G, the IScurve shifts right.

To keep Y constant, Fed reduces Mto shift LM curve left.

r2

Results:

Estimates of fiscal policy multipliers

from the DRI macroeconometric model

Estimated value of Y/G

Estimated value of Y/T

Assumption about monetary policy

Fed holds money supply constant

0.60

0.26

Fed holds nominal interest rate constant

1.93

1.19

1.55

0.90

Romer & Bernstein (2009)

0.90

1.10

Barro & Redlick (2010)

Shocks in the IS-LM model

IS shocks: exogenous changes in the demand for goods & services.

Examples:

stock market boom or crash change in households’ wealth C

change in business or consumer confidence or expectations I and/or C

Shocks in the IS-LM model

LM shocks: exogenous changes in the demand for money.

Examples:

a wave of credit card fraud increases demand for money.

more ATMs or the Internet reduce money demand.

CASE STUDY: The U.S. recession of 2001

During 2001,

2.1 million jobs lost, unemployment rose from 3.9% to 5.8%.

GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

CASE STUDY: The U.S. recession of 2001

Causes: 1) Stock market decline C

1500

S&P 500

1200

Index (1942 = 100)

900

600

300

1995

1996

1997

1998

1999

2000

2001

2002

2003

CASE STUDY: The U.S. recession of 2001

Causes: 2) 9/11

increased uncertainty

fall in consumer & business confidence

result: lower spending, IS curve shifted left

Causes: 3) Corporate accounting scandals

Enron, WorldCom, etc.

reduced stock prices, discouraged investment

CASE STUDY: The U.S. recession of 2001

Fiscal policy response: shifted IS curve right

tax cuts in 2001 and 2003

spending increases

airline industry bailout

NYC reconstruction

Afghanistan war

CASE STUDY: The U.S. recession of 2001

Monetary policy response: shifted LM curve right

7

Three-month T-Bill Rate

6

5

4

3

2

1

0

01/01/2000

04/02/2000

01/09/2003

04/11/2003

01/03/2001

04/05/2001

07/06/2001

10/06/2001

01/06/2002

04/08/2002

07/09/2002

10/03/2000

10/09/2002

07/03/2000

Deriving the AD curve

r

P

LM(P2)

LM(P1)

r2

r1

IS

Y

Y

P2

P1

Intuition for slope of AD curve:

P (M/P)

LM shifts left

r

I

Y

Y1

Y2

AD

Y2

Y1

Monetary policy and the AD curve

P

r

LM(M1/P1)

LM(M2/P1)

r1

r2

IS

Y

Y

Y2

Y1

P1

AD2

AD1

Y1

Y2

The Fed can increase aggregate demand:

M LM shifts right

r

I

Y at each value of P

Fiscal policy and the AD curve

r

P

LM

r2

r1

IS2

IS1

Y

Y

Y2

Y1

P1

AD2

AD1

Y1

Y2

Expansionary fiscal policy (G and/or T) increases agg. demand:

T C

IS shifts right

Y at each value of P

IS-LM and AD-AS in the short run & long run

Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices.

In the short-run equilibrium, if

then over time, the price level will

rise

fall

remain constant

The SR and LR effects of an IS shock

A negative IS shock shifts IS and AD left, causing Y to fall.

LRAS

r

P

LM(P1)

IS1

IS2

Y

Y

LRAS

SRAS1

P1

AD1

AD2

The SR and LR effects of an IS shock

LRAS

r

P

LM(P1)

IS2

Y

Y

SRAS1

P1

AD2

In the new short-run equilibrium,

IS1

LRAS

AD1

The SR and LR effects of an IS shock

LRAS

r

P

LM(P1)

IS2

Y

Y

SRAS1

P1

AD2

In the new short-run equilibrium,

IS1

Over time, P gradually falls, causing

- SRAS to move down
- M/P to increase, which causes LMto move down

LRAS

AD1

The SR and LR effects of an IS shock

LRAS

r

P

LM(P2)

IS2

Y

Y

SRAS2

P2

AD2

LM(P1)

IS1

Over time, P gradually falls, causing

- SRAS to move down
- M/P to increase, which causes LMto move down

LRAS

SRAS1

P1

AD1

The SR and LR effects of an IS shock

LRAS

P

r

LM(P2)

IS2

Y

Y

SRAS2

P2

AD2

LM(P1)

This process continues until economy reaches a long-run equilibrium with

IS1

LRAS

SRAS1

P1

AD1

NOW YOU TRY: Analyze SR & LR effects of M

LRAS

r

P

IS

Y

Y

LRAS

SRAS1

P1

AD1

Draw the IS-LM and AD-AS diagrams as shown here.

Suppose Fed increases M. Show the short-run effects on your graphs.

Show what happens in the transition from the short run to the long run.

How do the new long-run equilibrium values of the endogenous variables compare to their initial values?

LM(M1/P1)

The Great Depression

Unemployment (right scale)

Real GNP(left scale)

240

30

220

25

200

20

billions of 1958 dollars

180

15

percent of labor force

160

10

140

5

120

0

1929

1931

1933

1935

1937

1939

THE SPENDING HYPOTHESIS: Shocks to the IS curve

asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IScurve.

evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

THE SPENDING HYPOTHESIS: Reasons for the IS shift

Stock market crash exogenous C

Oct-Dec 1929: S&P 500 fell 17%

Oct 1929-Dec 1933: S&P 500 fell 71%

Drop in investment

“correction” after overbuilding in the 1920s

widespread bank failures made it harder to obtain financing for investment

Contractionary fiscal policy

Politicians raised tax rates and cut spending to combat increasing deficits.

THE MONEY HYPOTHESIS: A shock to the LM curve

asserts that the Depression was largely due to huge fall in the money supply.

evidence: M1 fell 25% during 1929-33.

But, two problems with this hypothesis:

P fell even more, so M/Pactually rose slightly during 1929-31.

nominal interest rates fell, which is the opposite of what a leftward LMshift would cause.

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

asserts that the severity of the Depression was due to a huge deflation:P fell 25% during 1929-33.

This deflation was probably caused by the fall in M, so perhaps money played an important role after all.

In what ways does a deflation affect the economy?

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

The stabilizing effects of deflation:

P (M/P) LMshifts right Y

Pigou effect:

P (M/P)

consumers’ wealth

C

IS shifts right

Y

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

The destabilizing effects of expected deflation:

E

r for each value of i

I because I= I(r)

planned expenditure & agg. demand

income & output

THE MONEY HYPOTHESIS AGAIN: The effects of falling prices

The destabilizing effects of unexpected deflation: debt-deflation theory

P (if unexpected)

transfers purchasing power from borrowers to lenders

borrowers spend less, lenders spend more

if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

Why another Depression is unlikely

Policymakers (or their advisors) now know much more about macroeconomics

Federal deposit insurance makes widespread bank failures very unlikely.

Automatic stabilizers make fiscal policy expansionary during an economic downturn.

The Great Recession2008-2009

- NBER: December 2007 to June 2009
- Real GDP fell by 4%, u-rate hit 10.6%
- Important factors in the crisis:

Change in U.S. house price index and rate of new foreclosures, 1999-2009

House price change and new foreclosures, 2006:Q3 – 2009Q1

Nevada

Illinois

Florida

Ohio

Michigan

California

Georgia

New foreclosures, % of all mortgages

Colorado

Arizona

Rhode Island

Texas

New Jersey

S. Dakota

Hawaii

Oregon

Wyoming

Alaska

N. Dakota

Cumulative change in house price index

Consumer sentiment and growth in consumer durables and investment spending

NBER: December 2007 to June 2009

Real GDP fell by 4%, u-rate hit 10.6%

Important factors in the crisis:

early 2000s Federal Reserve interest rate policy

sub-prime mortgage crisis

bursting of house price bubble, rising foreclosure rates

falling stock prices

failing financial institutions

declining consumer confidence, drop in spending on consumer durables and investment goods

The Great Recession2008-2009

Policy Responses to Great Recession

- Fiscal Policy
- Economic Stimulus Act of 2008
- TARP (2008)
- American Recovery and Reinvestment Act of 2009
- Cash for Clunkers (2009)
- Additional UI
- Monetary Policy
- Quantitative Easing I, II
- New Credit Facilities
- Financial Regulation
- Stress tests
- Dodd-Frank (2010)
- International Trade Policy

Over the business cycle, investment spending ______ consumption spending.

- is inversely correlated with
- is more volatile than
- has about the same volatility as
- is less volatile than

Most economists believe that prices are:

- flexible in the short run but many are sticky in the long run.
- flexible in the long run but many are sticky in the short run.
- sticky in both the short and long runs.
- flexible in both the short and long runs.

The vertical long-run aggregate supply curve satisfies the classical dichotomy because the natural rate of output does NOT depend on:

- the labor supply.
- the supply of capital.
- the money supply.
- technology.

If the short-run aggregate supply curve is horizontal, then a change in the money supply will change ______ in the short run and change ______ in the long run.

- only output; only prices
- only prices; only output
- both prices and output; only prices
- both prices and output; both prices and output

Assume that the economy is initially at point A with aggregate demand given by AD2. A shift in the aggregate demand curve to AD0 could be the result of either a(n) ______ in the money supply or a(n) ______ in velocity.

- increase; increase
- increase; decrease
- decrease; increase
- decrease; decrease

In the IS-LM model, which two variables are influenced by the interest rate?

- supply of nominal money balances and demand for real balances
- demand for real balances and government purchases
- supply of nominal money balances and investment spending
- demand for real money balances and investment spending

The equilibrium condition in the Keynesian-cross analysis in a closed economy is:

- income equals consumption plus investment plus government spending.
- planned expenditure equals consumption plus planned investment plus government spending.
- actual expenditure equals planned expenditure.
- actual saving equals actual investment.

In the Keynesian-cross model with a given MPC, the government-expenditure multiplier ______ the tax multiplier.

- is larger than
- equals
- is smaller than
- is the inverse of the

An increase in taxes shifts the IS curve, drawn with income along the horizontal axis and the interest rate along the vertical axis:

- downward and to the left.
- upward and to the right.
- upward and to the left.
- downward and to the right.

A decrease in the price level, holding nominal money supply constant, will shift the LM curve:

- upward and to the right.
- downward and to the right.
- downward and to the left.
- upward and to the left.

In the Keynesian-cross analysis, if the consumption function is given by C = 100 + 0.6(Y – T), and planned investment is 100, G is 100, and T is 100, then equilibrium Y is:

- 350
- 400
- 600
- 750

Based on the graph, starting from equilibrium at interest rate r1 and income Y1, a tax cut would generate the new equilibrium combination of interest rate and income:

- r2, Y2
- r3, Y2
- r2, Y3
- r3, Y3

Based on the graph, starting from equilibrium at interest rate r3, income Y2, IS1, and LM1, if there is an increase in government spending that shifts the IS curve to IS2, then in order to keep the interest rate constant the Federal Reserve should _____ the money supply shifting to _____.

- increase; LM2
- decrease; LM2
- increase; LM3
- decrease; LM3

Based on the graph, if the economy starts from a short-term equilibrium at A, then the long-run equilibrium will be at ____ with a _____ price level.

- B; higher
- B; lower
- C; higher
- C; lower

A tax cut combined with tight money, as was the case in the United States in the early 1980s, should lead to a:

- rise in the real interest rate and a fall in investment.
- fall in the real interest rate and a rise in investment.
- rise in both the real interest rate and investment.
- fall in both the real interest rate and investment.

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