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**Summary**• The long-run model determines potential output and the long-run rate of inflation. • The short-run model determines current output and current inflation. • In any given year, output consists of two components: • The long-run potential output • Short-run output**Short run output**• Is the percentage difference between actual and potential output. • Is positive when the economy is booming. • Is negative when the economy is slumping. • Recession: • Our Definition: • A period when actual output falls below potential • Short-run output becomes negative • (Ỹ < 0) • Usual Definition • (Roughly) 2 Quarters of negative GDP. • Declared by the NBER Business Cycle Dating Committee. • (ΔY < 0)**Short-run fluctuation**• The difference in actual and potential output, expressed as a percentage of potential output • Referred to as “detrended output” or short-run output:**Ỹ < 0**Ȳ Ỹ < 0 ΔY<0 ΔY>0 ΔY<0 but Ỹ > 0 Recession Ends ΔY>0 but Ỹ < 0**A recession:**• Begins when actual output falls below potential, and short-run output becomes negative. • Ends when short-run output starts to rise and become less negative. • During a recession: • Output is usually below potential for approximately two years, which results in a loss of about $2,400 per person. • Between 1.5 million and 3 million jobs are lost.**Measuring Potential Output**• There is no directly observable measure of potential output in an economy. • Ways to measure potential output: • Assume a perfectly smooth trend passes through quarterly movements of real GDP. • Take averages of the surrounding actual GDP numbers.**9.3 The Short-Run Model**• Short-run model features: • Open economy exists where global booms and recessions impact the local economy. • The economy will exhibit long-run growth and fluctuations. • Central Bank manages monetary policy to smooth fluctuations.**The short-run model is based on three premises:**1. The economy is constantly being hit by shocks: • Shocks: factors that cause fluctuations in output or inflation. 2. Monetary and fiscal policies affect output: • Policymakers may be able to neutralize shocks to the economy.**3. There is a dynamic trade-off between output and**inflation: • The Phillips curve is the dynamic trade-off between output and inflation.**The Empirical Fit of the Phillips Curve**• Empirically, the slope is approximately one-half. • Meaning: if output exceeds potential by 2 percent, the inflation rate increases one percentage point.**How the Short-Run Model Works**• Assume policymakers can select short-run output through monetary policy • Example: • 1979: inflation was increasing because of oil prices • Monetary Policy: raise interest rates • What happens? • Recession!**Important thing about the Philip Curve**• This is about accelerating and decelerating inflation. This is a change in the change of the price level • Is the Philips Curve fixed? • Supply Shocks. • Expectations.**Okun’s Law**Cyclical unemployment Current rate of unemployment Short-run output Natural rate of unemployment**11.1 Introduction**• In this chapter, we learn • The first building block of our short-run model: the IS curve • describes the effect of changes in the real interest rate on output in the short run. • How shocks to consumption, investment, government purchases, or net exports—“aggregate demand shocks”—can shift the IS curve.**A theory of consumption called the**life-cycle/permanent-income hypothesis. • That investment is the key channel through which changes in real interest rates affect GDP in the short run.**The Federal Reserve exerts a substantial influence on the**level of economic activity in the short run. • Sets the rate at which people borrow and lend in financial markets • The basic story is this:**The IS curve**• The IS curve captures the relationship between interest rates and output in the short run. • There is a negative relationship between the interest rate and short-run output. • An increase in the interest rate will decrease investment, which will decrease output.**11.2 Setting Up the Economy**• The national income accounting identity • Implies that the total resources available to the economy equal total uses • One equation with six unknowns Imports Production Investment Government purchases Exports Consumption**Consumption and Friends**• Level of potential output is given exogenously. • Consumption C, government purchases G, exports EX, and imports IM depend on the economy’s potential output. • Each of these components of GDP is a constant fraction of potential output. • the fraction is a parameter**Potential output is smoother than actual GDP.**• A shock to actual GDP will leave potential output unchanged • The equation depends on potential output. • Shocks to income are “smoothed” to keep consumption steady.**The Investment Equation**A term weighting the difference between the real interest rate and the MPK Marginal Product of Capital (MPK) The share of potential output that goes to investment Real interest rate**The MPK**• Is an exogenous parameter • Is time invariant • If the MPK is low relative to the real interest rate • Firms should save money and not invest in capital**If the MPK is high relative to the real interest rate**• Firms should borrow and invest in capital • In the short run, the MPK and the real interest rate can be different. • Installing capital to equate the two takes time.**11.3 Deriving the IS Curve**1. Divide the national income accounting identity by potential output. 2. Substitute the five equations into this equation.**3. Recall the definition of short-run output. Simplifies the**equation for the IS curve:**The gap between the real interest rate and the MPK is what**matters for output fluctuations. • Firms can always earn the MPK on new investments. • The parameter • Is • Is called the aggregate demand shock • Will equal zero when potential output is equal to actual output**Case Study: Why is it called the “IS Curve”?**• IS stands for “investment = savings” • See this again in Chapters 17 and 18.**11.4 Using the IS Curve**The Basic IS Curve • When the demand shock parameter equals zero, the IS curve has a short-run output of 0 where the real interest rate is equal to the long-run value of the MPK.