Week 4 Milestone 2

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ModernPrinciplesofEconomics-Chapter32.pdf

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MODERN PRINCIPLES OF ECONOMICS Fifth Edition

Chapter (32) Business Fluctuations:

Aggregate Demand and Supply

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

• Takeaway

Introduction (1 of 4)

• 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 65 years.

• The economy rarely grew at an average rate.

• Growth fluctuated from −5% to more than 8%.

• Recessions are of special concern to policymakers and the public because unemployment typically increases during them.

Definition (1 of 7)

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.

Introduction (2 of 4)

Quarterly growth rate in real GDP, 1948–2019

Introduction (3 of 4)

U.S. civilian unemployment rate, 1948–2019

Introduction (4 of 4)

• To understand booms and recessions, we will develop a model of aggregate demand and aggregate supply (AD–AS), with three curves: – Aggregate demand curve – Long-run aggregate supply curve – Short-run aggregate supply curve

• The AD–AS model shows how unexpected economic disturbances or “shocks” can temporarily increase or decrease the rate of growth.

Definition (2 of 7)

Aggregate demand curve: Shows all the combinations of inflation and real growth that are consistent with a specified rate of spending growth:

+   M v

The Aggregate Demand Curve (1 of 4)

• We can derive the AD curve using the quantity theory of money in dynamic form:

( )

+ = +

   

  



where : Growth rate of the money supply

Growth in velocity Growth rate of prices inflation

Growth rate of real GDP

M v P Y

The Aggregate Demand Curve (2 of 4)

• We can also write the equation as:

growthRealInflationvM +=+

• Example: If money growth = 5%, velocity = 0%, and real growth is 0%, the inflation rate = 5%.

• In other words, if the money supply is growing, velocity is constant, and there are no additional goods, then prices must go up.

The Aggregate Demand Curve (3 of 4)

• Another example: If money growth = 5%, velocity = 0%, and real growth is 3%, the inflation rate = 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 ν

• In our example, any combination of inflation and real growth that adds up to 5% is on the same AD curve.

The Aggregate Demand Curve (4 of 4)

An AD curve with a slope of –1 means a 1 percentage point increase in real growth reduces inflation by 1%.

Self-Check (1 of 5)

vM + equals:

a. Real growth.

b. Inflation + Nominal growth.

c. Inflation + Real growth.

Self-Check (1 of 5) (Answer)

vM + equals:

a. Real growth.

b. Inflation + Nominal growth.

c. Inflation + Real growth.

Answer:

c. growthRealInflationvM +=+

Shifts in Aggregate Demand Curve (1 of 2)

• Increased spending must flow into either a higher inflation rate or a higher growth rate. – If spending growth increases, because of either 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.

Shifts in Aggregate Demand Curve (2 of 2)

Long-Run Aggregate Supply Curve (1 of 2)

• 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.

Long-Run Aggregate Supply Curve (2 of 2)

Potential growth does not depend on the rate of inflation.

Definition (3 of 7)

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.

Long-run aggregate supply curve (LRAS): Is vertical at the Solow growth rate.

Self-Check (2 of 5)

An economy’s potential growth rate is called the:

a. Solow growth rate.

b. aggregate supply.

c. aggregate demand.

Self-Check (2 of 5) (Answer)

An economy’s potential growth rate is called the:

a. Solow growth rate.

b. aggregate supply.

c. aggregate demand.

Answer:

a. An economy’s potential growth rate is called the Solow growth rate.

Shifts in the LRAS Curve (1 of 2)

• When we put the AD and LRAS curves together, we can see how business fluctuations are caused by real shocks.

• In this model, the equilibrium inflation rate and the growth rate are determined by the intersection of the AD and LRAS curves.

AD and LRAS Curves (1 of 2)

If ν+M is 10% and real growth is 3%, then the inflation rate will be 7%.

Shifts in the LRAS Curve (2 of 2)

• Economies are continually hit by real shocks, which shifts the Solow growth rate.

• Real shocks are rapid changes in economic conditions that increase or diminish the productivity of capital and labor.

• This, in turn, influences GDP and employment.

• Possible shocks include wars, weather, major new regulations, tax rate changes, mass strikes, terrorist attacks, and new technologies.

AD and LRAS Curves (2 of 2)

Real Shocks (1 of 2)

• Agriculture has been the largest contributor to India’s GDP.

• If farmers struggle, many other sectors suffer.

• Weather shocks influence both agricultural output and GDP.

• As the Indian economy has grown and diversified, shocks due to the weather become less economically important.

Real Shocks: Weather

Real Shocks: Oil (1 of 3)

• 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.

Real Shocks: Oil (2 of 3)

• 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 a little more than two years.

Real Shocks: Oil (3 of 3)

The price of oil and U.S. recessions

Real Shocks (2 of 2)

Negative Shocks = LRAS Curve Moves Left

Positive Shocks = LRAS Curve Moves Right

Bad weather (important in agricultural economy)

Good weather (important in agricultural economy)

Higher price of oil or another important input

Lower price of oil or another important input

Productivity slump/technology slump Productivity boom/technology boom

Higher taxes or regulation Lower taxes or regulation

Disruption of production by war, earthquake, or pandemic

Smooth production without disruption

Self-Check (3 of 5)

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.

Self-Check (3 of 5) (Answer)

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 business taxes will decrease the LRAS curve, shifting it to the left.

Aggregate Demand Shocks (1 of 2)

In his book The General Theory of Employment, Interest and Money, John Maynard Keynes explained that when prices are not perfectly flexible, deficiencies in aggregate demand can generate recessions.

John Maynard Keynes

Definition (4 of 7)

Short-run aggregate supply (SRAS) curve: Shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky.

Short-Run Aggregate Supply Curve

• The SRAS curve is upward sloping.

• In the short run, an increase in AD will increase both inflation and the growth rate.

• In the short run, a decrease in AD will decrease both the inflation rate and the growth rate.

• Each SRAS curve is associated with a particular rate of expected inflation E(π).

Short-Run Aggregate Supply

Definition (5 of 7)

Aggregate demand shock: A rapid and unexpected shift in the AD curve (spending).

Aggregate Demand Shocks (2 of 2)

• A positive shock to spending must increase either 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.

• In the long run, therefore, an increase in spending will increase only the inflation rate.

An Increase in Aggregate Demand (1 of 3)

If there is an unexpected ↑ in

 ,M

both inflation and the growth rate increase in the short run (a → b).

An Increase in Aggregate Demand (2 of 3)

• Workers initially mistake a nominal wage increase for a real wage increase.

• Prices also don’t move instantly because it is costly to change prices (“menu costs”).

• Firms may also hold off on making 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.

Definition (6 of 7)

Menu costs: The costs of changing prices.

Definition (7 of 7)

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).

An Increase in Aggregate Demand (3 of 3)

Eventually, inflation expectations adjust, wages become unstuck, and the growth rate returns to the Solow rate (b → c).

Self-Check (4 of 5)

The costs associated with changing the prices of goods and services are called:

a. inflation costs.

b. inflationary expectations.

c. menu costs.

Self-Check (4 of 5) (Answer)

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 are associated with changing the prices of goods and services.

A Decrease in Aggregate Demand (1 of 3)

• When aggregate demand (AD) falls due to a fall in the money supply: – The economy shifts to a new short-run equilibrium point. – The inflation rate is reduced. – Real growth is reduced (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.

A Decrease in Aggregate Demand (2 of 3)

A decrease in AD can induce a lengthy recession.

A Decrease in Aggregate Demand (3 of 3)

Shocks to Components of AD

Changes in  v :

• Are the same as changes in the spending rate, holding M constant

• Can be broken down into changes in the growth rate of C, I, G, or NX

• Changes in tend to be temporary.  v

• The shares of GDP devoted to C, I, G, and NX have been quite stable over time.

A Shock to the Growth Rate of Spending

Factors That Shift AD

Positive Shocks (Increase AD) (= Higher Growth Rate of Spending)

Negative Shocks (Decrease AD) (= Lower Growth Rate of Spending)

A faster money growth rate A slower money growth rate

Confidence Fear

Increased wealth Reduced wealth

Lower taxes Higher taxes

Greater growth of government spending Lower growth of government spending

Increased export growth Decreased export growth

Decreased import growth Increased import growth

Self-Check (5 of 5)

A slower growth in the money supply will:

a. decrease AD.

b. increase AD.

c. not affect AD.

Self-Check (5 of 5) (Answer)

A slower growth in the money supply will:

a. decrease AD.

b. increase AD.

c. not affect AD.

Answer:

a. A slower growth in the money supply will decrease AD.

The Great Depression (1 of 6)

• The Great Depression was due primarily to a large fall in AD.

• In 1929, the U.S. stock market crashed.

• People felt poorer and decreased spending, reducing AD.

• In 1930, depositors lost confidence in their banks.

• From 1930 to 1932, there were four waves of banking panics.

• By 1933, more than 40% of American banks had failed.

The Great Depression (2 of 6)

• The fear and uncertainty also reduced investment spending.

• The U.S. capital stock was lower in 1940 than it had been in 1930.

• In 1931, instead of increasing the money supply to boost the economy, the Federal Reserve allowed the money supply to contract even further.

The Great Depression (3 of 6)

• Additional monetary contraction occurred from 1937 to 1938, prolonging the Great Depression.

• During the early 1930s, the U.S. money supply fell by about one-third, the largest negative shock to aggregate demand in American history.

The Great Depression (4 of 6)

The Great Depression (5 of 6)

• Real shocks also played a role in the Great Depression.

• Bank failures not only reduced the money supply and spending (AD shock), but 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.

The Great Depression (6 of 6)

• 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.

Takeaway (1 of 2)

• 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- sloping short-run aggregate supply curve.

Takeaway (2 of 2)

• 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.

MODERN PRINCIPLES OF ECONOMICS
Outline
Introduction (1 of 4)
Definition (1 of 7)
Introduction (2 of 4)
Introduction (3 of 4)
Introduction (4 of 4)
Definition (2 of 7)
The Aggregate Demand Curve (1 of 4)
The Aggregate Demand Curve (2 of 4)
The Aggregate Demand Curve (3 of 4)
The Aggregate Demand Curve (4 of 4)
Self-Check (1 of 5)
Self-Check (1 of 5) (Answer)
Shifts in Aggregate Demand Curve (1 of 2)
Shifts in Aggregate Demand Curve (2 of 2)
Long-Run Aggregate Supply Curve (1 of 2)
Long-Run Aggregate Supply Curve (2 of 2)
Definition (3 of 7)
Self-Check (2 of 5)
Self-Check (2 of 5) (Answer)
Shifts in the LRAS Curve (1 of 2)
AD and LRAS Curves (1 of 2)
Shifts in the LRAS Curve (2 of 2)
AD and LRAS Curves (2 of 2)
Real Shocks (1 of 2)
Real Shocks: Weather
Real Shocks: Oil (1 of 3)
Real Shocks: Oil (2 of 3)
Real Shocks: Oil (3 of 3)
Real Shocks (2 of 2)
Self-Check (3 of 5)
Self-Check (3 of 5) (Answer)
Aggregate Demand Shocks (1 of 2)
Definition (4 of 7)
Short-Run Aggregate Supply Curve
Short-Run Aggregate Supply
Definition (5 of 7)
Aggregate Demand Shocks (2 of 2)
An Increase in Aggregate Demand (1 of 3)
An Increase in Aggregate Demand (2 of 3)
Definition (6 of 7)
Definition (7 of 7)
An Increase in Aggregate Demand (3 of 3)
Self-Check (4 of 5)
Self-Check (4 of 5) (Answer)
A Decrease in Aggregate Demand (1 of 3)
A Decrease in Aggregate Demand (2 of 3)
A Decrease in Aggregate Demand (3 of 3)
Shocks to Components of AD
A Shock to the Growth Rate of Spending
Factors That Shift AD
Self-Check (5 of 5)
Self-Check (5 of 5) (Answer)
The Great Depression (1 of 6)
The Great Depression (2 of 6)
The Great Depression (3 of 6)
The Great Depression (4 of 6)
The Great Depression (5 of 6)
The Great Depression (6 of 6)
Takeaway (1 of 2)
Takeaway (2 of 2)