© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 22 Understanding Business Cycle Fluctuations

22-2 Understanding Business Cycle Fluctuations: The Big Questions 1.Why do aggregate demand curve and aggregate supply curves shift? 2.How do central bankers achieve their stabilization objectives?

22-3 Inflation and Business Cycles

22-4 Understanding Business Cycle Fluctuations: Roadmap Sources of Fluctuations Using the Aggregate Demand- Aggregate Supply Framework

22-5 Sources of Fluctuations: Preliminaries Long-run equilibrium 1.Y = Y P output = potential 2.  =  T inflation = target 3.  =  e inflation = expected Shocks –Supply shock: affects cots –Demand shock: affects expenditure

22-6 Sources of Fluctuations Shifts in Aggregate Demand –Change in the inflation target (  T ) –Change in Government Purchases Shifts in Short-Run Aggregate Supply –Changes in costs of production

22-7 Decline in Inflation Target: Monetary Policy Reaction Curve When  T , MPRC shifts to the left.

22-8 Decline in Inflation Target: Short-Run Equilibrium  T  AD shifts left Economy 1  2

22-9 Decline in Inflation Target: Adjustment At point 2, Y<Y P SRAS shifts right Until economy reaches point 3, the new long-run equilibrium

22-10 Decline in Inflation Target: Summary 1.Output falls and inflation falls. 2.With Y<Y P, output starts to rise and inflation continues to fall. 3.At the new equilibrium, Y=Y P and inflation equals the new target

22-11 Increase in Government Purchases Short-Run Equilibrium G  Shifts AD to the right Economy 1  2

22-12 Increase in Government Purchases Adjustment At point 2, Y>Y P SRAS shifts left Until economy reaches long-run equilibrium at point 3

22-13 Increase in Government Purchases Summary Output initially rises and inflation rises With Y>Y P, output and inflation fall The economy returns to its initial equilibrium. An increase in G causes Y and  to increase temporarily.

22-14 Summary of Impact of Increase in Dynamic Aggregate Demand

22-15 Shifts in Short-Run Aggregate Supply Increase in production cost changes shift SRAS left Economy 1  2

22-16 Summary of Impact of Decline in Short-Run Aggregate Supply

22-17 Recession: Decline in activity, not just a dip in growth Exact length is ambiguous. Determination involves judgment

22-18

22-19 A Shift in Aggregate Demand Drop in consumer or business confidence: AD 0  AD 1 Economy 1  2 Stabilization requires shifting AD back to where it started

22-20 A Shift in Aggregate Demand: Policy Response Drop in consumer or business confidence lowers r * Policymakers shift MPRC right, lowering the interest rate at every level of inflation

22-21 A Shift in Aggregate Demand: Stabilization To stabilize the economy following a drop in confidence, policymakers shift AD back to where it started

22-22 Stabilization improves welfare Individuals strive to stabilize consumption When income falls temporarily you can –Draw on savings (emergency funds) –Borrow

22-23 Fiscal Policy Two types –Automatic stabilizers –Discretionary policy Discretionary increase in G –Drives up aggregate expenditure –Shifts dynamic aggregate demand right –Elicits a monetary policy response: higher interest rates at every level of inflation

22-24 Positive Supply Shock Fall in Production Costs: Shifts SRAS Right Economy 1  2

22-25 Positive Supply Shock: Policy Options 1.  T unchanged 2. Lower  T

22-26 Positive Supply Shock: Policy Option 1  T unchanged At point 2, Y>Y P SRAS shifts left until Y=Y P at point 1

22-27 Positive Supply Shock: Policy Option 2 Policymakers take advantage and lower  T Shifts MPRC left

22-28 Positive Supply Shock: Policy Option 2 New, lower  T AD shifts left Economy 2  3

22-29 The Great Moderation Growth is much less volatile after 1984 than before.

22-30 The Great Moderation: Candidate Explanations 1.Luck But there were lots of shocks in the 1990s 2.Improved technology, especially for inventory management But the biggest inventory problems are in the high- technology sector 3.Better monetary policy

22-31 Increase in Potential Output Source: Technological Improvement How to think about it: An Increase in Trend Growth Using the model: Shifts both LRAS and SRAS

22-32 Increase in Potential Output: Shifts in Aggregate Supply An increase in Y P shifts SRAS right shifts LRAS right But SRAS still crosses LRAS where  =  e

22-33 Increase in Potential Output: Short-Run Equilibrium Following Y P increase: Economy 1  2 where AD crosses new SRAS 1

22-34 Increase in Potential Output: Long-Run In the short-run output and inflation fall In the long-run the economy goes to the new, higher Y P Policymakers have two options: –  T unchanged –  T lower (opportunistic disinflation)

22-35 Increase in Potential Output: Unchanged Inflation Target With  T unchanged: Policymakers shift AD right, economy moves to the new level of potential output and the original  T at point 3.

22-36 Increase in Potential Output: Lower Inflation Target With a new, lower  T: Policymakers allow the economy to move to point 4

22-37 Globalization and Inflation What is Globalization? –Globalization is about trade –Improved trade is the same as a technological advance –This is the same as an increase in potential output

22-38 Globalization and Inflation How big is the effect on inflation? –8% of household purchases are imports –Domestic content of imports = 1/3 –Imported goods prices account for 6% of household spending

22-39 Distinguishing a Recessionary Gap from a Fall in Potential Output When output falls is it 1.A recessionary gap 2.A fall in potential output How can you tell the difference?

22-40 Recessionary Output Gap Recessionary output gap caused by supply shock Policymakers focus on returning inflation to target, raise the interest rate along an unchanged MPRC

22-41 Fall in Potential Output Fall in potential output requires policymakers to shift MPRC. This shifts AD so that inflation returns to target at point 3.

22-42 You can measure GDP by either counting production or income. They should be the same, but they are not. The difference is called the “Statistical discrepancy” and it can be very large.

22-43 The Volatility Tradeoff Can Policymakers Stabilize Output and Inflation Simultaneously?

22-44 The Volatility Tradeoff Demand Shocks can be neutralized Supply Shocks create a tradeoff

22-45 The Volatility Tradeoff: Slope of MRPC

22-46 The Volatility Tradeoff: Slope of the AD curve

22-47 The Volatility Tradeoff Can Policymakers Stabilize Output and Inflation Simultaneously? NO! Keeping  near  T means Y volatile Keeping Y near Y P means  volatile

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 22 End of Chapter