Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 1 Economics THIRD EDITION By John B. Taylor Stanford University

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 2 Chapter 24 (Macro 11) The Economic Fluctuations Model

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 3 Overview The main purpose of this chapter is to provide an explanation of the dynamics of economic fluctuations, particularly inflation and real GDP. The economic fluctuations model is constructed by first deriving the aggregate demand/inflation curve and then the price adjustment line. The model can be used to study the determination of real GDP and the price level.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 4 Teaching Objectives 1. Explain that a basic set of factors causes real GDP to depart and return to potential over the business cycle. 2. Introduce interest rates and inflation into the dynamics of the business cycle. 3. Describe the important role that policy can play in altering the course of business cycles. This is done through a policy rule that relates interest rates to aggregate expenditure.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 5 Teaching Objectives 4. Explain the primary factors that determine location of the ADI curve. This occurs through the components of aggregate spending that are sensitive to interest rates (spending balance) and the policy rule. 5. Explain the factors that shift the ADI curve: Changes of the policy rule and changes in government spending, along with autonomous shocks to aggregate spending, determine the location of the ADI curve.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 6 Teaching Objectives 6. Introduce the microeconomic basis of price adjustment. 7. Explain the PA line and the factors that cause it to shift. 8. Explain how the intersection of the ADI curve and the PA line determines the level of equilibrium real GDP and the inflation rate at some point in time in the economy.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 7 Key Terms aggregate demand/inflation ( ADI ) curve target inflation rate monetary policy rule price adjustment ( PA ) line federal funds rate

Copyright © 2001 by Houghton Mifflin Company. All rights reserved The Aggregate Demand/Inflation Curve The ADI curve shows that there is an inverse (negative) relationship between inflation changes and the corresponding changes in real GDP. When inflation increases, real GDP declines. When inflation slows down, real GDP goes up. Real GDP = C + I + G + X = AE

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 9 Figure 24.1 (Macro 11) The Aggregate Demand Curve

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 10 Between Inflation Interest Rate and Real GDP

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 11 Showing Relation of Interest Rate to Investment

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 12 STAGE I: Interest rate and Investment As real (inflation-adjusted) interest rate goes up, cost of borrowing goes up, so that business investment (buying a new machine or extending business) and housing investment declines. As real interest rate declines, investment goes up, because the cost of investment declines

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 13 Showing Relation of Interest Rate to Net Exports

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 14 Interest Rate and Net Exports If US interest rates increase, it becomes more attractive to invest in the US, compared to other countries such as Canada or Mexico, our top trading partners. This raises the demand for US dollars and appreciates the US dollar against other currencies like Canadian $s or Mexican pesos. This hurts our exports but raises our imports.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 15 Interest Rate and Consumption Expenditures Evidence indicates that consumption is less sensitive to interest rate changes than investment and net exports In general, higher interest rates encourage people to save more (consume less), indicating an inverse relationship between interest rates and consumption Figure 24.2 shows the net impact.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 16 Figure 24.2 (Macro 11) The Interest Rate, Spending Balance, and Real GDP

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 17 STAGE II: Interest Rates and Inflation So far we have seen how real interest rates affect real GDP. Now we want to study how inflation affects interest rates. Real interest rate = nominal interest rates minus expected inflation rate Note that it is the real interest rate that we use to decide about our spending plans

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 18 Central Banks and Inflation When inflation increases (declines), the Fed raises (lowers) the nominal interest rates. This is called the “policy rule” Higher inflation signals a rise in aggregate expenditures. Central banks raise nominal interest rates more than the inflation rate, so that the real interest rate increases. Higher real interest rates lower AE and slows down inflation

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 19 Figure 24.3 (Macro 11) A Monetary Policy Rule

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 20 Monetary Policy Rule The monetary policy rule in Figure 24.3 shows that central banks raise the interest rate when inflation rises and lower it when inflation declines. The dashed line has a slope of 1. Monetary policy rule has a bigger slope: Nominal interest rate is increased by more than inflation, so that the real interest changes. Note that AE decisions depend on “real” rate.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 21 STAGE 3: Deriving AD curve When inflation increases, two things happen: (1) Central banks raise the nominal interest rate more than inflation, raising the real interest rate (2) The higher real interest rate will decrease real GDP because of lower AE Just the opposite happens when inflation decreases Thus, AD curve shows a negative link between real interest rates and real GDP

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 22 Figure 24.4 (Macro 11) A Self-Guided Graphical Overview

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 23 Movements along the AD curve A change in inflation causes a movement along the demand curve When inflation rises and the Fed raises the interest rate and real GDP declines. This causes a movement up and to the left along the AD curve. When inflation decreases, there is a movement down and to the right.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 24 Shifts of the AD curve Besides inflation, other things affects aggregate demand. When such non-inflation determinants of AD curve changes, we say that there is a “shift” in the AD curve. Changes in government purchases, shifts in monetary policy, changes in taxes, shifts in demand for next exports, changes consumer confidence, among others, affect AD.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 25 Figure 24.5 (Macro 11) How Government Purchases Shift the Aggregate Demand Curve

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 26 Figure 24.6 (Macro 11) A Shift in the Monetary Policy Rule

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 27 Figure 24.7 (Macro 11) A List of Possible Shifts in the Aggregate Demand Curve

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 28 Inflation Adjustment Line (IA) IA is a flat line showing the level of inflation in the economy at any point in time. It describes the behavior of firms and workers setting prices and wages in the economy

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 29 Figure 24.8 (Macro 11) Inflation Adjustment and Changes in Inflation

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 30 Inflation Adjustment Line (IA) The flat IA indicates that firms and workers adjust (change) prices and wages in such a way that the inflation remains intact in the short run as real GDP changes. There are two reasons why inflation stays steady even if real GDP is changing: expectations about continuing inflation and staggered wage and price setting in the economy

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 31 Reason #1 Pricing decisions for the whole economy require that the price expectations of other firms be taken into account. Similarly, wage adjustments are made in the context of existing and future wage agreements.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 32 Reason #1 Expectations about the price and wage decisions of other firms lead firms to raise prices by more than expected inflation if demand is high and by less than expected inflation if demand is low. A parallel process governs wage adjustments.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 33 Reason #2 Not all wages and prices are changed at the same time. Rather, they are staggered over months and even years. Staggered wages and prices act to slow down the rapid adjustment of prices. This also introduces a dependency between current and past price and wage decisions. On any given day, the vast majority of wages and prices do not change much.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 34 Inflation Adjustment Expectations, when combined with staggered decisions, make recent past inflation a factor in current inflation. Moreover, because the strength of a price adjustment relative to inflation expectations will depend on whether demand is high or low across the economy, the relation between real and potential GDP determines whether inflation increases, decreases, or remains unchanged. For example, if real GDP is below potential, inflation decreases.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 35 Inflation Adjustment Line Three assumptions about the IA line are needed. First, the IA line represents the rate of inflation in the economy at a point in time. It is flat, indicating that prices are sticky in the short run. Second, the IA line shifts after GDP departs from potential. Third, any change in expectations or materials prices will shift the IA line. These assumptions and the horizontal IA line receive statistical support in real world.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 36 Combining the Aggregate Demand/Inflation Curve and the Price Adjustment Line When the ADI curve and PA line are combined, as in Figure 27.10, the rate of inflation and real GDP are determined. This may occur above, below, or at potential GDP. The intersection of the ADI curve and the IA line gives a pair of observations on real GDP and inflation at any point time.

Copyright © 2001 by Houghton Mifflin Company. All rights reserved. 37 Figure (Macro 11) Determining Real GDP and Inflation