Matching History and Theory Keynesian Stimulus 1) Keynesian Stimulus – 1930’s 1)Fine tuning in the 1960’s

Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Keynesian Short-Run Aggregate Supply Curve – The horizontal portion of the aggregate supply curve in which there is excessive unemployment and unused capacity in the economy

Figure 11-7 Demand-Determined Equilibrium Real GDP at Less Than Full Employment Keynes assumed prices will not fall when aggregate demand falls

Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Real GDP and the price level, 1934–1940 – Keynes argued that in a depressed economy, increased aggregate spending can increase output without raising prices. – Data showing the U.S. recovery from the Great Depression seem to bear this out. – In such circumstances, real GDP is demand driven.

Figure 11-8 Real GDP and the Price Level, 1934–1940

Managing Economic “Fluctuations” 6 “Fine-tuning” the economy – can it be done?

How the Phillips curve is related to the model of aggregate demand and aggregate supply 2 7 Price level This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year Panel (a) shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is low (15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000), and the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises when aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises when aggregate demand is high, has low unemployment (4%) and high inflation (6%). Quantity of output 0 (a) The Model of AD and AS Inflation Rate (percent per year) Unemployment Rate (percent) 0 (b) The Phillips Curve Phillips curve 6% Low aggregate demand Short-run aggregate supply High aggregate demand 2 15,000 unemployment =7% 102 A 106 B 16,000 unemployment =4% 7% output =15,000 A 4% output =16,000 B

Shifts in Phillips Curve: Role of Expectations Natural experiment for natural-rate hypothesis Natural-rate hypothesis – Unemployment - eventually returns to its normal/natural rate – Regardless of the rate of inflation Late 1960s (short-run), policies: – Expand AD for goods and services 8

Shifts in Phillips Curve: Role of Expectations Natural experiment for natural-rate hypothesis – Expansionary fiscal policy Government spending rose – Vietnam War – Great Society Programs – Monetary policy The Fed – try to hold down interest rates Money supply – rose 13% per year High inflation (5-6% per year) Unemployment decreased Trade-off (Short-run AS) 9

Shifts in Phillips Curve: Role of Expectations The long-run Phillips curve – Expression of the classical idea of monetary neutrality – Increase in money supply Aggregate-demand curve – shifts right – Price level – increases – Output – natural rate Inflation rate – increases – Unemployment – natural rate 10

The Phillips Curve in the 1960s 6 11 This figure uses annual data from 1961 to 1968 on the unemployment rate and on the inflation rate (as measured by the GDP deflator) to show the negative relationship between inflation and unemployment.

The breakdown of the Phillips Curve 7 12 This figure shows annual data from 1961 to 1973 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks down in the early 1970s, just as Friedman and Phelps had predicted. Notice that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 5.

How the long-run Phillips curve is related to the model of aggregate demand and aggregate supply 4 13 Price level Panel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary policy shifts the AD curve to the right from AD 1 to AD 2, the equilibrium moves from point A to point B. The price level rises from P 1 to P 2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment Quantity of output 0 (a) The Model of AD and AS Inflation Rate Unemployment Rate 0 (b) The Phillips Curve Aggregate demand, AD 1 AD 2 Long-run aggregate supply Natural rate of output P1P1 A P2P2 B Long-run Phillips curve Natural rate of output B A 1. An increase in the money supply increases aggregate demand raises the price level and increases the inflation rate but leaves output and unemployment at their natural rates.

The Cost of Reducing Inflation The Volker disinflation – Paul Volker – chairman of the Fed, 1979 – Peak inflation: 10% Sacrifice ratio = 5 (5% dec in GNP for 1% dec in inflation) – Reducing inflation – great cost Rational expectations – Reducing inflation – smaller cost – 1984 inflation : Drops to 4% due to tightening monetary policy – High unemployment: 10% – Low output 14

The Volcker Disinflation This figure shows annual data from 1979 to 1987 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The reduction in inflation during this period came at the cost of very high unemployment in 1982 and Note that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 10.

The Cost of Reducing Inflation The Greenspan era Alan Greenspan – chair of the Fed, 1987 – Favorable supply shock (OPEC, 1986) Falling inflation & falling unemployment – : high inflation & low unemployment The Fed – raised interest rates – Contracted aggregate demand – 1990s – economic prosperity Prudent monetary policy 16

Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices

The Volcker Disinflation This figure shows annual data from 1979 to 1987 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The reduction in inflation during this period came at the cost of very high unemployment in 1982 and Note that the points labeled A, B, and C in this figure correspond roughly to the points in Figure 10.

The Cost of Reducing Inflation The Greenspan era 2001: recession – Depressed aggregate demand – Expansionary fiscal and monetary policy Bernanke’s challenges – Ben Bernanke – chair, the Fed, 2006 – : booming housing market New homeowners: subprime (high risk of default) 19

Friedman – steady growth rate of M1/M2 20 “Fine-tuning” the economy – can’t be done?

The Greenspan Era This figure shows annual data from 1984 to 2006 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). During most of this period, Alan Greenspan was chairman of the Federal Reserve. Fluctuations in inflation and unemployment were relatively small.

Neo-Keynesian Models Real GDP Determination with Fixed and Flexible Prices

The Cost of Reducing Inflation Bernanke’s challenges : housing & financial crises – Housing prices declined > 15% The new homeowners: underwater – Value of house < balance on mortgage – Mortgage defaults – Home foreclosures – Financial institutions – large losses – Depressing the aggregate demand 23

The Cost of Reducing Inflation Bernanke’s challenges : rising commodity prices – Increased demand from rapidly growing emerging economies – Prices of basic foods – rose significantly Droughts in Australia Demand increase from emerging economies Increased use of agricultural products – biofuels – Contracting aggregate supply 24