1. 12 Part 1 GOVERNMENT POLICY INFLATION, AND DEFLATION
THE BUSINESS CYCLE,
GOVERNMENT POLICY
INFLATION, AND DEFLATION

2. Goals: Case Study: Great Recession 2007 - 2009
Explain how demand-pull (AD) and cost-push (AS) forces bring cycles in inflation and output
Describe the causes and consequences of deflation – falling prices.
Describe the short-run and long-run trade-off between inflation and unemployment – the Phillips Curve.

3. Mainstream Business Cycle Theory
The Business Cycle
SKIP (pp )
Mainstream Business Cycle Theory
Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.
This mainstream theory comes in a number of special forms that differ in what is regarded as the source of fluctuations in aggregate demand growth and the source of money wage stickiness.
Keynesian Cycle Theory In Keynesian cycle theory, fluctuations in investment driven by fluctuations in business confidence—summarized in the phrase “animal spirits”—are the main source of fluctuations in aggregate demand.
Monetarist Cycle Theory In monetarist cycle theory, fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main source of fluctuations in aggregate demand.
Both the Keynesian and monetarist cycle theories simply assume that the money wage rate is rigid and don’t explain that rigidity. Two newer theories seek to explain money wage rate rigidity and to be more careful about working out its consequences.
New Classical Cycle Theory In new classical cycle theory, the rational expectation of the price level, which is determined by potential GDP and expected aggregate demand, determines the money wage rate and the position of the SAS curve. In this theory, only unexpected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.
New Keynesian Cycle Theory The new Keynesian cycle theory emphasizes the fact that today’s money wage rates were negotiated at many past dates, which means that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. In this theory, both unexpected and currently expected fluctuations in aggregate demand bring fluctuations in real GDP around potential GDP.
The mainstream cycle theories don’t rule out the possibility that occasionally an aggregate supply shock might occur. An oil price rise, a widespread drought, a major hurricane, or another natural disaster, could, for example, bring a recession. But supply shocks are not the normal source of fluctuations in the mainstream theories. In contrast, real business cycle theory puts supply shocks at center stage.

4. Positive AD Shocks: C↑, I↑, G, T, W(wealth) ↑
Shift of AD to the Right
Positive AD Shocks: C↑, I↑, G, T, W(wealth) ↑ P
Intuition: C↑, I↑,G, T, W ↑ => AE↑ => Y↑
AD1
AD0 Y

5. Negative AD Shocks: C↓, I↓,G, T, W↓
Shift of AD to the Left
Negative AD Shocks: C↓, I↓,G, T, W↓ P
Intuition: C↓, I↓,G, T , W↓ => AE↓ => Y↓
AD0
AD1 Y

6. Example: Effect on Equilibrium Income – Positive Demand Shock
SAS P1 B P0 A
AD1
AD0 Y Y0 Y1
The economy grows and prices (inflation) increase.

7. Example: Effect on Equilibrium Income – Negative Demand Shock
SAS P0 A P1 B
AD0
AD1 Y Y1 Y0
The economy contracts and prices (inflation) decrease.

8. Case Study Housing & Financial Market Crisis 2007
W = Nominal Wealth = Assets – Liabilities
W = Financial Assets (Money, Stocks, Bank Accounts, etc.)
+ Durable Goods Assets (Value of House, etc.)
- Liabilities (Mortgage, Auto Loan, etc.)

9. House Prices fell dramatically in 2007 - 2009

10. Stock Market Prices Fell Dramatically in 2008
Dow Jones Industrial Average
2008
2009

11. Effects of Decline in Nominal Wealth (W) W↓ => C↓ => AD↓ = Y ↓P AS W↓ P0 A P1 B
AD0
AD1 Y Y1 Y0

12. The Story Doesn't Stop at Point B Credit Market Effects
Tighter credit markets
Higher Interest Rates and stiffer Terms for Borrowing
cause declines in
Purchases of New Houses
Purchases of New Plant & Equipment
Consumer Durables Spending (e.g., Autos)
AD-AS Model Effects
Decline in Investment Spending
Further Decline in Consumption Spending
AD shifts further to the left

13. Effects of Decline in Nominal Wealth and Tighter Credit MarketP W↓ AS
Tight Credit P0 A P1 B P2 C
AD0
AD1
AD2 Y Y2 Y1 Y0

14. Real GDP Growth Inflation

15. The Worry: Without Stimulus - AD Would Continue to Decline from point “C” to “D” and Recession Would be Far Worse P AS
Due to W and Tight Credit P0 A
AD if no Stimulus P2 C P3 D
AD0
AD3
AD2 Y3 Y2 Y0 Y

16. Fiscal Policy Obama Stimulus Package
American Recovery and Reinvestment Act of 2009 (ARRA)
• Passed by Congress February 13, 2009 and signed into law by President Obama February 17, 2009
Size of the Stimulus = $787billion (5.5% of GDP)
Largest Fiscal Stimulus in US History

17. Stimulus Package (Billions of Dollars)
Government Spending Increases $260 (1/3)
Tax Cuts $260 (1/3)
Transfer Payment Increases $260 (1/3)
Total $787

18. Goal of the ARRA Stimulus – Shift AD2 to the RightP AS P0 A P2 C
AD0
AD3
AD2 Y2 Y0 Y

19. Real GDP Growth

20. Expansionary Fiscal and Monetary Policy
Effect on Equilibrium Income if G↑, Ms↑, T↓, t↓ P AS P1 P0
AD1
AD0 Y Y0 Y1

21. Contractionary Fiscal and Monetary Policy
Effect on Equilibrium Income - G↓, Ms↓, T↑, t↑ P AS P0 P1
AD0
AD1 Y Y1 Y0

22. Policy Controversies Activism “Fine-Tuning” Spending v. Tax Policies
Supply-Side Economics

23. Activism: Recession – Use Expansionary PolicyAS P1 P0
AD1
AD0 Y Y0 Y1

24. Activism: High Prices – Use Contractionary PolicyAS P1 P0
AD0
AD1 Y Y0 Y1

25. Fine Tuning- Problem Suppose target is to increase Y by $400 billion
Government Spending Multiplier = 2
Government decides to increase spending by
$200 billion
Problem is there are lags in conduct of fiscal
policy
Suppose Investment spending increases as G increases

26. Can Overshoot Real Income TargetP AS
G↑ by $200b I↑
Ptarget
AD2 P0
AD1
AD0 Y Y0
Ytarget
Target ΔY=400