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

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) ↑
Intuition: C↑, I↑, 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↓, W ↓ => AE↓ => Y↓
AD0
AD1 Y

6. Example: Short-run Effect on Equilibrium Income -
Increase in Investment (I) P AS P1 B P0 A
AD1
AD0 Y Y0 Y1

7. Example: Short-run Effect on Equilibrium Income - Decrease in Investment (I)
AD0
AD1 Y Y1 Y0

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

9. House Prices fell dramatically in 2007 - 2009

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

11. Effects of Decline in Nominal Wealth 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
Caused 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 2008 P0 A P1 B P2 C
AD0
AD1
AD2 Y Y2 Y1 Y0

14. Real GDP Growth Inflation

15. The Worry: If No Stimulus – AD Would Continue to Decline to AD3 and Recession Would be Far WorseP 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
$787B P0 A E P2 C D
AD0
AD3
AD2
AD3 Y2 Y0 Y

19. Real GDP Growth

20. Expansionary Fiscal and Monetary Policy
Effect on Equilibrium Income: 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. Overshoot Real Income TargetP AS I↑
G↑,or T↓
Ptarget
AD2 P0
AD1
AD0
ΔY= 400 Y Y0
Ytarget

27. Causes of Inflation
In the long run, inflation occurs if the quantity of money grows faster than potential GDP
– quantity theory of money.
In the short run, many factors can start an inflation. We distinguish between two sources of inflation:
Demand-pull inflation
Cost-push inflation

28. Demand-Pull Inflation
An inflation that starts because aggregate demand increases is called demand-pull inflation.
Demand-pull inflation can begin with any factor that increases aggregate demand such as:
monetary policy that cuts interest rates by increasing the quantity of money,
an increase in government expenditure or a tax cut,
an increase in exports, or
an increase in investment stimulated by an increase in expected future profits.
The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift continuously to the right, for example because of persistent and growing government budget deficits. What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate this with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central bank is less independent than the Fed, it has been more common.

29. Demand Pull Inflation
Initial Effect of an Increase in Aggregate Demand starting from Full Employment
An increase in aggregate demand (for any reason) shifts the AD curve rightward.

30. Demand Pull Inflation
The price level rises, real GDP increases - have an inflationary gap. The rising price level is the first step in the demand-pull inflation. This is short-run!

31. Demand Pull Inflation Money Wage Rate Response (long-run)
The money wage rate rises (“self-correcting”) and the SAS curve shifts leftward.
The price level rises and real GDP decreases back to potential GDP.
With no further increase in AD, the process ends with the price level increasing from to 121.
One shot deal! A one - time increase in the price level. This is not inflation.

32. Demand Pull Inflation
For demand pull inflation, aggregate demand must keep increasing and the process just described keeps repeating. Inflation is a sustained increase in the price level and requires a sustained increase in aggregate demand.

33. Demand Pull Inflation
Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it. Demand-pull inflation occurred in the United States during the late 1960s.

34. Demand Pull Inflation – 1960s
1960s: positive demand shocks
C and I were increasing and G was increasing because of Vietnam and Johnson’s War on Poverty.
Unemployment very low, close to 3%
As G increased, holding T fixed, the deficit increased and the government sells bonds, interest rates increase.
Also, as the demand for money increases, interest rates increase.
Fed policy was to maintain low interest rates
Increased the money supply
What effect does this have on AD?

35. There are two main sources of increased costs:
Cost-Push Inflation
An inflation that starts with an increase in costs of production is called cost-push inflation.
There are two main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the price of raw materials, such as oil
Referred to a negative supply shocks.
The text gives a good description of the first oil price increase in the 1970s as a cost-push inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is caused by monetary growth. One way to point out the fallacy is to use a baseball analogy. Several years ago the average number of home runs hit during major league baseball games increased. Virtually every commentator asked whether the ball had been doctored to make it livelier. No one explained the additional home runs by saying “home runs are higher because Parkin is hitting more home runs than last year.” To explain inflation, economists are looking for an explanation similar to the “doctored ball” explanation of the additional home runs, not an explanation that focuses on the performance of specific players.

36. Cost-Push Inflation
Initial Effect of a Decrease in Aggregate Supply starting from Full Employment
An increase in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward.
Real GDP decreases and the price level rises – recession with inflation - called stagflation.

37. Cost-Push Inflation
The initial increase in costs creates a one-time rise in the price level, not inflation.
To create inflation, aggregate demand must increase.
That is, the Fed must increase the quantity of money persistently.

38. Cost-Push Inflation
Suppose that the Fed stimulates aggregate demand to counter the higher unemployment rate and lower level of real GDP. Real GDP increases and the price level rises again.

39. Cost-Push Inflation A Cost-Push Inflation Process
If negative supply shocks continue….
and the Fed responds by increasing the quantity of money, ...
a process of cost-push inflation continues.

40. Cost-Push Inflation
Cost-push inflation occurred in the United States during the 1970s when the Fed responded to the OPEC oil price rise by increasing the quantity of money.

41. Question – Negative Supply Shock Supposed the Fed did nothing
Decrease in Aggregate Supply starting from Full Employment
An increase in the price of oil decreases short-run aggregate supply and shifts the SAS curve leftward.
Real GDP decreases and the price level rises – recession with inflation - called stagflation.

42. Expected Inflation -
Suppose aggregate demand increases, but the increase is expected (anticipated), so its effect on the price level is expected. Wages will adjust upward at the same time reflecting the expected inflation.

43. Expected Inflation and money wage rate rises in line with the expected price level
The AD curve shifts rightward and the SAS curve shifts leftward at the same time… so that the price level rises as expected and real GDP remains at potential GDP.

44. Expected Inflation To expect inflation, people must forecast it.
Forecasting Inflation
Great quote: “we expect inflation because we have it, we have inflation because we expect it.”
To expect inflation, people must forecast it.
The best forecast available is one that is based on all the relevant information and is called a rational expectation.
A rational expectation is not necessarily correct, but it is the best available.

45. Deflation
An economy experiences deflation when it has a persistently falling price level.
A one-time fall in the price level either because the AD shifts to the left or SAS shifts to the right is NOT deflation.
Examples of “one-timers”:
a fall in exports,
or a fall in profit expectations,
increase in the capital stock that increases potential GDP,
an agricultural boom.

46. Deflation and The Quantity Theory of Money
What Causes Deflation?
Primarily a monetary phenomenon.
Expressing the equation of exchange in growth rates:
∆𝑴 𝑴 + ∆𝑽 𝑽 = ∆𝑷 𝑷 + ∆𝒀 𝒀
Rearranging:
∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀
Deflation occurs if money growth rate is low relative to velocity and growth in economic activity.
∆𝑷 𝑷 = ∆𝑴 𝑴 +(0.5 – 3)

47. Deflation What are the Consequences of Deflation?
Unanticipated deflation lowers real GDP and employment, and diverts resources from production.
deflation is generally not expected (“unanticipated”).
Loan and wage contracts entered into with the expectation some inflation.
With unexpected deflation, workers with long-term contracts see real wages increase, but firms see profits fall. They cut back on employment.
firm re-evaluate investment plans and cut back on projects that are now viewed as unprofitable…
as investment falls, growth in capital stock is reduced and the growth rate in potential GDP is reduced.
Classroom activity
Check out Economics in the News: The Stagnating Eurozone

48. Deflation in Japan 1998 - 2013 ∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀
Real GDP growth rate was 0.8 percent a year, the money growth rate was 2.5 percent a year, and the rate of velocity change was -3 percent a year.
Inflation rate = ( ) percent a year.
Deflation rate = 1.3 percent a year.
RGDP growth fell to 0.5% in the 2000s, down from around 5% in the 1970s and 80s.
∆𝑷 𝑷 = ∆𝑴 𝑴 + ∆𝑽 𝑽 - ∆𝒀 𝒀
Classroom activity
Check out Economics in Action: Fifteen Years of Deflation in Japan