3. Recovery from what? From the short-run (“first steps”) to the long-run (back to potential GDP) Four scenarios today –(1) Reduction in government purchases –(2) Shift to more inflationary monetary policy –(3) Shift to a less inflationary monetary policy –(4) Combo of (2) and (3): Boom-Bust Cycle

4. The short-run and the long-run effects of a change in G Suppose that there is a sudden, big, decline in government purchases –A reduction in demand –We know that in the short run real GDP will fall below potential GDP Now we want to see how real GDP recovers--moves back to potential GDP

5. Starting point in the main diagram

6. Cut in government purchases causes real GDP to decline as shown by shift of ADI

7. But now real GDP is lower than potential GDP, so inflation starts to fall (PA moves down)

8. Could you go over that again, sketching the diagram by hand?

9. FYI: Here is what is happening in the supporting diagrams

10. What happens to C, I, X in the short run (SR) and the long run (LR)?

11. The LR is the same as SAM. In the long run, real GDP is back to potential, but with G down and –I up, X up, C up The spending allocation model (SAM) predicted the same thing: when G/Y down –I/Y up, X/Y up, C/Y up But with ADIPA we now we have the short run story to go with the long run story

12. In the long run, real GDP returns to potential GDP, but (with more I) the growth rate of potential GDP may be higher as shown here

13. A Lesson for Prospective Central Bankers We want to suppose there is a shift in monetary policy –This shift is a common tactical mistake What are the short run and the long run economic effects? What are the political implications? To learn this lesson let’s first observe some “Textbook Maneuvers”

14. WELCOME TO A school for central bankers. Dedicated to teaching the science and art of monetary policy.

15. Key Dialogue Tom Cruise –You don’t have time to think up there. If you think your dead. Kelly McGillis –That’s a big gamble with a $30,000,000 plane Lieutenant. Let me teach you about the “gain then pain scenario”. It starts with the Fed cutting interest rates when inflation is not too low and real GDP is just about equal to potential GDP.

17. “Gain then pain” scenario Start: inflation rate = 2%, real GDP = potential GDP –Fed cuts interest rate buys bonds –Economy booms---the “gain” real GDP> potential GDP –Inflation starts to rise –Fed must raise interest rate End: Economy returns to potential –real GDP = potential GDP –inflation is higher than 2%---the “pain”

18. Could you sketch the “pain then gain” scenario by hand?

19. A disinflation The Fed decides that inflation is too high –Or Jimmy Carter appoints Paul Volcker to chair the Fed and says “reduce inflation, Paul” The monetary policy must shift towards lower inflation –Fed raises the interest rate, –ADI shifts to left, –and then...

20. A Disinflation in a Graph

21. A boom-bust cycle First, the Fed lowers the interest rate when it shouldn’t have (the mistake Kelly McGillis warned Tom Cruise about)--this causes a boom Then the Fed undoes the mistake by shifting monetary policy back towards a lower inflation rate Now look at what happens over time

23. Any animated graphics for the boom-bust cycle?

24. END OF LECTURE and BEAT CAL