1. Macroeconomics of Business Cycles macro

2. Growth rates of real GDP, consumption Percent change from 4 quarters earlier Average growth rate Real GDP growth rate Consumption growth rate

3. Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate Consumption growth rate

4. Unemployment Percent of labor force

5. Okun’s Law Percentage change in real GDP Change in unemployment rate 1975 1982 1991 2001 1984 1951 1966 2003 1987 2008 1971

6. Facts about the business cycle  GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.  Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.  Unemployment rises during recessions and falls during expansions.  Okun’s Law: the negative relationship between GDP and unemployment.

7. Index of Leading Economic Indicators  Published monthly by the Conference Board.  Aims to forecast changes in economic activity 6-9 months into the future.  Used in planning by businesses and govt, despite not being a perfect predictor.

8. Components of the LEI index  Average workweek in manufacturing  Initial weekly claims for unemployment insurance  New orders for consumer goods and materials  New orders, nondefense capital goods  Vendor performance  New building permits issued  Index of stock prices  M2  Yield spread (10-year minus 3-month) on Treasuries  Index of consumer expectations

9. Index of Leading Economic Indicators Source: Conference Board 2004 = 100

10. Time horizons in macroeconomics  Long run Prices are flexible, respond to changes in supply or demand.  Short run Many prices are “sticky” at a predetermined level. The economy behaves much differently when prices are sticky.

11. Recap of classical macro theory  Output is determined by the supply side: – supplies of capital, labor – technology  Changes in demand for goods & services ( C, I, G ) only affect prices, not quantities.  Assumes complete price flexibility.  Applies to the long run.

12. When prices are sticky… …output and employment also depend on demand, which is affected by: – fiscal policy (G and T ) – monetary policy (M ) – other factors, like exogenous changes in C or I

13. AD/AS Model  The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy  Shows how the price level and aggregate output are determined  Shows how the economy’s behavior is different in the short run and long run

14. Aggregate demand  The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.  we use a simple theory of AD based on the quantity theory of money.  Recall the quantity equation M V = P Y  For given values of M and V, this equation implies an inverse relationship between P and Y : Y = M V / P

15. The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. Y P AD

16. Shifting the AD curve An increase in the money supply shifts the AD curve to the right. Y P AD 1 AD 2

17. Aggregate supply in the long run  Recall from Chapter 3: In the long run, output is determined by factor supplies and technology is the full-employment or natural level of output, at which the economy’s resources are fully employed. “Full employment” means that unemployment equals its natural rate (not zero).

18. The long-run aggregate supply curve Y P LRAS does not depend on P, so LRAS is vertical.

19. Long-run effects of an increase in M Y P AD 1 LRAS An increase in M shifts AD to the right. P1P1 P2P2 In the long run, this raises the price level… …but leaves output the same. AD 2

20. Aggregate supply in the short run  Many prices are sticky in the short run.  For now we assume – all prices are stuck at a predetermined level in the short run. – firms are willing to sell as much at that price level as their customers are willing to buy.  Therefore, the short-run aggregate supply (SRAS) curve is horizontal:

21. The short-run aggregate supply curve Y P SRAS The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

22. Short-run effects of an increase in M Y P AD 1 In the short run when prices are sticky,… …causes output to rise. SRAS Y2Y2 Y1Y1 AD 2 …an increase in aggregate demand…

23. From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? rise fall remain constant In the short-run equilibrium, if then over time, P will… The adjustment of prices is what moves the economy to its long-run equilibrium.

24. The SR & LR effects of  M > 0 Y P AD 1 LRAS SRAS P2P2 Y2Y2 A = initial equilibrium A B C B = new short- run eq’m after Fed increases M C = long-run equilibrium AD 2

25. How shocking!!!  shocks: exogenous changes in agg. supply or demand  Shocks temporarily push the economy away from full employment.  Example: exogenous decrease in velocity If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.

26. SRAS LRAS AD 2 The effects of a negative demand shock Y P AD 1 P2P2 Y2Y2 AD shifts left, depressing output and employment in the short run. A B C Over time, prices fall and the economy moves down its demand curve toward full- employment.

27. Supply shocks  A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)  Examples of adverse supply shocks: – Bad weather reduces crop yields, pushing up food prices. – Workers unionize, negotiate wage increases. – New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.  Favorable supply shocks lower costs and prices.

28. CASE STUDY: The 1970s oil shocks  Early 1970s: OPEC coordinates a reduction in the supply of oil.  Oil prices rose 11% in 1973 68% in 1974 16% in 1975  Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

29. SRAS 1 Y P AD LRAS Y2Y2 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. A B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. SRAS 2 A

30. CASE STUDY: The 1970s oil shocks Predicted effects of the oil shock: inflation  output  unemployment  …and then a gradual recovery.

31. CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

32. CASE STUDY: The 1980s oil shocks 1980s: A favorable supply shock-- a significant fall in oil prices. As the model predicts, inflation and unemployment fell:

33. Stabilization policy  def: policy actions aimed at reducing the severity of short-run economic fluctuations.  Example: Using monetary policy to combat the effects of adverse supply shocks…

34. Stabilizing output with monetary policy SRAS 1 Y P AD 1 B A Y2Y2 LRAS The adverse supply shock moves the economy to point B. SRAS 2

35. Stabilizing output with monetary policy Y P AD 1 B A C Y2Y2 LRAS But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level. SRAS 2 AD 2

36. Aggregate Demand I: The IS-LM Model The IS-LM model determines income and the interest rate in the short run when P is fixed

37. The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply Explanation of short-run fluctuations

38. The Keynesian Cross  A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)  Notation: I = planned investment PE = C + I + G = planned expenditure Y = real GDP = actual expenditure  Difference between actual & planned expenditure = unplanned inventory investment

39. Elements of the Keynesian Cross consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure

40. Graphing planned expenditure income, output, Y PE planned expenditure PE =C +I +G MPC 1

41. Graphing the equilibrium condition income, output, Y PE planned expenditure PE =Y 45 º

42. The equilibrium value of income income, output, Y PE planned expenditure PE =Y PE =C +I +G Equilibrium income

43. An increase in government purchases Y PE PE =Y PE =C +I +G 1 PE 1 = Y 1 PE =C +I +G 2 PE 2 = Y 2 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. GG

44. Solving for  Y equilibrium condition in changes because I exogenous because  C = MPC  Y Collect terms with  Y on the left side of the equals sign: Solve for  Y :

45. The government purchases multiplier Example: If MPC = 0.8, then Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals An increase in G causes income to increase 5 times as much!

46. Why the multiplier is greater than 1  Initially, the increase in G causes an equal increase in Y:  Y =  G.  But  Y   C  further  Y  further  C  further  Y  So the final impact on income is much bigger than the initial  G.

47. An increase in taxes Y PE PE =Y PE =C 2 +I +G PE 2 = Y 2 PE =C 1 +I +G PE 1 = Y 1 YY At Y 1, there is now an unplanned inventory buildup… …so firms reduce output, and income falls toward a new equilibrium  C =  MPC  T Initially, the tax increase reduces consumption, and therefore PE:

48. Solving for  Y eq’m condition in changes I and G exogenous Solving for  Y : Final result:

49. The tax multiplier def: the change in income resulting from a $1 increase in T : If MPC = 0.8, then the tax multiplier equals

50. The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the govt spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

51. The IS curve def: a graph of all combinations of r and Y that result in goods market equilibrium i.e. actual output = planned expenditure The equation for the IS curve is: J.R. Hicks

52. Y2Y2 Y1Y1 Y2Y2 Y1Y1 Deriving the IS curve  r   I Y PE r Y PE =C +I (r 1 )+G PE =C +I (r 2 )+G r1r1 r2r2 PE =Y IS II   PE  Y Y

53. Why the IS curve is negatively sloped  A fall in the interest rate motivates firms to increase investment spending, which drives up total planned spending (PE ).  To restore equilibrium in the goods market, output (a.k.a. actual expenditure, Y ) must increase.

54. Fiscal Policy and the IS curve  We can use the IS-LM model to see how fiscal policy (G and T ) affects aggregate demand and output.  Let’s start by using the Keynesian cross to see how fiscal policy shifts the IS curve…

55. Y2Y2 Y1Y1 Y2Y2 Y1Y1 Shifting the IS curve:  G At any value of r,  G   PE   Y Y PE r Y PE =C +I (r 1 )+G 1 PE =C +I (r 1 )+G 2 r1r1 PE =Y IS 1 The horizontal distance of the IS shift equals IS 2 …so the IS curve shifts to the right. YY

56. NOW YOU TRY: Shifting the IS curve:  T  Use the diagram of the Keynesian cross or loanable funds model to show how an increase in taxes shifts the IS curve.

57. The Theory of Liquidity Preference  Due to John Maynard Keynes.  A simple theory in which the interest rate is determined by money supply and money demand.

58. Equilibrium The interest rate adjusts to equate the supply and demand for money: M/P real money balances r interest rate L (r )L (r ) r1r1

59. How the Fed raises the interest rate To increase r, Fed reduces M M/P real money balances r interest rate L (r )L (r ) r1r1 r2r2

60. The LM curve Now let’s put Y back into the money demand function: The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is:

61. Deriving the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 L (r, Y2 )L (r, Y2 ) r2r2 Y2Y2 LM (a) The market for real money balances (b) The LM curve

62. Why the LM curve is upward sloping  An increase in income raises money demand.  Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.  The interest rate must rise to restore equilibrium in the money market.

63. How  M shifts the LM curve M/P r L (r, Y1 )L (r, Y1 ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 LM 1 (a) The market for real money balances (b) The LM curve LM 2

64. The short-run equilibrium The short-run equilibrium is the combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods & money markets: Y r IS LM Equilibrium interest rate Equilibrium level of income

65. Policy analysis with the IS -LM model We can use the IS-LM model to analyze the effects of fiscal policy: G and/or T monetary policy: M IS Y r LM r1r1 Y1Y1

66. causing output & income to rise. IS 1 An increase in government purchases 1. IS curve shifts right Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 3.

67. IS 1 1. A tax cut Y r LM r1r1 Y1Y1 IS 2 Y2Y2 r2r2 Consumers save (1  MPC) of the tax cut, so the initial boost in spending is smaller for  T than for an equal  G… and the IS curve shifts by 1. 2. …so the effects on r and Y are smaller for  T than for an equal  G. 2.

68. 2.…causing the interest rate to fall IS Monetary policy: An increase in M 1.  M > 0 shifts the LM curve down (or to the right) Y r LM 1 r1r1 Y1Y1 Y2Y2 r2r2 LM 2 3.…which increases investment, causing output & income to rise.

69. The Fed’s response to  G > 0  Suppose Congress increases G.  Possible Fed responses: 1. hold M constant 2. hold r constant 3. hold Y constant  In each case, the effects of the  G are different…

70. If Congress raises G, the IS curve shifts right. IS 1 Response 1: Hold M constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 If Fed holds M constant, then LM curve doesn’t shift. Results:

71. If Congress raises G, the IS curve shifts right. IS 1 Response 2: Hold r constant Y r LM 1 r1r1 Y1Y1 IS 2 Y2Y2 r2r2 To keep r constant, Fed increases M to shift LM curve right. LM 2 Y3Y3 Results:

72. IS 1 Response 3: Hold Y constant Y r LM 1 r1r1 IS 2 Y2Y2 r2r2 To keep Y constant, Fed reduces M to shift LM curve left. LM 2 Results: Y1Y1 r3r3 If Congress raises G, the IS curve shifts right.

73. Estimates of fiscal policy multipliers from the DRI macroeconometric model Assumption about monetary policy Estimated value of  Y /  G Fed holds nominal interest rate constant Fed holds money supply constant 1.93 0.60 Estimated value of  Y /  T  1.19  0.26

74. Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services. Examples: – stock market boom or crash  change in households’ wealth   C – change in business or consumer confidence or expectations   I and/or  C

75. Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money. Examples: – a wave of credit card fraud increases demand for money. – more ATMs or the Internet reduce money demand.

76. NOW YOU TRY: Analyze shocks with the IS-LM Model Use the IS-LM model to analyze the effects of 1.a boom in the stock market that makes consumers wealthier. 2.after a wave of credit card fraud, consumers using cash more frequently in transactions. For each shock, a.use the IS-LM diagram to show the effects of the shock on Y and r. b.determine what happens to C, I, and the unemployment rate.

77. CASE STUDY: The U.S. recession of 2001  During 2001, – 2.1 million jobs lost, unemployment rose from 3.9% to 5.8%. – GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).

78. CASE STUDY: The U.S. recession of 2001 Causes: 1) Stock market decline   C 300 600 900 1200 1500 199519961997199819992000200120022003 Index (1942 = 100) S&P 500

79. CASE STUDY: The U.S. recession of 2001 Causes: 2) 9/11 – increased uncertainty – fall in consumer & business confidence – result: lower spending, IS curve shifted left Causes: 3) Corporate accounting scandals – Enron, WorldCom, etc. – reduced stock prices, discouraged investment

80. CASE STUDY: The U.S. recession of 2001  Fiscal policy response: shifted IS curve right – tax cuts in 2001 and 2003 – spending increases airline industry bailout NYC reconstruction Afghanistan war

81. CASE STUDY: The U.S. recession of 2001  Monetary policy response: shifted LM curve right Three-month T-Bill Rate 0 1 2 3 4 5 6 7 01/01/200004/02/2000 07/03/200010/03/2000 01/03/200104/05/200107/06/200110/06/200101/06/200204/08/200207/09/2002 10/09/2002 01/09/200304/11/2003

82. IS-LM and aggregate demand  So far, we’ve been using the IS-LM model to analyze the short run, when the price level is assumed fixed.  However, a change in P would shift LM and therefore affect Y.  The aggregate demand curve (introduced in Chap. 9) captures this relationship between P and Y.

83. Y1Y1 Y2Y2 Deriving the AD curve Y r Y P IS LM(P 1 ) LM(P 2 ) AD P1P1 P2P2 Y2Y2 Y1Y1 r2r2 r1r1 Intuition for slope of AD curve:  P   (M/P )  LM shifts left  r r  I I  Y Y

84. Monetary policy and the AD curve Y P IS LM(M 2 /P 1 ) LM(M 1 /P 1 ) AD 1 P1P1 Y1Y1 Y1Y1 Y2Y2 Y2Y2 r1r1 r2r2 The Fed can increase aggregate demand:  M  LM shifts right AD 2 Y r  r r  I I   Y at each value of P

85. Y2Y2 Y2Y2 r2r2 Y1Y1 Y1Y1 r1r1 Fiscal policy and the AD curve Y r Y P IS 1 LM AD 1 P1P1 Expansionary fiscal policy (  G and/or  T ) increases agg. demand:  T   C  IS shifts right   Y at each value of P AD 2 IS 2

86. IS-LM and AD-AS in the short run & long run Recall from Chapter 9: The force that moves the economy from the short run to the long run is the gradual adjustment of prices. rise fall remain constant In the short-run equilibrium, if then over time, the price level will

87. The SR and LR effects of an IS shock A negative IS shock shifts IS and AD left, causing Y to fall. Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1

88. The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium,

89. The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 2 AD 1 In the new short-run equilibrium, Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down

90. AD 2 The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 SRAS 2 P2P2 LM(P 2 ) Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down Over time, P gradually falls, causing SRAS to move down M/P to increase, which causes LM to move down

91. AD 2 SRAS 2 P2P2 LM(P 2 ) The SR and LR effects of an IS shock Y r Y P LRAS IS 1 SRAS 1 P1P1 LM(P 1 ) IS 2 AD 1 This process continues until economy reaches a long-run equilibrium with

92. NOW YOU TRY: Analyze SR & LR effects of  M a. Draw the IS-LM and AD-AS diagrams as shown here. b. Suppose Fed increases M. Show the short-run effects on your graphs. c. Show what happens in the transition from the short run to the long run. d. How do the new long-run equilibrium values of the endogenous variables compare to their initial values? Y r Y P LRAS IS SRAS 1 P1P1 LM( M 1 /P 1 ) AD 1

93. The Great Depression Unemployment (right scale) Real GNP (left scale) 120 140 160 180 200 220 240 192919311933193519371939 billions of 1958 dollars 0 5 10 15 20 25 30 percent of labor force

94. THE SPENDING HYPOTHESIS: Shocks to the IS curve  asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.  evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

95. THE SPENDING HYPOTHESIS: Reasons for the IS shift  Stock market crash  exogenous  C – Oct-Dec 1929: S&P 500 fell 17% – Oct 1929-Dec 1933: S&P 500 fell 71%  Drop in investment – “correction” after overbuilding in the 1920s – widespread bank failures made it harder to obtain financing for investment  Contractionary fiscal policy – Politicians raised tax rates and cut spending to combat increasing deficits.

96. THE MONEY HYPOTHESIS: A shock to the LM curve  asserts that the Depression was largely due to huge fall in the money supply.  evidence: M1 fell 25% during 1929-33.  But, two problems with this hypothesis: – P fell even more, so M/P actually rose slightly during 1929-31. – nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

97. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  asserts that the severity of the Depression was due to a huge deflation: P fell 25% during 1929-33.  This deflation was probably caused by the fall in M, so perhaps money played an important role after all.  In what ways does a deflation affect the economy?

98. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The stabilizing effects of deflation:   P   (M/P )  LM shifts right   Y  Pigou effect:  P   (M/P )  consumers’ wealth    C  IS shifts right   Y

99. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The destabilizing effects of expected deflation:  E   r  for each value of i  I  because I = I (r )  planned expenditure & agg. demand   income & output 

100. THE MONEY HYPOTHESIS AGAIN: The effects of falling prices  The destabilizing effects of unexpected deflation: debt-deflation theory  P (if unexpected)  transfers purchasing power from borrowers to lenders  borrowers spend less, lenders spend more  if borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y falls

101. Why another Depression is unlikely  Policymakers (or their advisors) now know much more about macroeconomics: – The Fed knows better than to let M fall so much, especially during a contraction. – Fiscal policymakers know better than to raise taxes or cut spending during a contraction.  Federal deposit insurance makes widespread bank failures very unlikely.  Automatic stabilizers make fiscal policy expansionary during an economic downturn.

102. CASE STUDY The 2008-09 Financial Crisis & Recession  2009: Real GDP fell, u-rate approached 10%  Important factors in the crisis: – early 2000s Federal Reserve interest rate policy – sub-prime mortgage crisis – bursting of house price bubble, rising foreclosure rates – falling stock prices – failing financial institutions – declining consumer confidence, drop in spending on consumer durables and investment goods

103. Interest rates and house prices

104. Change in U.S. house price index and rate of new foreclosures, 1999-2009

105. House price change and new foreclosures, 2006:Q3 – 2009Q1 New foreclosures, % of all mortgages Cumulative change in house price index Nevada Georgia Colorado Texas Alaska Wyoming Arizona California Florida S. Dakota Illinois Michigan Rhode Island N. Dakota Oregon Ohio New Jersey Hawaii

106. U.S. bank failures by year, 2000-2009 * as of July 24, 2009. *

107. Major U.S. stock indexes (% change from 52 weeks earlier)

108. Consumer sentiment and growth in consumer durables and investment spending

109. Real GDP growth and Unemployment