1. 13 CHAPTER D YNAMIC P OWER P OINT ™ S LIDES BY S OLINA L INDAHL Business Fluctuations: Aggregate Demand and Supply

2. CHAPTER OUTLINE The Dynamic Aggregate Demand Curve The Solow Growth Curve Real Shocks Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Shocks to the Components of Aggregate Demand Understanding the Great Depression: Aggregate Demand Shocks and Real Shocks For applications, click herehere To Video To Video

3. Some good blogs and other sites to get the juices flowing: Food for Thought….

4. B ACK TO Introduction Economic Growth is Not a Smooth Process Real GDP grew at an average rate of 3% over the past 50 years. Growth wasn’t smooth. business fluctuation A business fluctuation is a fluctuation in the growth rate of real GDP around its trend growth rate.

5. B ACK TO Introduction Economic Growth is Not a Smooth Process What causes the deviations from the average: booms and recessions recession A recession is a significant, widespread decline in real income and employment. (Shaded blue areas)

6. B ACK TO The Model To understand booms and recessions, we use the dynamic aggregate demand framework. Ultimately the model will have 3 curves: 1.Dynamic aggregate demand curve 2.Solow growth curve 3.Short-run aggregate supply curve

7. B ACK TO The Dynamic Aggregate Demand Curve Aggregate Demand Curve: Aggregate Demand Curve: A curve showing all the combinations of inflation and real growth that are consistent with a specified rate of spending growth. Deriving the Dynamic Aggregate Demand Curve from the quantity theory in dynamic form: Where represents total spending growth.

8. B ACK TO The Dynamic Aggregate Demand Curve The rate of spending growth = so that: Spending growth = Inflation + Real Growth Important: For a given level of spending growth the AD curve shows the combinations of inflation and real growth that add up to that spending growth.

9. B ACK TO The Dynamic Aggregate Demand Curve Plotting inflation against real growth gives a dynamic AD curve for each level of spending growth.

10. B ACK TO The Dynamic Aggregate Demand Curve AD curve when spending growth = 5% Real GDP growth rate 2% -2%0% 5% 7% Inflation Rate (  ) 0% 7%5%3% AD (spending growth = 5%) Note: The sum of inflation and real growth will always equal spending growth, which equals money growth plus the growth of velocity. e.g. 5% + 0% = 5% 2% + 3% = 5%

11. B ACK TO The Dynamic Aggregate Demand Curve AD curve when spending growth = 7% Real GDP growth rate 2% -2%0% 5% 7% Inflation Rate (  ) 0% 7%5%3% AD (spending growth = 7%) Conclusion: 1.Increases in spending growth, shifts the AD curve to the right. 2.Decreases in spending growth, shifts the AD curve to the left. AD (spending growth = 5%)

12. B ACK TO Building the Model Moving on to the next piece of the model: 1.Dynamic aggregate demand curve 2.Solow growth curve 3.Short-run aggregate supply curve

13. B ACK TO The Solow Growth Curve Solow growth rate: Solow growth rate: is an economy’s potential growth rate, the rate of economic growth that would occur given flexible prices and existing real factors of production. Important point: If markets are working well and prices are perfectly flexible, the economy will grow at the potential growth rate.

14. B ACK TO The Solow Growth Curve Real GDP growth rate Inflation Rate (  ) Solow growth curve 3% Why is the Solow Growth Curve vertical ? Potential growth does not depend on the inflation rate.

15. B ACK TO What causes the Solow Growth Curve to Shift? Real GDP growth rate Inflation Rate (  ) Solow growth curve 7% Real shocks (“Productivity Shocks”) Real shocks (“Productivity Shocks”) which increase or decrease the potential growth rate. Positive productivity shocks increase the ability of the economy to produce. Negative productivity shocks decrease the ability of the economy to produce. Negative shock Positive shock -1%3%

16. An increase in inflation will cause the Solow growth curve to: a)shift inward. b)shift outward. c)not shift at all. d)shift randomly.

17. Solow growth rates fluctuate over time because of: a)real shocks. b)monetary shocks. c)changes in the rate of inflation. d)All of the answers are correct.

18. Which of the following choices can explain the shift of the Solow growth curve from A to B in the figure above? a)development of new technology b)negative supply shock c)war d)oil crisis

19. B ACK TO The Solow Growth Curve and AD Putting the AD and the Solow growth curve together. Real GDP growth rate Inflation Rate (  ) Solow growth curve 3% 7% AD Equilibrium

20. B ACK TO The Solow Growth Curve and AD Putting the AD and the Solow growth curve together. Real GDP growth rate Inflation Rate (  ) Solow growth curve 7% Negative shock Positive shock -1%3% 7% Conclusions: 1. A positive shock results in a higher real growth rate, 7%, and lower inflation, 3%. 2. A negative shock results in a lower real growth rate, -1%, and higher inflation, 11%. 11% AD

21. Take a look….. Besides co-authoring this text, Tyler Cowen writes the most popular Economics blog, he has written a book called “The Great Stagnation.” Here is clip of Paul Solman’s (PBS Newshour) interview which focuses on the question, Why Hasn't Recent Technology Created More Jobs? (8:56 minutes) http://www.youtube.com/watch?v=yxaiWFwAfUc B ACK TO

22. Real Shocks If there are rapid changes in economic conditions that affect the productivity of capital and labor then the economy’s growth rate will change. Rainfall Shocks in India Correlate Well with Agricultural Output and GDP Source: Reserve Bank of India and Indian Institute of Tropical Meteorology

23. B ACK TO Real Shocks: The Price of Oil and U.S. Recessions Note: Real price of oil per barrel in $2000.

24. B ACK TO Real Shocks: The Price of Oil and U.S. Recessions Real Output Growth Response to a 10 Percent Increase in Oil Price Source: Stylized graph based on results in Sill, Keith. 2007. “The Macroeconomics of Oil Shocks.” Federal Reserve Bank of Philadelphia, Business Review Q1: 21–31. Oil shocks create disruptions, bottlenecks and recessions- and impact growth for two years.

25. B ACK TO Real Shocks: Examples & Analysis

26. B ACK TO Building the Model Moving on to the next piece of the model: 1.Dynamic aggregate demand curve 2.Solow growth curve 3.Short-run aggregate supply curve

27. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve To understand why aggregate demand (AD) shocks matter, we need to look at the behavior of prices and short-run aggregate supply (SRAS). aggregate demand shock An aggregate demand shock is a rapid and unexpected shift in the AD curve (spending).

28. SEE THE INVISIBLE HAND John Maynard Keynes (1883-1946) The General Theory of Employment, Interest, and Money, 1936. Wrote in the context of the Great Depression. Explained that when prices are not perfectly flexible (sticky), deficiencies in aggregate demand could cause recessions Key to the model: when prices are sticky, the economy can grow faster or slower than the Solow growth rate.

29. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve The Short-Run Aggregate Supply Curve If wages are not as flexible as prices… Inflation will result in higher profits. Result: higher profits lead to increased output, or, real GDP growth. Two reasons why there can be a positive relationship between the inflation rate and the growth rate of real GDP in the short-run : 1.Sticky wages 2.Sticky prices

30. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve 1.Sticky Wages Expected inflation is built into labor contracts. What happens if inflation is higher or lower than expected? Result: An upward sloping SRAS curve. Inflation higher that expected Prices increase faster than wages Profits increase Firms increase Output and real GDP growth increases Inflation lower that expected Prices increase slower than wages Profits decrease Firms decrease Output and real GDP growth decreases

31. If prices are perfectly flexible, the economy will always be growing: a)at its potential rate. b)below its potential rate. c)above its potential rate. d)near its potential rate.

32. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve short-run aggregate supply curve (SRAS) The short-run aggregate supply curve (SRAS) shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky.

33. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Real GDP growth rate Inflation Rate (  ) Solow growth curve 3% 2% AD Short Run aggregate supply (SRAS)( E(  = 2%) Conclusions: 1.Sticky wages result in an upward sloping SRAS. 2.There is a different SRAS for every level of expected inflation, E( .

34. If the growth rate of money is 3%, and the growth rate of velocity is 1%, the growth rate of nominal GDP is: a)4%. b)1%. c)0%. d)2%.

35. B ACK TO Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Real GDP growth rate Inflation Rate (  ) Solow growth curve 3% 2% (SRAS 2 ) ( E(  = 4%) (SRAS 1 ) ( E(  = 2%) 4% 6% 7% If  = 2% and E(  = 2%, economy stays at point a. If  = 4% and E(  = 2%, economy moves to b. and real growth ↑ to 7% If  = 4% and E(  = 4%, SRAS shifts up and economy stays at point c. If  = 4% and E(  = 6%, economy moves to d. and real growth ↑ to 7% a b c d

36. If  >  e : a)firms' profits will increase. b)money growth will cause the short-run aggregate supply curve to shift. c) firms' profits will decrease. d) there will be no change in real GDP growth because it is determined by real factors.

37. B ACK TO Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Nominal Wage Confusion Menu Costs Uncertainty Nominal wage confusion: Nominal wage confusion: when workers respond to their nominal wage instead of to their real wage, when workers respond to the wage number on their paychecks rather than to what their wage can buy in goods and services (the wage after correcting for inflation).

38. B ACK TO Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Menu costs: Menu costs: the costs of changing prices. Printing costs and the desire not to upset consumers with rapid price changes keep firms from changing prices frequently.

39. B ACK TO Why is the SRAS Upward-Sloping? (Why Do Spending Increases Temporarily Increase Growth?) Uncertainty causes firms to hold off changing prices. They can be unsure about whether: A shock is permanent or temporary. Increases in demand are nominal, caused by inflation, or real. Sticky prices cause upward sloping SRAS

40. B ACK TO In the Long Run, Real Growth Eventually Returns to the Solow Rate An Unexpected increase in Inflation Rate (  ) Solow growth curve 3% 2% (SRAS 2 ) (E(  = 7%) (SRAS 1 ) (E(  = 2%) 4% 7% 6% a b c Real GDP growth rate AD 2 AD 1 Short-run: a → b 1.Real growth ↑ to 6%  ↑ to 4% Long-run: b → c 1.Real growth ↓ to 3%  ↑ to 7%

41. B ACK TO A Fall in Aggregate Demand Could Induce a Lengthy Recession Sometimes the adjustment (and pain) takes a while. Inflation Rate (  ) Solow growth curve -1% 6% (SRAS 1 ) (E(  = 7%) 7% 3% a b Real GDP growth rate AD 1 AD 2 Short-run: a → b 1.Real growth ↓ to -1%  ↓ to 6% Long-run: b → c 1.Real growth ↑ to 3% as prices become unstuck 0% c

42. B ACK TO Shocks to the Components of Aggregate Demand Other Factors that Shift the AD Curve 1.Fear and confidence also affect growth of investment spending,, as well as. Fear about the future will cause business people to put off large investments in capital. Confidence about the future will result in greater investment spending by businesses. 2.Wealth shocks can also increase or decrease AD. Negative wealth shock→ Positive wealth shock →

43. B ACK TO Shocks to the Components of Aggregate Demand 3.Taxes also shift and. ↑ (↓) in taxes can ↓ (↑). Taxes targeted at investment (i.e. investment tax credit) will have a similar effect on. 4.Changes in government spending,, shift AD. ↑ (↓) → shift the AD to the right (left). 5.Changes in the growth of net exports, NX. Other countries ↑ spending on our goods → ↑ AD. We ↑ our spending on foreign goods → ↓AD.

44. B ACK TO Changes in the rate of growth of velocity. It is easier to think of changes in working through. Example: A reduction in working through a reduction in. Workers may become fearful of losing their jobs and reduce consumption. Shocks to the Components of Aggregate Demand

45. B ACK TO A Temporary Shock to the Aggregate Demand and the Adjustment A temporary reduction in working through a reduction in Inflation Rate (  ) Solow growth curve -1% 6% (SRAS 1 ) (E(  = 7%) 7% 3% a b Real GDP growth rate AD 1 AD 2 Short-run: a → b 1.Real growth ↓ to -1%  ↓ to 6% Long-run: b → a 1.Real growth ↑ to 3%  ↑ to 7% 0%

46. B ACK TO What did we learn from this example? A negative spending shock reduces the real growth rate and inflation in the short-run only. Why?: Changes in spending growth are temporary. Shares of GDP devoted to C, I, G, and NX have been stable over time. This implies that their growth rates must also be stable. Changes in the growth rates of spending do not change the long-run rate of inflation. Shocks to the Components of Aggregate Demand

47. B ACK TO Shocks to the Components of Aggregate Demand A final important point: We know now that changes in spending growth,, shift the AD curve. A fundamental difference between and is that can be set at any permanent rate Changes in are temporary. Conclusion: Sustained inflation requires continuing increases in the money supply.

48. B ACK TO Shocks to the Components of Aggregate Demand

49. B ACK TO The Great Depression (1929-1940) Most catastrophic economic event in the history of the United States. GDP plummeted by 30 percent. Unemployment rates exceeded 20 percent. Stock market fell by more than two thirds. It was a worldwide event. Germany: Led to a totalitarian regime. The Great Depression became “Great” because policy makers allowed aggregate demand to collapse. Understanding the Great Depression

51. B ACK TO Understanding the Great Depression Shocks to AD and the Great Depression October 1929: the stock market crashed. Caused in part by tight monetary policy aimed at limiting a stock market bubble. Created a wealth shock. Along with the tight monetary policy → AD curve shifted to the left. 1930: Depositors lost confidence in their banks and they withdrew their deposits. 1929-1933: Four waves of bank panics. By 1933, 40% of all American banks failed.

52. Crowd at New York's American Union Bank during a bank run early in the Great Depression. The Bank opened in 1917 and went out of business on June 30, 1931.

53. B ACK TO Understanding the Great Depression Shocks to Aggregate Demand and the Great Depression Between 1929 and 1933 investment spending fell by nearly 75%. Spending on new capital was not enough to replace depreciated capital. By 1940 the U.S. capital stock was lower than it was in 1930. The Fed allowed the money supply to fall by 1/3. This is the largest negative shock in U.S. history.

54. B ACK TO Understanding the Great Depression Shocks to Aggregate Demand and the Great Depression What should the Fed have done? Increase the money supply To drive up AD and output. Increase reserves of banks to stop panics. 1937-1938: The Fed caused another monetary contraction. Contracted the economy and unemployment increased. Prolonged the “Great Depression.”

55. B ACK TO Understanding the Great Depression The Great Depression and the Great Fall in AD Real GDP growth rate Inflation Rate (  ) Solow growth curve -13% 0% AD SRAS -10% 4% 1. 2. 3.3. AD

56. B ACK TO Understanding the Great Depression Real Shocks and the Great Depression Real shocks played a role in the failure of the economy to recover more quickly. We will look at three: 1.Bank failures reduced the efficiency of financial intermediation. The bridge between savers and investors collapsed. Small businesses were especially harmed because they couldn’t get credit.

57. B ACK TO Understanding the Great Depression 2.Smoot-Hawley Tariff of 1930 Intent: increase demand for domestic goods. What really happened: Other countries retaliated with tariffs and exports fell. This reduced AD. A tariff is a negative productivity shock (shifts LRAS to the left). Pushes capital and labor into lower productivity sectors.

58. B ACK TO Understanding the Great Depression 3.The Dust Bowl: natural disasters are negative real shocks Severe drought turned millions of acres of farmland to dust. The Dust Bowl: a real shock

59. Discuss the 2008 Financial Crisis and identify what type of shock hit the economy: a “real” shock or a demand-side shock? If you like, look at www.bls.gov and www.bea.gov for a look at inflation and GDP for evidence.www.bls.govwww.bea.gov B ACK TO