layout: true background-image: url(figs/tcb-logo.png) background-position: bottom right background-attachment: fixed; background-origin: content-box; background-size: 10% --- class: title-slide .row[ .col-7[ .title[ # Principles of Macroeconomics ] .subtitle[Business Fluctuations ] .author[ ### Dennis A.V. Dittrich ] .affiliation[ ] ] .col-5[ ] ] --- # The Birth of Macroeconomics .row[ .col-6[ ### The U.S. Great Depression A deep recession that began in 1929 and lasted for 10 years * Output fell by 30% * Unemployment rose to 25% * It was a defining event that undermined people's faith in markets * Led to emphasis on the short-run and the demand side of the economy and the development of macroeconomic theory separate from microeconomics ] .col-6[ ### Classical Economists * Earlier economists who focused on long-run issues * Markets were self-regulating through the _invisible hand_ * The economy would always return to its potential output and target rate of unemployment in the long run * Blamed the Depression on labor unions and government policies that prevented prices from falling * Advocated a laissez-faire economic policy ] ] --- # "In the long run, we're all dead" .row[.col-7[ Problems of the Depression required a short-run, rather than long-run, focus First outlined in 1936 by John Maynard Keynes Adjustments to equilibrium for a single market (micro issue) and the aggregate economy (macro issue) are different Keynesians argued that, in times of recession, spending is a public good that benefits everyone Short-run equilibrium income may differ from long-run potential income **Equilibrium income** is the level of income toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production **Potential income** is the level of income that the economy technically is capable of producing without generating accelerating inflation ] .col-5[ ![](img09/f32keynes.jpg) ] ] --- # Keynesian Economics .col-7[ Market forces may not be strong enough to get the economy out of a recession **Paradox of thrift** * In the long run, saving leads to investment and growth * In the short run, saving may lead to a decrease in spending, output, and employment **Aggregate demand management**, which is government's attempt to control the aggregate level of spending, may be necessary Keynesian economists advocated an activist demand management policy ] --- ## Economic Growth is Not a Smooth Process .row[.col-6[ ![](img09/f3202.jpg) ] .col-6[ ![](img09/f3201.jpg) ]] .col-7[ * Real GDP grew at an average rate of 3% over the past 50 years. Growth wasn't smooth. * A business fluctuation is a fluctuation in the growth rate of real GDP around its trend growth rate. * A recession is a significant, widespread decline in real income and employment. (Shaded blue areas) ] --- class: practice-slide # 1. .col-8[ What is (the) Aggregate Demand (Curve)? ] ??? A curve showing all the combinations of inflation and real growth that are consistent with a specified rate of spending growth. 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. --- # The Dynamic Aggregate Demand Curve .row[.col-7[ ![](img09/f3203.jpg) ] .col-5[ A curve showing all the combinations of inflation and real growth that are consistent with a specified rate of spending growth. 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. ]] --- class: practice-slide # 2. .col-8[ What leads to a shift in the aggregate demand curve? ] ??? Increases in spending growth lead to a shift to the right. Decreases in spending growth lead to a shift to the left. A shift in the AD curve means that at every inflation level, total expenditures growth has changed. important shift factors are: changes in the money growth rate changes in consumer and/or business confidence changes in taxes changes in government spending changes in export or import growth Deliberate shifting of the AD curve is what most policy makers mean by macro policy --- # The Dynamic Aggregate Demand Curve .row[ .col-6[ Deriving the Dynamic Aggregate Demand Curve from the quantity theory of money in dynamic form: `$$\vec{M}+\vec{v} =\vec{P}+\vec{Y}$$` The AD curve represents a specific nominal spending growth, e.g. 5%, so that: `$$\text{nominal spending growth }= \vec{M}+\vec{v} =\vec{P}+\vec{Y}$$` Increases in spending growth lead to a shift to the right. Decreases in spending growth lead to a shift to the left. A shift in the AD curve means that at every inflation level, total expenditures growth has changed. Deliberate shifting of the AD curve is what most policy makers mean by macro policy ] .col-6[ Important shift factors are: * changes in the money growth rate * changes in consumer and/or business confidence * changes in taxes * changes in government spending * changes in export or import growth .col-10[ ![](img09/f3204.jpg) ] ]] --- ## 3. .row[ .col-4[![](img09/f3203.jpg) ] .col-2[] .col-5[![](img09/f3204.jpg) ] ] .row[ .col-6[ a. When you look at a fixed dynamic aggregate demand curve, like in Figure 32.3, what is being held constant (choose one): 1. Spending growth (growth in M + v), 2. Real GDP growth (growth in Y), or 3. Inflation (growth in P) ] .col-6[ b. When you look at a shifting aggregate demand curve, like in Figure 32.4, what had to change to make the curve shift (choose one): 1. Spending growth or 2. Real GDP growth or 3. Inflation ] ] ??? a. Spending growth is held constant. b. Spending growth increases to shift the curve. --- # Solow growth rate .row[ .col-6[ ...an economy's **potential growth** rate, the rate of economic growth that would occur given flexible prices and existing real factors of production used efficiently. If markets are working well and prices are perfectly flexible, the economy will grow at the potential growth rate. Potential growth does not depend on the inflation rate. **Real shocks** (_Productivity Shocks_) 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. ] .col-6[ ![](img09/f3205.jpg) ]] --- class: practice-slide # 4. .col-8[ What determines the long run aggregate supply? ] ??? An economy’s potential growth rate, the rate of economic growth that would occur given flexible prices and existing real factors of production. If markets are working well and prices are perfectly flexible, the economy will grow at the potential growth rate. Potential growth does not depend on the inflation rate. Real shocks (”Productivity Shocks”) increase or decrease the potential growth rate. Increases in the Solow Growth Curve are caused by increases in: Capital Resources Growth-compatible institutions Technology Entrepreneurship --- # The Solow Growth Curve .row[ .col-5[ .col-10[ ![](img09/f3205.jpg) ] Increases in the Solow Growth Curve are caused by increases in: * Capital * Resources * Growth-compatible institutions * Technology * Entrepreneurship ] .col-7[ ![](img09/c26-3c.jpg) ]] --- ## Long-run Equilibrium: ## The Solow Growth Curve and AD .row[.col-6[ .col-11[![](img09/f3206.jpg) ]] .col-6[ The notion of _long-run_ equilibrium does not necessarily imply that a long period of time is required to achieve it, but rather, only a period of time long enough that prices have fully adjusted. ]] --- class: practice-slide # 5. .col-8[ When negative real shocks hit, what typically happens to the long-run aggregate supply curve: Does it shift left, shift right, or stay in the same place? ] --- ## Real Shocks Shift the Solow Growth Curve .col-8[![](img09/f3207.jpg) ] --- # Real Shocks ![](img09/tab3201.jpg) --- class: practice-slide # 6. .col-8[ If the long-run aggregate supply curve increased because of a sudden fall in the price of oil, what would happen to inflation? Assume that spending growth (aggregate demand) does not change—only the LRAS curve shifts. Draw the AS-AD graph. ] --- ## Key Characteristics of Fluctuations Caused by Real Shocks .col-7[ * Business fluctuations result from shifts in the Solow growth curve. * Fluctuations are accompanied by changes in the inflation rate. * Changes in money growth have no real effects, but cause proportionate changes in inflation (money is neutral in the long run). * Inflation is a monetary phenomenon (since money is the only factor that can permanently shift the AD curve). ] --- # John Maynard Keynes (1883-1946) .row[.col-7[ ![](img09/c30-004.png) John Maynard Keynes (1883-1946) --- The General Theory of Employment, Interest, and Money, 1936. ] .col-5[ 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. ]] --- # 7. .row[ .col-7[ Assume that in the long run, workers offer a fixed supply of labor: In other words, while they may be picky about jobs in the short run, in the long run they’ll work regardless of the going wage. It’s the businesses who demand labor and workers who supply labor. Assume the economy starts off at long-run equilibrium, so that the normal number of workers, `\(Q^*\)`, are working. a. Suppose labor demand falls, shifting to the left, as in the figure. What does the short-run supply curve for labor look like if workers refuse to take pay cuts even if it means losing their jobs (we can call this the “take this job and shove it” strategy after the famous country and Western song). Indicate your answer by drawing a new line on the figure, labeling it “Short-run labor supply.” You only need to focus on the area to the left of Q*. ] .col-5[ ![](img09/e3201.jpg) ]] ??? --- # 1. .row[ .col-7[ b. Recalling your basic supply and demand model, does this fall in labor demand then create a “surplus” of workers or a “shortage” of workers? c. According to the basic supply and demand model, what will happen to the price of labor over time as a result of this fall in labor demand? ] .col-5[ ![](img09/e3201.jpg) ]] ??? b. This creates a surplus of workers: Short-run wage stickiness works just like a price floor. c. The supply and demand model says that when there’s a surplus, the price tends to fall. Here, the wage is the important price, so it will tend to fall, but it may take time because the endowment effect makes workers reluctant to take a pay cut until they are certain that they cannot get higher wages elsewhere. --- ## Aggregate Demand Shocks and ## the Short-Run Aggregate Supply Curve .col-6[ An **aggregate demand shock** is a rapid and unexpected shift in the AD curve (spending). 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 **The Short-Run Aggregate Supply Curve** If wages are not as flexible as prices... * Inflation will result in higher profits. * Higher profits lead to increased output, or, real GDP growth. ] --- ## The short-run aggregate supply curve (SRAS) .row[ .col-7[ ![](img09/f3211.jpg) ] .col-5[ Shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky. ]] --- class: practice-slide # 8. .col-8[ Why is the short run aggregate supply curve upward-sloping? ] ??? Shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky. Nominal Wage Confusion workers respond to their nominal wage instead of to their real wage, they 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). 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. 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 --- ## Why is the SRAS Upward-Sloping? .col-7[ **Nominal Wage Confusion** * workers respond to their nominal wage instead of to their real wage, they 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). **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. **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 ] --- class: practice-slide # 9. .row[ .col-7[ ![](img09/e3202.jpg) ] .col-5[ What is the inflation rate X? If spending growth were 15% in this economy, what would the inflation rate be in the long run, assuming the Solow growth rate stays fixed? ]] --- class: practice-slide # 10. .col-8[ In the following cases, will real growth rise, fall, or remain unchanged according to the New Keynesian model? Expected inflation 5%, Actual inflation 7% Expected inflation 3%, Actual inflation 1% Expected inflation 6%, Actual inflation 6% Expected inflation 7%, Actual inflation -10% Expected inflation -1%, Actual inflation 0% ] ??? Rise Fall No change Fall—maybe a big fall! Rise --- ## In the Long Run, Real Growth Eventually Returns to the Solow Rate .row[ .col-6[![](img09/f3212.jpg) Increase in money growth ] .col-6[![](img09/f3213.jpg) `\(\Rightarrow\)` Change in inflation expectations ] ] --- ## A Fall in Aggregate Demand ##Could Induce a Lengthy Recession .row[ .col-7[![](img09/f3214.jpg) ] .col-5[ Decrease in money growth `\(\Rightarrow\)` Fall in AD `\(\Rightarrow\)` Fall in real GDP growth ] ] --- # Other Factors that Shift the AD Curve .col-7[ **Fear** and **confidence** also affect growth of investment spending * 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. **Wealth shocks** can also increase or decrease AD. **Taxes** also shift consumption and investment Changes in **government spending** shift AD. Changes in the growth of **net exports**, NX. * Other countries increase spending on our goods leads to an increase in AD. * We increase our spending on foreign goods leads to a decrease in AD. ] --- class: practice-slide # 11. .col-8[ Under what circumstances can aggregate demand be increased without leading to problems with inflation? Under what circumstances is an increase in aggregate demand likely to cause inflation? ] --- ## A Temporary Shock to the AD and the Adjustment .row[ .col-6[ ![](img09/f3215.jpg) ] .col-6[ A change in the velocity: decrease in spending * 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. Sustained inflation requires continuing increases in the money supply. ]] --- ## Shocks to Aggregate Demand ![](img09/tab3202.jpg) --- class: practice-slide # 12. .col-8[ Firms experience a rise in stocks. Explain why this might have occurred and what you expect firms’ response to this event might be and how this might affect output. ] ??? The sell less than expected at the given price level: the economy contracts. The decrease future production, GDP declines. --- ## Key Characteristics of Fluctuations Caused by Demand Shocks .col-7[ * Business fluctuations result from shifts in the AD curve. * Changes in money growth (and demand shocks in general) have real effects in the short run, implying that money is not neutral in the short run. * Changes in money growth (and demand shocks in general) have no real effects in the long run, implying that money remains neutral in the long run. ] --- class: practice-slide # 13. .col-8[ Here is a puzzle. A country with a relatively small positive aggregate demand shock (a shift outward in the AD curve) may have a substantial economic boom, but sometimes countries that have massive increases in the AD curve (hyperinflation countries like Germany before World War II, e.g.) don’t seem to have massive economic booms. Why does a small AD increase sometimes raise GDP much more than a giant AD increase? ] ??? A very big AD increase is less likely to create real/nominal confusion of the type we talked about in Chapter 11. If consumers enter the bakery with wheelbarrows of cash, the baker is likely to figure out very quickly that this is not a real increase in the demand for bread but a nominal increase created by an increase in the money supply. Thus, when AD increases are big, then prices and wages become flexible very, very quickly, which pushes output right back to potential. --- # Aggregate Demand Policy .col-7[ * A primary reason for government policy makers' interest in the AS/AD model is that monetary or fiscal policy shifts the AD curve * Monetary policy involves the Central Bank changing the money supply and interest rates * Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy ] --- class: practice-slide # 14. .col-8[ In India, the economy grows faster when there’s a lot of rain and grows more slowly when there is a drought. This creates big fluctuations in the economy. If the government wrote laws to smooth out these fluctuations by paying people to work more in the dry years and by taxing people so that they would work less in the heavy-rain years, would that make the average Indian better off? Why or why not? ] ??? It would probably make the average Indian worse off because the returns to an additional hour of work are low. Working more when there’s no rain is a bad idea. As the saying goes, you should “make hay while the sun shines.” (This saying refers to the fact that if you gather hay when it’s damp outside, the hay is more likely to get moldy and musty.)