Macroeconomics of Business Cycles - Intermediate Macroeconomics - Lecture Slides, Slides of Introduction to Macroeconomics

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Macroeconomics of Business Cycles m ac ro Docsity.com Growth rates of real GDP, consumption -4 -2 0 2 4 6 8 10 1970 1975 1980 1985 1990 1995 2000 2005 2010 Percent change from 4 quarters earlier Average growth rate Real GDP growth rate Consumption growth rate Docsity.com Okun’s Law Percentage change in real GDP Change in unemployment rate -4 -2 0 2 4 6 8 10 -3 -2 -1 0 1 2 3 4 = −3 2Y u Y ∆ ∆ 1975 1982 1991 2001 1984 1951 1966 2003 1987 2008 1971 Docsity.com Facts about the business cycle • GDP growth averages about 3 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. Docsity.com 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. Docsity.com 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. Docsity.com 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 Docsity.com Aggregate demand • 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 Docsity.com Aggregate supply in the long run • Recall from Chapter 3: In the long run, output is determined by factor supplies and technology ,= ( )Y F K L is the full-employment or natural level of output, at which the economy’s resources are fully employed. Y “Full employment” means that unemployment equals its natural rate (not zero). Docsity.com The long-run aggregate supply curve does not depend on P, so LRAS is vertical. Y P LRAS Y ( )= , Y F K L Docsity.com Long-run effects of an increase in M An increase in M shifts AD to the right. Y P AD1 LRAS Y P1 P2 In the long run, this raises the price level… …but leaves output the same. AD2 Docsity.com From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? Y Y> Y Y< Y Y= 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. Docsity.com The SR & LR effects of ∆M > 0 A = initial equilibrium Y P AD1 LRAS Y P SRAS P2 Y2 A B C B = new short- run eq’m after Fed increases M C = long-run equilibrium AD2 Docsity.com P SRAS LRAS AD2 The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. Y P AD1 Y P2 Y2 A B C Over time, prices fall and the economy moves down its demand curve toward full- employment. Docsity.com 1P SRAS1 Y P AD LRAS YY2 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. 2P SRAS2 Docsity.com CASE STUDY: The 1970s oil shocks Predicted effects of the oil shock: • inflation ↑ • output ↓ • unemployment ↑ …and then a gradual recovery. 0% 10% 20% 30% 40% 50% 60% 70% 1973 1974 1975 1976 1977 4% 6% 8% 10% 12% Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) Docsity.com CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 0% 10% 20% 30% 40% 50% 60% 1977 1978 1979 1980 1981 4% 6% 8% 10% 12% 14% Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) Docsity.com Stabilizing output with monetary policy 1P SRAS1 Y P AD1 B A Y2 LRAS Y The adverse supply shock moves the economy to point B. 2P SRAS2 Docsity.com Stabilizing output with monetary policy 1P Y P AD1 B A C Y2 LRAS Y But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level. 2P SRAS2 AD2 Docsity.com 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 Docsity.com Elements of the Keynesian Cross ( )C C Y T= − I I= ,G G T T= = = − + +( )PE C Y T I G =Y PE consumption function: for now, planned investment is exogenous: planned expenditure: equilibrium condition: govt policy variables: actual expenditure = planned expenditure Docsity.com The equilibrium value of income income, output, Y PE planned expenditure PE =Y PE =C +I +G Equilibrium income Docsity.com An increase in government purchases Y PE PE =C +I +G1 PE1 = Y1 PE =C +I +G2 PE2 = Y2 ∆Y At Y1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium. ∆G Docsity.com 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. Docsity.com An increase in taxes Y PE PE =C2 +I +G PE2 = Y2 PE =C1 +I +G PE1 = Y1 ∆Y At Y1, 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: Docsity.com Solving for ∆Y Y C I G∆ = ∆ + ∆ + ∆ ( )MPC= × ∆ − ∆Y T C= ∆ (1 MPC) MPC− ×∆ = − × ∆Y T eq’m condition in changes I and G exogenous Solving for ∆Y : MPC 1 MPC  − ∆ = × ∆ −  Y TFinal result: Docsity.com Y2 Y1 Y2 Y1 Deriving the IS curve ↓r ⇒ ↑I Y PE r Y PE =C +I (r1 )+G PE =C +I (r2 )+G r1 r2 PE =Y IS ∆I ⇒ ↑PE ⇒ ↑Y Docsity.com Y2 Y1 Y2 Y1 Shifting the IS curve: ∆G At any value of r, ↑G ⇒ ↑PE ⇒ ↑Y Y PE r Y PE =C +I (r1 )+G1 PE =C +I (r1 )+G2 r1 PE =Y IS1 The horizontal distance of the IS shift equals IS2 …so the IS curve shifts to the right. 1 1 MPC ∆ = ∆ − Y G ∆Y Docsity.com 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 Docsity.com Equilibrium The interest rate adjusts to equate the supply and demand for money: M/ P real money balances r interest rate ( )sM P M P ( )M P L r= L (r ) r1 Docsity.com How the Fed raises the interest rate To increase r, Fed reduces M M/ P real money balances r interest rate 1M P L (r ) r1 r2 2M P Docsity.com The LM curve Now let’s put Y back into the money demand function: ( , )M P L r Y= 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: ( )dM P L r Y= ( , ) Docsity.com 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 C Y T I r G= − + + Y r ( , )M P L r Y= IS LM Equilibrium interest rate Equilibrium level of income Docsity.com 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 ( ) ( )Y C Y T I r G= − + + ( , )M P L r Y= IS Y r LM r1 Y1 Docsity.com causing output & income to rise. IS1 An increase in government purchases 1. IS curve shifts right Y r LM r1 Y1 1by 1 MPC G∆ − IS2 Y2 r2 1. 2. This raises money demand, causing the interest rate to rise… 2. 3. …which reduces investment, so the final increase in Y 1is smaller than 1 MPC G∆ − 3. Docsity.com 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… Docsity.com If Congress raises G, the IS curve shifts right. IS1 Response 1: Hold M constant Y r LM1 r1 Y1 IS2 Y2 r2 If Fed holds M constant, then LM curve doesn’t shift. Results: 2 1Y Y Y∆ = − 2 1r r r∆ = − Docsity.com If Congress raises G, the IS curve shifts right. IS1 Response 2: Hold r constant Y r LM1 r1 Y1 IS2 Y2 r2 To keep r constant, Fed increases M to shift LM curve right. 3 1Y Y Y∆ = − 0r∆ = LM2 Y3 Results: Docsity.com Percent Unemployment Rate With and Without the Recovery Plan oo e eee December ’09 = e 10, September 09 ——, ,* 9 May 199s 8 e With Recovery Plan 4 Maroon dots are actual unemployment data Everything in blue was created by Obarna's economic team hifo:“innocentbystanders. net qi Q3 qi Q3 qi Q3 qi Q3 qi Q3 qi Q3 qi Q3 qi 2007 2008 2009 2010 2011 2012 2013 2014 Docsity.com 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 Docsity.com 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. Docsity.com 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 Docsity.com 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 Docsity.com 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 Docsity.com Y2 Y2 r2 Y1 Y1 r1 Fiscal policy and the AD curve Y r Y P IS1 LM AD1 P1 Expansionary fiscal policy (↑G and/or ↓T ) increases agg. demand: ↓T ⇒ ↑C ⇒ IS shifts right ⇒ ↑Y at each value of P AD2 IS2 Docsity.com 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. Y Y> Y Y< Y Y= rise fall remain constant In the short-run equilibrium, if then over time, the price level will Docsity.com 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 Y LRAS Y IS1 SRAS1 P1 LM(P1) IS2 AD2 AD1 Docsity.com AD2 The SR and LR effects of an IS shock Y r Y P LRAS Y LRAS Y IS1 SRAS1 P1 LM(P1) IS2 AD1 SRAS2 P2 LM(P2) Over time, P gradually falls, causing • SRAS to move down • M/P to increase, which causes LM to move down Docsity.com AD2 SRAS2 P2 LM(P2) The SR and LR effects of an IS shock Y r Y P LRAS Y LRAS Y IS1 SRAS1 P1 LM(P1) IS2 AD1 This process continues until economy reaches a long-run equilibrium with Y Y= Docsity.com 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 Y LRAS Y IS SRAS1 P1 LM(M1/P1) AD1 Docsity.com 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. Docsity.com 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. Docsity.com 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? Docsity.com 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 Docsity.com Why another Depression is unlikely • Policymakers (or their advisors) now know much more about macroeconomics • Federal deposit insurance makes widespread bank failures very unlikely. • Automatic stabilizers make fiscal policy expansionary during an economic downturn. Docsity.com The Great Recession 2008-2009 • NBER: December 2007 to June 2009 – Real GDP fell by 4%, u-rate hit 10.6% • Important factors in the crisis: Docsity.com House price change and new foreclosures, 2006:Q3 – 2009Q1 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% -40% -30% -20% -10% 0% 10% 20% N ew fo re cl os ur es , % o f a ll m or tg ag es 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 Docsity.com U.S. bank failures by year, 2000-2010 0 20 40 60 80 100 120 140 160 180 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 N um be r o f b an k fa ilu re s Docsity.com Major U.S. stock indexes (% change from 52 weeks earlier) -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140% 12 /6 /1 99 9 8/ 13 /2 00 0 4/ 21 /2 00 1 12 /2 8/ 20 01 9/ 5/ 20 02 5/ 14 /2 00 3 1/ 20 /2 00 4 9/ 27 /2 00 4 6/ 5/ 20 05 2/ 11 /2 00 6 10 /2 0/ 20 06 6/ 28 /2 00 7 3/ 5/ 20 08 11 /1 1/ 20 08 7/ 20 /2 00 9 DJIA S&P 500 NASDAQ Docsity.com