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National Income & Business Cycles Ohio Wesleyan University Goran Skosples 10. Oil Shocks of the 1970s and the Great Depression 0 Objectives Two case studies: 1. Oil shocks of the 1970s 2. The Great Depression 1 Supply shocks A supply shock alters production costs, affects the prices that firms charge. (also called ____ shocks) Examples of adverse supply shocks: • Bad weather reduces crop yields, pushing ____ __________. • Workers unionize, negotiate ______________. • New environmental regulations require firms to reduce emissions. Firms ________________ to help cover the costs of compliance. Favorable supply shocks _______ costs and prices. 2 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. 3 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS ____, causing output and employment to ___. In absence of further price shocks, prices will ___ over time and economy moves ______________ ______________. P LRAS A P1 SRAS1 AD Y Y 4 CASE STUDY: The 1970s oil shocks 70% Predicted effects of the oil shock: • inflation __ • output __ • unemployment _ …and then a gradual recovery. 12% 60% 50% 10% 40% 8% 30% 20% 6% 10% 0% 1973 1974 1975 1976 4% 1977 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 5 CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 60% 14% 50% 12% 40% 10% 30% 8% 20% 6% 10% 0% 1977 1978 1979 1980 4% 1981 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 6 CASE STUDY: The 1980s oil shocks 40% 1980s: A favorable supply shock-a significant fall in oil prices. As the model predicts, inflation and unemployment ______: 10% 30% 8% 20% 10% 6% 0% -10% 4% -20% -30% 2% -40% -50% 1982 1983 1984 1985 1986 0% 1987 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) 7 CASE STUDY: The 1970s oil shocks What is the prediction about interest rates? 8 Exercise An oil cartel effectively increases the price of oil by 100 percent, leading to an adverse supply shock in both Country A and Country B. Both countries were in long-run equilibrium at the same level of output and prices at the time of the shock. The central bank of Country A takes no stabilizingpolicy actions. After the short-run impacts of the adverse supply shock become apparent, the central bank of Country B increases the money supply to return the economy to full employment. a. Describe the short-run impact of the adverse supply shock on prices and output in each country. b. Compare the long-run impact of the adverse supply shock on prices and output in each country. 9 Exercise A r r LM0 (M0/P0) r0 IS1 Y0 P B Y Y0 P SRAS0 Y0 r0 IS1 LRAS Po LM0 (M0/P0) AD0 Y Y LRAS Po SRAS0 Y0 AD0 Y 10 The Great Depression U.S. Unemployment, Output Growth, Prices, and Money, 1929 to 1942 Year Unemployment Rate (%) 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 3.2 8.7 15.9 23.6 24.9 21.7 20.1 16.9 14.3 19.0 17.2 14.6 9.9 4.7 Output Growth Rate (%) 9.8 7.6 14.7 1.8 9.1 9.9 13.9 5.3 5.0 8.6 8.5 16.1 12.9 13.2 Price Level 100.0 97.4 88.8 79.7 75.6 78.1 80.1 80.9 83.8 82.2 81.0 81.8 85.9 95.1 Nominal Money Stock 26.6 25.7 24.1 21.1 19.9 21.9 25.9 29.5 30.9 30.5 34.1 39.6 46.5 55.3 11 Shocks to the IS curve an exogenous fall in the demand for goods & services – a leftward shift of the IS curve. 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. 12 A shock to the LM curve a huge fall in the money supply. evidence: M1 fell 25% during 1929-33. • The relation between the money stock, M1, and the monetary base (physical money) is given by: - M1 = monetary base x money multiplier Money, Nominal and Real, 1929 to 1933 Year Nominal Money Stock, M1 Monetary Base Money Multiplier Real Money Stock, M1/P 1929 26.6 7.1 3.7 26.4 1930 25.7 6.9 3.7 26.0 1931 24.1 7.3 3.3 26.5 1932 21.1 7.8 2.7 25.8 1933 19.4 8.2 2.4 25.6 13 A shock to the LM curve but, P also fell 25% during 1929-33. the effect on the LM curve should be neutral What was the problem then? • recall: r = i - e The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929 to 1933 Year One-Year Nominal Interest Rate (%), i Inflation Rate (%), One-Year Real Interest Rate (%), r 1929 5.3 0.0 5.3 1930 4.4 2.5 6.9 1931 3.1 9.2 12.3 1932 4.0 10.8 14.8 1933 2.6 5.2 7.8 14 How e shifts the LM curve (a) The market for r (b) The LM curve real money balances r LM2 LM1 r2 r1 L (i-2 e, Y 1) L (i-1e, Y1 ) M/P M1/P1 r2 r1 Y1 e _ L _ r (for the same i) __ LM Y 15 r=i- e The effects of falling prices r LM0(M0/P0) r0 IS0 Y Y0 LRAS P P0 AD0 Y0 IS AD shifts __ Y1 Y0 P LM should shift __ but, M LM const AD shifts ___ At the same time P e e LM shifts ___ AD shifts ___ SRAS0 Result: __ P, __ Y, __ r Y 16 The Recovery Monetary policy played an important role • 1933-41, the nominal money stock increased by 140% and the real money stock by 100%. Other factors that played an important role were: • The New Deal — a set of programs implemented by the Roosevelt administration. • The creation of the Federal Deposit Insurance Corporation (FDIC). • Other programs administered by the National Recovery Administration (NRA). 17 Why another Depression is unlikely Policymakers (or their advisors) now know much more about macroeconomics: • The Fed knows better than to let __ fall so much, especially during a contraction. • Fiscal policymakers know better than to raise ______ or cut __________ during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic ___________ make fiscal policy expansionary during an economic downturn. 18