Download 10. Oil Shocks of the 1970s and the Great Depression

National Income &
Business Cycles
Ohio Wesleyan University
Goran Skosples
10. Oil Shocks of the 1970s and the Great
Depression
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Objectives
Two case studies:
1. Oil shocks of the 1970s
2. The Great Depression
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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.
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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.
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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
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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)
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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)
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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)
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CASE STUDY:
The 1970s oil shocks
What is the
prediction about
interest rates?
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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.
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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
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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
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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.
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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
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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
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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
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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
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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).
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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.
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