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13
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Business Fluctuations:
Aggregate Demand and Supply
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 here
To Try it!
questions
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Video
Food for Thought….
Some good blogs and other sites to get the juices flowing:
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.
A business
fluctuation is a
fluctuation in
the growth
rate of real
GDP around its
trend growth
rate.
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Introduction
Economic Growth is Not a Smooth Process
What causes the deviations from the average: booms
and recessions
A recession is
a significant,
widespread
decline in real
income and
employment.
(Shaded blue
areas)
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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
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The Dynamic
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:
M  v  P  YR  Inflation  Real Growth
Where
M  v represents total spending growth.
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The Dynamic
Aggregate Demand Curve
The rate of spending growth =
M  v 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.
M  v  P  YR  Inflation  Real Growth
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The Dynamic
Aggregate Demand Curve
Spending growth = 5%
Real
Inflation
growth
0
1
2
3
4
5
6
5
4
3
2
1
0
-1
Spending growth = 7%
Real
Inflation
growth
0
1
2
3
4
5
6
7
6
5
4
3
2
1
Plotting inflation against real growth gives a
dynamic AD curve for each level of spending
growth.
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The Dynamic
Aggregate Demand Curve
Inflation
Rate (p)
AD curve when 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.
7%
5%
M  v  P  YR
5% + 0% = 5%
2% + 3% = 5%
2%
0%
-2%
AD (spending growth = 5%)
0%
3%
5%
7%
Real GDP growth rate
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The Dynamic
Aggregate Demand Curve
Inflation
Rate (p)
AD curve when spending growth = 7%
Conclusion:
1.Increases in spending growth,
 M and/or  v
7%
shifts the AD curve to the right.
2.Decreases in spending growth,
5%
 M and/or  v
shifts the AD curve to the left.
AD (spending growth = 7%)
2%
0%
-2%
AD (spending growth = 5%)
0%
3%
5%
7%
Real GDP growth rate
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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
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The Solow Growth Curve
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.
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The Solow Growth Curve
The Solow Growth Curve
Inflation
Rate (p)
Solow growth
curve
Why is the Solow Growth
Curve vertical?
• Potential growth does not
depend on the inflation rate.
3%
Real GDP growthB rate
A CK T O
What causes the Solow Growth Curve
to Shift?
Inflation
Rate (p)
Solow growth
curve
Real shocks (“Productivity
Shocks”) which increase or
decrease the potential
growth rate.
Positive productivity shocks
Negative
shock
Positive
shock
increase the ability of the economy to
produce.
Negative productivity shocks
decrease the ability of the economy to
produce.
-1%
3%
7%
Real GDP growth rate
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Try it!
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.
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Try it!
Try it!
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.
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Try it!
Try it!
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
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Try it!
d) oil crisis
The Solow Growth Curve and AD
Putting the AD and the Solow growth curve together.
Inflation
Rate (p)
Solow growth
curve
Equilibrium
7%
AD (M  v  10%)
3%
Real GDP growth rate
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The Solow Growth Curve and AD
Putting the AD and the Solow growth curve together.
Inflation
Rate (p)
Solow growth
curve
Negative
shock
Positive
shock
11%
7%
3%
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%.
AD (M  v  10%)
-1%
3%
7%
Real GDP growth rate
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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
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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
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Real Shocks:
The Price of Oil and U.S. Recessions
Note: Real price of oil per barrel in $2000.
BACK 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.
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Real Shocks: Examples & Analysis
BACK 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
BACK 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).
An aggregate demand shock is a rapid
and unexpected shift in the AD curve
(spending).
BACK TO
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.
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
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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?
Inflation higher
that expected
Prices
increase
faster
than wages
Inflation lower
that expected
Prices
increase
slower
than wages
Profits
increase
Profits
decrease
Firms increase
Output and real
GDP growth
increases
Firms decrease
Output and real
GDP growth
decreases
Result: An upward sloping SRAS curve.
BACK TO
Try it!
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.
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Try it!
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
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.
BACK TO
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
Inflation
Rate (p)
Solow growth
curve
Short Run aggregate
supply (SRAS)(E(p) = 2%)
Conclusions:
1.Sticky wages result in an
upward sloping SRAS.
2.There is a different SRAS
for every level of expected
inflation, E(p) .
2%
AD (M  v  5%)
3%
Real GDP growth rate
BACK TO
Try it!
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%.
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Try it!
Aggregate Demand Shocks and the
Short-Run Aggregate Supply Curve
Inflation
Rate (p)
Solow growth
curve
(SRAS2)
(E(p) = 4%)
d
6%
If p = 2% and E(p) = 2%,
economy stays at point
(SRAS1)
(E(p) = 2%) If p = 4% and E(p) = 2%,
a.
economy moves to b.
and real growth ↑ to 7%
4%
c
b
If p = 4% and E(p) = 4%,
SRAS shifts up and economy
stays at point c.
2%
If p = 4% and E(p) = 6%,
a
3%
economy moves to d.
and real growth ↑ to 7%
7%
Real GDP growth rate
BACK TO
Try it!
If p > p 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.
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Try it!
Why is the SRAS Upward-Sloping? (Why Do
Spending Increases Temporarily Increase Growth?)
Nominal Wage Confusion
Menu Costs
Uncertainty
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).
BACK TO
Why is the SRAS Upward-Sloping? (Why Do
Spending Increases Temporarily Increase Growth?)
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.
BACK 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
BACK TO
In the Long Run, Real Growth Eventually Returns to
the Solow Rate
An Unexpected increase in
Inflation
Rate (p)
Solow growth
curve
c
7%
(SRAS2)
(E(p) = 7%)
(SRAS1)
(E(p) = 2%)
b
4%
M
Short-run: a → b
1. Real growth ↑ to 6%
2. p ↑ to 4%
Long-run: b → c
1. Real growth ↓ to 3%
2. p ↑ to 7%
AD2
2%
(M  v  10%)
a
AD1 (M  v
3%
6%
 5%)
Real GDP growth rate
BACK TO
A Fall in Aggregate Demand Could
Induce a Lengthy Recession
Sometimes the adjustment (and pain) takes a while.
Inflation
Rate (p)
Solow growth
curve
(SRAS1)
(E(p) = 7%)
a
7%
b
6%
c
-1%
0%
3%
Short-run: a → b
1.Real growth ↓ to -1%
2. p ↓ to 6%
Long-run: b → c
1.Real growth ↑ to 3%
as prices become
unstuck
AD1 (M  v  10%)
AD2
(M  v  5%)
Real GDP growth rate
BACK 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, I , as well as C .
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→ C
Positive wealth shock →
I
 C I
BACK TO
Shocks to the Components of
Aggregate Demand
3. Taxes also shift C and I .
↑ (↓) in taxes can ↓ (↑) C .
Taxes targeted at investment (i.e. investment
tax credit) will have a similar effect on I .
4. Changes in government spending, G , shift
AD.
↑ (↓) G → 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.
BACK TO
Shocks to the Components of
Aggregate Demand
Changes in the rate of growth of velocity.
It is easier to think of changes in v
working through C, I , G, and NX .
Example: A reduction in v working
through a reduction in C .
Workers may become fearful of losing
their jobs and reduce consumption.
BACK TO
A Temporary Shock to the Aggregate Demand
and the Adjustment
A temporary reduction in vworking through a reduction in C
Inflation
Rate (p)
Solow growth
curve
Short-run: a → b
1.Real growth ↓ to -1%
2. p ↓ to 6%
Long-run: b → a
1.Real growth ↑ to 3%
2. p ↑ to 7%
(SRAS1)
(E(p) = 7%)
a
7%
b
6%
AD1 (M  v  10%)
AD2 (M  v
-1%
0% 3%
 5%)
Real GDP growth rate
BACK TO
Shocks to the Components of
Aggregate Demand
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
(M  v) 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.
BACK TO
Shocks to the Components of
Aggregate Demand
A final important point:
We know now that changes in spending
growth, (M  v  5%) , shift the AD curve.
A fundamental difference between Mand
v
is that
Mcan be set at any permanent rate
Changes in
v are temporary.
Conclusion: Sustained inflation requires
continuing increases in the money supply.
BACK TO
Shocks to the Components of
Aggregate Demand
BACK TO
Understanding the Great Depression
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.
BACK 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.
BACK TO
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.
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.
BACK 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.”
BACK TO
Understanding the
Great Depression
The Great Depression and the Great Fall in AD
Solow growth
curve
Inflation
Rate (p)
SRAS
1.  C
C
0%
2.  I
I
3.  M
M
-10%
AD (M  v  4%)
AD (M  v  - 23%)
-13%
4%
Real GDP growth rate
BACK 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.
BACK 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.
BACK 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
BACK TO
Try it!
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.
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