Download ch09

Economics
THIRD EDITION
By John B. Taylor
Stanford University
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
1
Chapter 24 (Macro 11)
The Economic
Fluctuations Model
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
2
Overview
• The main purpose of this chapter is to
provide an explanation of the dynamics of
economic fluctuations, particularly inflation
and real GDP. The economic fluctuations
model is constructed by first deriving the
aggregate demand/inflation curve and then
the price adjustment line. The model can be
used to study the determination of real GDP
and the price level.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
3
Teaching Objectives
1. Explain that a basic set of factors causes
real GDP to depart and return to potential
over the business cycle.
2. Introduce interest rates and inflation into
the dynamics of the business cycle.
3. Describe the important role that policy
can play in altering the course of business
cycles. This is done through a policy rule
that relates interest rates to aggregate
expenditure.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
4
Teaching Objectives
4. Explain the primary factors that determine
location of the ADI curve. This occurs through the
components of aggregate spending that are
sensitive to interest rates (spending balance) and
the policy rule.
5. Explain the factors that shift the ADI curve:
Changes of the policy rule and changes in
government spending, along with autonomous
shocks to aggregate spending, determine the
location of the ADI curve.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
5
Teaching Objectives
• 6. Introduce the microeconomic basis of price
adjustment.
7. Explain the PA line and the factors that cause it
to shift.
8. Explain how the intersection of the ADI curve
and the PA line determines the level of equilibrium
real GDP and the inflation rate at some point in
time in the economy.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
6
Key Terms
•
•
•
•
•
aggregate demand/inflation ( ADI ) curve
target inflation rate
monetary policy rule
price adjustment ( PA ) line
federal funds rate
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
7
1. The Aggregate Demand/Inflation Curve
• The ADI curve shows that there is an
inverse (negative) relationship between
inflation changes and the corresponding
changes in real GDP.
• When inflation increases, real GDP
declines.
• When inflation slows down, real GDP goes
up.
• Real GDP = C + I + G + X = AE
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
8
Figure 24.1
(Macro 11)
The Aggregate
Demand Curve
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
9
Between Inflation Interest Rate and Real GDP
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
10
Showing Relation of
Interest Rate to
Investment
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
11
STAGE I: Interest rate and Investment
• As real (inflation-adjusted) interest rate
goes up, cost of borrowing goes up, so that
business investment (buying a new machine
or extending business) and housing
investment declines.
• As real interest rate declines, investment
goes up, because the cost of investment
declines
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
12
Showing Relation of
Interest Rate to Net
Exports
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
13
Interest Rate and Net Exports
• If US interest rates increase, it becomes
more attractive to invest in the US,
compared to other countries such as Canada
or Mexico, our top trading partners.
• This raises the demand for US dollars and
appreciates the US dollar against other
currencies like Canadian $s or Mexican
pesos.
• This hurts our exports but raises our
imports.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
14
Interest Rate and Consumption Expenditures
• Evidence indicates that consumption is less
sensitive to interest rate changes than
investment and net exports
• In general, higher interest rates encourage
people to save more (consume less),
indicating an inverse relationship between
interest rates and consumption
• Figure 24.2 shows the net impact.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
15
Figure 24.2
(Macro 11)
The Interest Rate, Spending Balance, and Real GDP
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
16
STAGE II: Interest Rates and Inflation
• So far we have seen how real interest rates
affect real GDP.
• Now we want to study how inflation affects
interest rates.
• Real interest rate = nominal interest rates
minus expected inflation rate
• Note that it is the real interest rate that we
use to decide about our spending plans
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
17
Central Banks and Inflation
• When inflation increases (declines), the Fed
raises (lowers) the nominal interest rates.
This is called the “policy rule”
• Higher inflation signals a rise in aggregate
expenditures. Central banks raise nominal
interest rates more than the inflation rate, so
that the real interest rate increases.
• Higher real interest rates lower AE and
slows down inflation
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
18
Figure 24.3
(Macro 11)
A Monetary Policy Rule
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
19
Monetary Policy Rule
• The monetary policy rule in Figure 24.3
shows that central banks raise the interest
rate when inflation rises and lower it when
inflation declines.
• The dashed line has a slope of 1. Monetary
policy rule has a bigger slope: Nominal
interest rate is increased by more than
inflation, so that the real interest changes.
• Note that AE decisions depend on “real”
rate.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
20
STAGE 3: Deriving AD curve
• When inflation increases, two things happen:
(1) Central banks raise the nominal interest
rate more than inflation, raising the real
interest rate
(2) The higher real interest rate will decrease
real GDP because of lower AE
• Just the opposite happens when inflation
decreases
• Thus, AD curve shows a negative link between
real interest rates and real GDP
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
21
Figure 24.4
(Macro 11)
A Self-Guided
Graphical Overview
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
22
Movements along the AD curve
• A change in inflation causes a movement
along the demand curve
• When inflation rises and the Fed raises the
interest rate and real GDP declines. This
causes a movement up and to the left along
the AD curve.
• When inflation decreases, there is a
movement down and to the right.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
23
Shifts of the AD curve
• Besides inflation, other things affects
aggregate demand.
• When such non-inflation determinants of
AD curve changes, we say that there is a
“shift” in the AD curve.
• Changes in government purchases, shifts in
monetary policy, changes in taxes, shifts in
demand for next exports, changes consumer
confidence, among others, affect AD.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
24
Figure 24.5
(Macro 11) How
Government
Purchases Shift the
Aggregate Demand
Curve
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
25
Figure 24.6
(Macro 11) A Shift in
the Monetary Policy
Rule
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
26
Figure 24.7
(Macro 11)
A List of Possible Shifts in the Aggregate Demand Curve
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
27
Inflation Adjustment Line (IA)
• IA is a flat line showing the level of
inflation in the economy at any point in
time.
• It describes the behavior of firms and
workers setting prices and wages in the
economy
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
28
Figure 24.8
(Macro 11)
Inflation Adjustment and Changes in Inflation
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
29
Inflation Adjustment Line (IA)
• The flat IA indicates that firms and workers
adjust (change) prices and wages in such a
way that the inflation remains intact in the
short run as real GDP changes.
• There are two reasons why inflation stays
steady even if real GDP is changing:
expectations about continuing inflation and
staggered wage and price setting in the
economy
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
30
Reason #1
• Pricing decisions for the whole economy
require that the price expectations of other
firms be taken into account. Similarly, wage
adjustments are made in the context of
existing and future wage agreements.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
31
Reason #1
• Expectations about the price and wage
decisions of other firms lead firms to raise
prices by more than expected inflation if
demand is high and by less than expected
inflation if demand is low. A parallel
process governs wage adjustments.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
32
Reason #2
• Not all wages and prices are changed at the
same time. Rather, they are staggered over
months and even years.
• Staggered wages and prices act to slow
down the rapid adjustment of prices. This
also introduces a dependency between
current and past price and wage decisions.
• On any given day, the vast majority of
wages and prices do not change much.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
33
Inflation Adjustment
• Expectations, when combined with staggered
decisions, make recent past inflation
a factor in current inflation. Moreover, because the
strength of a price adjustment relative to inflation
expectations will depend on whether demand is
high or low across the economy, the relation
between real and potential GDP determines
whether inflation increases, decreases, or remains
unchanged. For example, if real GDP is below
potential, inflation decreases.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
34
Inflation Adjustment Line
• Three assumptions about the IA line are
needed . First, the IA line represents the rate
of inflation in the economy at a point in
time. It is flat, indicating that prices are
sticky in the short run. Second, the IA line
shifts after GDP departs from potential.
Third, any change in expectations or
materials prices will shift the IA line.
• These assumptions and the horizontal IA
line receive statistical support in real world.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
35
Combining the Aggregate Demand/Inflation Curve and
the Price Adjustment Line
• When the ADI curve and PA line are
combined, as in Figure 27.10, the rate of
inflation and real GDP are determined. This
may occur above, below, or at potential
GDP.
• The intersection of the ADI curve and the
IA line gives a pair of observations on real
GDP and inflation at any point time.
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
36
Figure 24.10
(Macro 11)
Determining Real GDP and Inflation
Copyright © 2001 by Houghton
Mifflin Company. All rights reserved.
37