Download Lecture31(Ch28)

Recovery from what?
• From the short-run (“first steps”) to the
long-run (back to potential GDP)
• Four scenarios today
–
–
–
–
(1) Reduction in government purchases
(2) Shift to more inflationary monetary policy
(3) Shift to a less inflationary monetary policy
(4) Combo of (2) and (3): Boom-Bust Cycle
The short-run and the long-run
effects of a change in G
• Suppose that there is a sudden, big, decline
in government purchases
– A reduction in demand
– We know that in the short run real GDP will fall
below potential GDP
• Now we want to see how real GDP
recovers--moves back to potential GDP
Starting point in the main diagram
Cut in government purchases causes real
GDP to decline as shown by shift of ADI
But now real GDP is lower than potential GDP,
so inflation starts to fall (PA moves down)
Could you go over that again,
sketching the diagram by hand?
FYI: Here is what is happening in
the supporting diagrams
28_03A
INTEREST
RATE
SPENDING
Monetary
policy
rule
SR
45-degree line
MR
Decrease in
government
purchases
shifts line
down.
AE line
LR
LR
MR
SR
INFLATION RATE
REAL GDP
What happens to C, I, X in the short run (SR)
and the long run (LR)?
The LR is the same as SAM.
• In the long run, real GDP is back to
potential, but with G down and
– I up, X up, C up
• The spending allocation model (SAM)
predicted the same thing: when G/Y down
– I/Y up, X/Y up, C/Y up
• But with ADIPA we now we have the short
run story to go with the long run story
In the long run, real GDP returns to potential
GDP, but (with more I) the growth rate of
potential GDP may be higher as shown here
28_04
BILLIONS
OF DOLLARS
Potential
GDP
LR
MR
SR
YEARS
A Lesson for Prospective
Central Bankers
• We want to suppose there is a shift in
monetary policy
– This shift is a common tactical mistake
• What are the short run and the long run
economic effects?
• What are the political implications?
• To learn this lesson let’s first observe some
“Textbook Maneuvers”
WELCOME TO
A school for central bankers.
Dedicated to teaching the science
and art of monetary policy.
Key Dialogue
• Tom Cruise
– You don’t have time to think up there. If you
think your dead.
• Kelly McGillis
– That’s a big gamble with a $30,000,000 plane
Lieutenant. Let me teach you about the “gain
then pain scenario”. It starts with the Fed
cutting interest rates when inflation is not too
low and real GDP is just about equal to
potential GDP.
“Gain then pain” scenario
• Start: inflation rate = 2%,
real GDP = potential GDP
– Fed cuts interest rate
• buys bonds
– Economy booms---the “gain”
• real GDP> potential GDP
– Inflation starts to rise
– Fed must raise interest rate
• End: Economy returns to potential
– real GDP = potential GDP
– inflation is higher than 2%---the “pain”
Could you sketch the “pain then
gain” scenario by hand?
A disinflation
• The Fed decides that inflation is too high
– Or Jimmy Carter appoints Paul Volcker to chair
the Fed and says “reduce inflation, Paul”
• The monetary policy must shift towards
lower inflation
– Fed raises the interest rate,
– ADI shifts to left,
– and then...
A Disinflation in a Graph
28_05B
INFLATION
RATE
Potential GDP
PA (SR )
SR
PA (MR )
MR
PA(LR )
LR
Y
SR
C
I
X
G
ADI
LR
REAL GDP
A boom-bust cycle
• First, the Fed lowers the interest rate when
it shouldn’t have (the mistake Kelly
McGillis warned Tom Cruise about)--this
causes a boom
• Then the Fed undoes the mistake by shifting
monetary policy back towards a lower
inflation rate
• Now look at what happens over time
Any animated graphics
for the boom-bust cycle?
END
OF
LECTURE
and
BEAT CAL