Download Lecture30(Ch27)

Goal: To develop a model of
economic fluctuations
• Two key ideas: economic fluctuations are
– (1) departures of real GDP from potential GDP
– (2) caused by changes in demand
• Last time First steps: showed how real
GDP moves away from potential GDP
• This time  Forces of adjustment:
changes in interest rates and prices
(inflation) bring real GDP back to potential
GDP
What happens to inflation during
a typical economic fluctuation?
27_01
BILLIONS OF
1992 DOLLARS
PERCENT
6,750
5.0
6,500
Potential GDP
'89
'94
4.5
'90
'91
'93
6,250
Real GDP
6,000
'89
'92
'90
'91
'88
5,750
Inflation rate
4.0
3.5
'88
3.0
'87
'92
'93
'94
'87
5,500
1987 1988 1989 1990 1991 1992 1993 1994
2.5
1987 1988 1989 1990 1991 1992 1993 1994
Summarize the inflation and real
GDP observations in one diagram
27_02
INFLATION RATE
(PERCENT)
Potential GDP
5
'89
'90
'91
4
3
'87
'92
'93
'88
'94
2
–2
–1
0
1
2
3
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
Model will be developed in
graphical form
27_02
• Use a diagram with
the same axes (sketch
it by hand)
– inflation rate on the
vertical axis
– real GDP on the
horizontal axis
• But put curves in the
diagram to explain the
observations
INFLATION RATE
(PERCENT)
Potential GDP
5
'89
'90
'91
4
3
'87
'92
'93
'88
'94
2
–2
–1
0
1
2
3
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
The graphical representation of this macro
model is analogous to a micro model
• Economic fluctuations
model
• Supply and demand
model
– aggregate
demand/inflation
curve
– Price adjustment line
– equilibrium at the
intersection of the
two curves
– diagram with
inflation and real
GDP
– demand
curve
– supply
curve
– equilibrium at the
intersection of the
two curves
– diagram with price
and quantity of
peanuts
Let’s derive the
aggregate demand inflation curve
in three stages.
27_03
INFLATION RATE
(PERCENT)
5
4
3
Aggregate
demand/inflation curve
2
–2
–1
0
1
2
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
Stage one: real GDP is negatively
related to the interest rate.
• WHY?
– consumption (C) negatively related to interest rate
– investment (I) negatively related to interest rate
– net export (X) negatively related to interest rate
• Nothing new here

You can show the negative effect of
the interest rate on real GDP with the
45-degree line diagram
Stage two: the interest rate is
positively related to inflation
• The Fed tends to
– raise the interest rate when inflation rises and
– lower the interest rate when inflation falls
• It does this by open market operations
• this is a behavioral description of the the
people at the Fed, much like a demand
curve is a behavioral description of
consumers
• Call this response a monetary policy rule
Monetary policy rule
in a graph
27_05
INTEREST RATE
(PERCENT)
Monetary policy rule
7
6
Interest rate
when inflation
is on target
5
4
3
2
Inflation
target
1
0
1
2
3
4
5
6
INFLATION RATE (PERCENT)
Stage three: putting the first two
stages together
• Suppose that inflation increases
– the Fed will raise the interest rate
– the higher interest rate will decrease real GDP
• Suppose that inflation decreases
– the Fed will lower the interest rate
– the lower interest rate will increase real GDP
• In sum, there is a negative relationship, which
is simply the ADI curve
More details of the three stages
A little bit of that fancy animated
graphics would be real nice now
Shifts versus movements along
the ADI curve
• Movements along the
ADI curve:
– when changes in the
inflation rate cause real
GDP to change
• Shifts of the ADI
curve:
– when changes in
anything else cause
real GDP to change
• change in government
purchases
• change in net exports
(Asian financial crisis)
• change in monetary
policy rule
Example: a shift in ADI curve
due to increase in G
A change in the monetary policy rule
also causes a shift in the ADI curve
Inflation and the
price adjustment line
• Prices and wages adjust slowly in many
markets
– Thus inflation does not usually change
immediately (PA line is flat)
• But inflation does change over time
– real GDP above potential GDP
• inflation rises (PA line rises)
– real GDP below potential GDP
• inflation falls (PA line falls)
The price adjustment line
INFLATION
RATE
Potential GDP
When real GDP is above
potential GDP, the PA
line shifts up.
Price adjustment (PA) line
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
INFLATION
RATE
Potential GDP
Price adjustment (PA) line
When real GDP is below
potential GDP, the PA
line shifts down.
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
Historical evidence consistent
with the price adjustment line
27_11
INFLATION RATE
(PERCENT)
12
1980
10
1974
8
1973
1975
6
4
1976
1988
1982
1990
1989
1983
1992
2
1979
–6
–4
1991
1986
–2
0
2
4
REAL GDP
(PERCENT DEVIATION FROM POTENTIAL GDP)
Intersection of ADI and PA gives a
prediction of real GDP and inflation
27_12
INFLATION RATE
INFLATION RATE
Potential
GDP
INFLATION RATE
Potential
GDP
Potential
GDP
PA
PA
ADI
REAL GDP
Real GDP
below
potential GDP
PA
ADI
ADI
REAL GDP
REAL GDP
Real GDP
equal to
potential GDP
Real GDP
above
potential GDP
How about a little more of that
fancy animated graphics?
Next Time
Using the forces of adjustment
we see how the economy
recovers
and maybe find out who that
narrator is
END
OF
LECTURE