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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