Source: US. Bureau of Economic Analysis Shaded areas indicate US recessions research.stlouisfed.org
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1 Business Cycles
2 0 Real Gross Domestic Product 18,000 16,000 (Billions of Chained 2009 Dollars) 14,000 12,000 10,000 8,000 6,000 4,000 2, Source: US. Bureau of Economic Analysis Shaded areas indicate US recessions research.stlouisfed.org
3 Real Gross Domestic Product (Percent Change from Year Ago) Source: US. Bureau of Economic Analysis research.stlouisfed.org
4 Recession Unusually low growth of output over a long period Rising unemployment
5 Recession Unusually low growth of output over a long period Rising unemployment National Bureau of Economic Research Most recent recession: 3rd quarter, nd quarter, 2009
6 Recession Unusually low growth of output over a long period Rising unemployment National Bureau of Economic Research Most recent recession: 3rd quarter, nd quarter, 2009 Note on GDP growth timing: Measure from exactly a year earlier Suppose I tell you at the end of January that GDP fell by 2% that month
7 Business Cycles
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11 Corelations with GDP growth: Consumption growth: + Investment growth: + Unemployment: Employment: + Okun s Law
12 Corelations with GDP growth: Consumption growth: + Investment growth: + Unemployment: Employment: + Okun s Law Magnitudes: % I > % C
13 Corelations with GDP growth: Consumption growth: + Investment growth: + Unemployment: Employment: + Okun s Law Magnitudes: % I > % C Major goal of theory: Secondary goal: explain observed correlations explain magnitudes
14 Okun s Law in the US Correlation: -.89 Line: % Y = 3% 2 u
15 Okun s Law in the US Correlation: -.89 Line: % Y = 3% 2 u What if u goes from 5% to 9%?
16 Aggregate Demand and Aggregate Supply
17 Simple Aggregate Demand Relationship between output demanded and aggregate price level P Y
18 Simple Aggregate Demand Relationship between output demanded and aggregate price level Simple examples: MV = P Y P ( ) M P s = ( ) M P d = L (i, Y ) Y
19 Simple Aggregate Demand Relationship between output demanded and aggregate price level Simple examples: MV = P Y P ( ) M P s = ( ) M P d = L (i, Y ) AD Y
20 Simple Aggregate Demand Relationship between output demanded and aggregate price level Simple examples: MV = P Y P ( ) M P s = ( ) M P d = L (i, Y ) Less simple example: IS-LM system AD Y
21 Why does AD slope down? Most demand curves:
22 Why does AD slope down? Most demand curves: falling marginal benefit
23 Why does AD slope down? Most demand curves: falling marginal benefit AD is different:
24 Why does AD slope down? Most demand curves: falling marginal benefit AD is different: drawn for fixed M, so if P rises, purchases must fall
25 What if M changes? ( M P ) = L (i, Y ) or P = 1 k M Y P AD 1 Y
26 What if M changes? ( M P ) = L (i, Y ) or P = 1 k M Y P AD 2 AD 1 Y
27 What if M changes? ( M P ) = L (i, Y ) or P = 1 k M Y P AD 2 AD 1 Y Note: velocity (or 1 k ) also can change
28 IS-LM gives us AD Relax the assumption of P
29 IS-LM gives us AD Relax the assumption of P Higher P reduces real money balances ( ) M P
30 IS-LM gives us AD Relax the assumption of P Higher P reduces real money balances ( ) M P
31 IS-LM AD practice Work through: 1. effect of an increase in G 2. effect of new tech that increases MPK 3. effect of an increase in M 4. effect of an increase in P 5. effect of an increase in T 6. a loss of consumer confidence ( Animal spirits )...but now finishing with AD
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34 Aggregate Demand with inflation Relationship between Y and π CB is usually increasing money supply over time When inflation is high, CB raises interest rates to fight it Higher r lowers I, lowering Y
35 Long-run AS Relationship between π and Y
36 Long-run AS Relationship between π and Y Output determined by
37 Long-run AS Relationship between π and Y Output determined by Capital Labor supplied at full employment Technology
38 Long-run AS Relationship between π and Y Output determined by Capital Labor supplied at full employment Technology Not inflation
39 Long-run AS Relationship between π and Y Output determined by Capital Labor supplied at full employment Technology Not inflation π LRAS Y
40 Long-run AS Relationship between π and Y Output determined by Capital Labor supplied at full employment Technology Not inflation Terminology Natural rate of output Potential GDP Natural rate of unemployment Classical dichotomy π LRAS Y
41 Combine LRAS and AD π LRAS Y
42 Combine LRAS and AD π LRAS AD 1 Y
43 Combine LRAS and AD π LRAS Equilibrium Inflation AD 1 Y
44 Combine LRAS and AD π LRAS Equilibrium Inflation AD 2 AD 1 Y
45 Short-run AS Sticky prices: Menu costs Angry customers Some price changes are temporary Prices set by contracts Imperfect/incomplete information
46 How many times per year does your firm change prices?
47 Short-run AS Things that cause firms to raise prices:
48 Short-run AS Things that cause firms to raise prices: Expected inflation
49 Short-run AS Things that cause firms to raise prices: Expected inflation Output gap
50 Short-run AS Things that cause firms to raise prices: Expected inflation Output gap Inflation shocks
51 Short-run AS Things that cause firms to raise prices: Expected inflation Output gap Inflation shocks π SRAS = π e + γ ( Y SRAS Y P ) + ρ (1)
52 SRAS shifts π LRAS SRAS AD Y
53 SRAS shifts π LRAS SRAS AD Y Why do they cross at the same point?
54 SRAS shifts LRAS SRAS π AD Y Why do they cross at the same point? SRAS conditional on π e
55 SRAS shifts LRAS SRAS π AD Y Why do they cross at the same point? SRAS conditional on π e Every point on LRAS has a separate SRAS
56 Demand shift and transition to LR π LRAS SRAS AD Y
57 Demand shift and transition to LR π LRAS SRAS AD 2 AD 1 Y
58 Demand shift and transition to LR π LRAS SRAS 2 SRAS 1 AD 2 AD 1 Y
59 Show what will happen in our AD-AS framework in each scenario: 1. Suppose the Fed issues a press release stating that they will keep interest rates low until unemployment falls below a particular level 2. Show the effect on the US from an oil field discovery in Jordan 3. Aggregate output grows by 2 3% per year in the US 4. How will SRAS change if prices become less sticky? 5. The CB becomes more responsive to inflation 6. Access to credit cards lowers the demand for money
60 Supply shock: typical diagram π LRAS SRAS AD Y
61 Supply shock: typical diagram π LRAS SRAS 2 SRAS 1 AD 1 Y
62 Supply shock: typical diagram π LRAS SRAS 2 SRAS 1 SRAS 3 AD 1 Y
63 Long-run growth Aggregate output grows by 2 3% per year in the US
64 Long-run growth Aggregate output grows by 2 3% per year in the US LRAS 1 SRAS 1 π AD 1 Y
65 Long-run growth Aggregate output grows by 2 3% per year in the US LRAS 1 LRAS 2 SRAS 1 π SRAS 2 AD 2 AD 1 Y
66 Micro origins of upward-sloping SRAS: market power Think about an individual firm with a little market power: p s = P + a ( Y Y ) (2)
67 Micro origins of upward-sloping SRAS: market power Think about an individual firm with a little market power: p s = P + a ( Y Y ) (2) p s = P on average
68 Micro origins of upward-sloping SRAS: market power Think about an individual firm with a little market power: p s = P + a ( Y Y ) (2) p s = P on average If Y is high, MC is high, so firm charges higher price
69 Micro origins of upward-sloping SRAS: market power Think about an individual firm with a little market power: p s = P + a ( Y Y ) (2) p s = P on average If Y is high, MC is high, so firm charges higher price Suppose s proportion set price in advance (p s = EP ) 1 s proportion follow the rule in real time
70 Micro origins of upward-sloping SRAS: market power P = sep + (1 s) ( P + a [ Y Y ]) (3)
71 Micro origins of upward-sloping SRAS: market power P = sep + (1 s) ( P + a [ Y Y ]) (3) Solve for P : P = EP + 1 s a ( Y Y ) (4) s
72 Micro origins of upward-sloping SRAS: market power P = sep + (1 s) ( P + a [ Y Y ]) (3) Solve for P : P = EP + 1 s a ( Y Y ) (4) s Prices fixed in advance make EP the average
73 Micro origins of upward-sloping SRAS: market power P = sep + (1 s) ( P + a [ Y Y ]) (3) Solve for P : P = EP + 1 s a ( Y Y ) (4) s Prices fixed in advance make EP the average High Y means some firms raise their prices
74 Micro origins of upward-sloping SRAS: market power P = EP + 1 s a ( Y Y ) (5) s Y = Y + α (P EP ) (6)
75 Lucas islands model (imperfect info) No price rigidity
76 Lucas islands model (imperfect info) No price rigidity Firms
77 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices
78 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices
79 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices Must guess whether increased willingness to pay (higher demand price) is due to inflation or to real changes (e.g. wealth, preferences, or a productivity shock in other markets)
80 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices Must guess whether increased willingness to pay (higher demand price) is due to inflation or to real changes (e.g. wealth, preferences, or a productivity shock in other markets) Stable AD
81 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices Must guess whether increased willingness to pay (higher demand price) is due to inflation or to real changes (e.g. wealth, preferences, or a productivity shock in other markets) Stable AD expect most changes are real
82 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices Must guess whether increased willingness to pay (higher demand price) is due to inflation or to real changes (e.g. wealth, preferences, or a productivity shock in other markets) Stable AD expect most changes are real Unstable AD
83 Lucas islands model (imperfect info) No price rigidity Firms Know their own prices Do not know many other prices Must guess whether increased willingness to pay (higher demand price) is due to inflation or to real changes (e.g. wealth, preferences, or a productivity shock in other markets) Stable AD expect most changes are real Unstable AD expect most changes are due to price level fluctuations
84 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7)
85 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD Unstable AD
86 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD high α Unstable AD
87 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD high α Unstable AD small α
88 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD high α Unstable AD small α Empirical claim: nations with more stable prices see bigger impacts from AD shifts (flatter SRAS)
89 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD high α Unstable AD small α Empirical claim: nations with more stable prices see bigger impacts from AD shifts (flatter SRAS) But...
90 Lucas islands model (imperfect info) Expectations determine α: Y = Y + α (P EP ) (7) Stable AD high α Unstable AD small α Empirical claim: nations with more stable prices see bigger impacts from AD shifts (flatter SRAS) But... firms in nations with highly variable inflation will not set prices beforehand, so sticky price models predict the same empirical facts
91 Phillips Curve
92 Phillips Curve?
93 Deriving the Phillips Curve P = EP + ( ) 1 (Y ) Y + ν (8) α
94 Deriving the Phillips Curve ( ) 1 (Y ) P = EP + Y + ν α (8) ( ) 1 (Y ) P P 1 = EP P 1 + Y + ν α (9)
95 Deriving the Phillips Curve ( ) 1 (Y ) P = EP + Y + ν α (8) ( ) 1 (Y ) P P 1 = EP P 1 + Y + ν α (9) ( ) 1 (Y ) π = Eπ + Y + ν α (10)
96 Deriving the Phillips Curve ( ) 1 (Y ) P = EP + Y + ν α (8) ( ) 1 (Y ) P P 1 = EP P 1 + Y + ν α (9) ( ) 1 (Y ) π = Eπ + Y + ν α (10) Okun s Law: ( ) 1 (Y ) ( Y = β u u N ) α
97 Deriving the Phillips Curve ( ) 1 (Y ) P = EP + Y + ν α (8) ( ) 1 (Y ) P P 1 = EP P 1 + Y + ν α (9) ( ) 1 (Y ) π = Eπ + Y + ν α (10) Okun s Law: ( ) 1 (Y ) ( Y = β u u N ) α π = Eπ + β ( u u N) + ν (11)
98 Phillips Curve observations π = Eπ + β ( u u N) + ν
99 Phillips Curve observations π = Eπ + β ( u u N) + ν It is a representation of the same facts that build AS
100 Phillips Curve observations π = Eπ + β ( u u N) + ν It is a representation of the same facts that build AS Theory implies the curve is real
101 Phillips Curve observations π = Eπ + β ( u u N) + ν It is a representation of the same facts that build AS Theory implies the curve is real Includes expected inflation
102 π = Eπ + β ( u u N) + ν (12)
103 π = Eπ + β ( u u N) + ν (12) When will policy manipulations of this relationship stop working?
104 π = Eπ + β ( u u N) + ν (13)
105 Phillips Curve? π = Eπ + β ( u u N) + ν
106 Phillips Curve? π = Eπ + β ( u u N) + ν Only a short-run relationship
107 The Phillips Curve is clockwise
108 What determines Eπ? Adaptive expectations: π = π 1
109 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν
110 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment
111 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment Idea: if prices have risen quickly in the past, the SRAS will shift up quickly
112 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment Idea: if prices have risen quickly in the past, the SRAS will shift up quickly What is going on with AD, though?
113 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment Idea: if prices have risen quickly in the past, the SRAS will shift up quickly What is going on with AD, though? AD must be rising for u = u N at π = π 1
114 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment Idea: if prices have risen quickly in the past, the SRAS will shift up quickly What is going on with AD, though? AD must be rising for u = u N at π = π 1 AD rising for same reason that people expect Eπ = π 1 : money growth
115 What determines Eπ? Adaptive expectations: π = π 1 π = π 1 β ( u u N) + ν u N : non-accelerating inflation rate of unemployment Idea: if prices have risen quickly in the past, the SRAS will shift up quickly What is going on with AD, though? AD must be rising for u = u N at π = π 1 AD rising for same reason that people expect Eπ = π 1 : money growth Is this model of expectations consistent with real behavior?
116 Disinflation Adaptive (or naive) expectations recession from disinflation (See Phillips Curve and AD-AS)
117 Disinflation Adaptive (or naive) expectations recession from disinflation (See Phillips Curve and AD-AS) How can we get disinflation with no problems?
118 Disinflation Adaptive (or naive) expectations recession from disinflation (See Phillips Curve and AD-AS) How can we get disinflation with no problems? Rational
119 Disinflation Adaptive (or naive) expectations recession from disinflation (See Phillips Curve and AD-AS) How can we get disinflation with no problems? Rational Truth is probably somewhere between the extremes
120 What is the sacrifice ratio? How much GDP do we have to give up to bring down inflation by 1%?
121 What is the sacrifice ratio? How much GDP do we have to give up to bring down inflation by 1%? Usually 5%
122 What is the sacrifice ratio? How much GDP do we have to give up to bring down inflation by 1%? Usually 5% Okun s Law: 1% higher u (over a year) 2% lower GDP
123 What is the sacrifice ratio? How much GDP do we have to give up to bring down inflation by 1%? Usually 5% Okun s Law: 1% higher u (over a year) 2% lower GDP How much more u do we need to reduce π by 1%?
124 What is the sacrifice ratio? How much GDP do we have to give up to bring down inflation by 1%? Usually 5% Okun s Law: 1% higher u (over a year) 2% lower GDP How much more u do we need to reduce π by 1%? 2.5%
125 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years?
126 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years
127 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years 9.5%u GDP loss
128 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years 9.5%u 19% GDP loss
129 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years 9.5%u 19% GDP loss Sacrifice ratio in the Volcker recession:
130 Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years 9.5%u 19% GDP loss Sacrifice ratio in the Volcker recession: = 2.8
131 Faster disinflations have lower sacrifice ratios Sacrifice ratio What if we want to reduce inflation from 9.7% to 3% over 4 years? 3.5% + 3.5% + 1.4%1.1% = 9.5% unemployment years 9.5%u 19% GDP loss Sacrifice ratio in the Volcker recession: = 2.8
132 What is u N? Staiger, Stock, and Watson: 95% confidence interval lower bound (1990): 95% confidence interval upper bound (1990):
133 What is u N? Staiger, Stock, and Watson: 95% confidence interval lower bound (1990): 5.1% 95% confidence interval upper bound (1990): 7.7%
134 What is u N? Staiger, Stock, and Watson: 95% confidence interval lower bound (1990): 5.1% 95% confidence interval upper bound (1990): 7.7% 6.2% is their best estimate for 1990
135 Hysteresis Unemployment can be persistent
136 Hysteresis Unemployment can be persistent Unemployed people lose skills, contacts, etc.
137 Hysteresis Unemployment can be persistent Unemployed people lose skills, contacts, etc. Unemployed people lose insider status
138 Hysteresis Unemployment can be persistent Unemployed people lose skills, contacts, etc. Unemployed people lose insider status Affect public policies
139 Hysteresis Unemployment can be persistent Unemployed people lose skills, contacts, etc. Unemployed people lose insider status Affect public policies Leads to more rent-seeking
140 Hysteresis Unemployment can be persistent Unemployed people lose skills, contacts, etc. Unemployed people lose insider status Affect public policies Leads to more rent-seeking Increases the cost of disinflation
141 Business cycle terminology Shocks: exogenous events that shift AD or AS Demand shock Supply shock
142 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model.
143 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves
144 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves
145 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves Which curve shifts initially and why?
146 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves Which curve shifts initially and why? What is going on in the SR (equilibrium)
147 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves Which curve shifts initially and why? What is going on in the SR (equilibrium) What happens in the LR (eq. and transition mechanism)?
148 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves Which curve shifts initially and why? What is going on in the SR (equilibrium) What happens in the LR (eq. and transition mechanism)? What could/would a central bank do in response?
149 Practice with AD/AS shocks Work through each of the numbered scenarios with our simple AS-AD model. Things on axes do not shift curves Which curve shifts initially and why? What is going on in the SR (equilibrium) What happens in the LR (eq. and transition mechanism)? What could/would a central bank do in response? 1. Banks become more confident and loan out more 2. Credit cards and ATMs become more available 3. The central bank increases the money base 4. OPEC temporarily colludes to raise the price of oil 5. Unions succeed at raising wages temporarily 6. New technology increases MPK 7. Government buys more stuff 8. Government raises taxes T 9. Loss of consumer confidence ( Animal spirits )
150 Demand shock Suppose banks become more confident and loan out more
151 Demand shock Suppose banks become more confident and loan out more What happens to money supply?
152 Demand shock Suppose banks become more confident and loan out more What happens to money supply? What happens to AD, AS?
153 Demand shock Suppose banks become more confident and loan out more What happens to money supply? What happens to AD, AS?
154 Demand shock Suppose credit cards become more available
155 Demand shock Suppose credit cards become more available What happens to the velocity of money?
156 Demand shock Suppose credit cards become more available What happens to the velocity of money? M P = ky = Y V
157 Demand shock Suppose credit cards become more available What happens to the velocity of money? M P = ky = Y V
158 Supply shock (price shock) OPEC raises the price of oil or unions succeed at raising wages
159 Supply shock (price shock) OPEC raises the price of oil or unions succeed at raising wages How can the Fed respond to this stagflation?
160 Supply shock (price shock) OPEC raises the price of oil or unions succeed at raising wages How can the Fed respond to this stagflation? Do nothing
161 Supply shock (price shock) OPEC raises the price of oil or unions succeed at raising wages How can the Fed respond to this stagflation? Do nothing Raise money supply
162 Fed response to supply shock If Fed raises money supply:
163 Keynesian theory in algebraic terms Y = C(Y T ) + I(r) + G M P = L(r, Y ) P SR = P Y LR = Y
164
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