Modern Principles of Economics, Chapter 32 PDF

MODERN PRINCIPLES OF ECONOMICS Sixth Edition Chapter 32 Business Fluctuations: Aggregate Demand and...

MODERN PRINCIPLES OF ECONOMICS Sixth Edition Chapter 32 Business Fluctuations: Aggregate Demand and Supply AI generated image provided by Alex Tabarrok © 2024 Worth Publishers. All Rights Reserved.  Outline The Aggregate Demand Curve The Long-Run Aggregate Supply Curve Real Shocks Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve Shocks to the Components of Aggregate Demand Understanding the Great Recession and the COVID-19 Recession Takeaway © 2024 Worth Publishers. All Rights Reserved.  Introduction (1 of 4) Economic growth is not a smooth process. Real GDP in the United States has grown at an average rate of 3.1% per quarter over the past 60 years. The economy rarely grew at an average rate. Growth fluctuated from −5% to more than 8%. Recessions are of special concern to policymakers and the public because unemployment typically increases during them. © 2024 Worth Publishers. All Rights Reserved.  Definition (1 of 7) Business fluctuations: Fluctuations in the growth rate of real GDP around its trend growth rate. Recession: A significant, widespread decline in real income and employment. © 2024 Worth Publishers. All Rights Reserved.  Introduction (2 of 4) Quarterly growth rate in real GDP, 1960–2022 © 2024 Worth Publishers. All Rights Reserved.  Introduction (3 of 4) U.S. civilian unemployment rate, 1960–2022 © 2024 Worth Publishers. All Rights Reserved.  Introduction (4 of 4) To understand booms and recessions, we will develop a model of aggregate demand and aggregate supply (AD–AS), with three curves: – Aggregate demand curve – Long-run aggregate supply curve – Short-run aggregate supply curve The AD–AS model shows how unexpected economic disturbances or "shocks" can temporarily increase or decrease the rate of growth. © 2024 Worth Publishers. All Rights Reserved.  Definition (2 of 7) Aggregate demand curve: Shows all the combinations of inflation and real growth that are consistent with a specified rate of spending growth:   M  © 2024 Worth Publishers. All Rights Reserved.  The Aggregate Demand Curve (1 of 4) We can derive the AD curve using the quantity theory of money in dynamic form:     M    p  YR where:  M = Growth rate of the money supply   = Growth in velocity  p = Growth rate of prices (inflation)  YR = Growth rate of real GDP © 2024 Worth Publishers. All Rights Reserved.  The Aggregate Demand Curve (2 of 4) We can also write the equation as:   M    Inflation + Real growth Example: If money growth = 5%, velocity = 0%, and real growth is 0%, the inflation rate = 5%. In other words, if the money supply is growing, velocity is constant, and there are no additional goods, then prices must go up. © 2024 Worth Publishers. All Rights Reserved.  The Aggregate Demand Curve (3 of 4) Another example: If money growth = 5%, velocity = 0%, and real growth is 3%, the inflation rate = 2%. An AD curve tells us all the combinations of inflation and real growth that are consistent with a specified rate of spending growth:   M  In our example, any combination of inflation and real growth that adds up to 5% is on the same AD curve. © 2024 Worth Publishers. All Rights Reserved. The Aggregate Demand Curve (4 of 4) An AD curve with a slope of –1 means a 1 percentage point increase in real growth reduces inflation by 1%. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (1 of 5)   M   equals: a. real growth. b. inflation + nominal growth. c. inflation + real growth. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (1 of 5) (Answer)   M   equals: a. real growth. b. inflation + nominal growth. c. inflation + real growth. Answer:   c. M   = inflation + real growth. © 2024 Worth Publishers. All Rights Reserved. Shifts in the Aggregate Demand Curve (1 of 2) Increased spending must flow into either a higher inflation rate or a higher growth rate. – If spending growth increases, because of either an increase in money supply or an increase in velocity, then the AD curve shifts up and to the right. A decrease in spending growth shifts the AD curve inward. © 2024 Worth Publishers. All Rights Reserved. Shifts in the Aggregate Demand Curve (2 of 2) © 2024 Worth Publishers. All Rights Reserved. Long-Run Aggregate Supply Curve (1 of 2) Every economy has a potential growth rate determined by: – Increases in the stocks of labor and capital – Increases in productivity The rate of growth, as given by these real factors of production, is called the Solow growth rate. The long-run aggregate supply curve is a vertical line at the Solow growth rate, independent of the inflation rate. © 2024 Worth Publishers. All Rights Reserved. Long-Run Aggregate Supply Curve (2 of 2) Potential growth does not depend on the rate of inflation. © 2024 Worth Publishers. All Rights Reserved.  Definition (3 of 7) Solow growth rate: An economy's potential growth rate; the rate of economic growth that would occur given flexible prices and the existing real factors of production. Long-run aggregate supply curve (LRAS): Is vertical at the Solow growth rate. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (2 of 5) An economy's potential growth rate is called the: a. Solow growth rate. b. aggregate supply. c. aggregate demand. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (2 of 5) (Answer) An economy's potential growth rate is called the: a. Solow growth rate. b. aggregate supply. c. aggregate demand. Answer: a. An economy's potential growth rate is called the Solow growth rate. © 2024 Worth Publishers. All Rights Reserved.  Shifts in the LRAS Curve (1 of 2) When we put the AD and LRAS curves together, we can see how business fluctuations are caused by real shocks. In this model, the equilibrium inflation rate and the growth rate are determined by the intersection of the AD and LRAS curves. © 2024 Worth Publishers. All Rights Reserved. AD and LRAS Curves (1 of 2)   If M   is 10% and real growth is 3%, then the inflation rate will be 7%. © 2024 Worth Publishers. All Rights Reserved.  Shifts in the LRAS Curve (2 of 2) Economies are continually hit by real shocks, which shifts the Solow growth rate. Real shocks are rapid changes in economic conditions that increase or diminish the productivity of capital and labor. This, in turn, influences GDP and employment. Possible shocks include wars, weather, major new regulations, tax rate changes, mass strikes, terrorist attacks, and new technologies. © 2024 Worth Publishers. All Rights Reserved. AD and LRAS Curves (2 of 2) © 2024 Worth Publishers. All Rights Reserved.  Real Shocks (1 of 2) Agriculture has been the largest contributor to India's GDP. If farmers struggle, many other sectors suffer. Weather shocks influence both agricultural output and GDP. As the Indian economy has grown and diversified, shocks due to the weather become less economically important. © 2024 Worth Publishers. All Rights Reserved. Real Shocks: Weather © 2024 Worth Publishers. All Rights Reserved.  Real Shocks: Oil (1 of 3) In an economy with a large manufacturing sector, a reduction in the oil supply reduces GDP. Oil and machines are complementary: They work together with labor to produce output. When the oil supply is reduced, capital and labor become less productive. The first OPEC oil shock came in late 1973, and the price of oil more than tripled in two years. © 2024 Worth Publishers. All Rights Reserved.  Real Shocks: Oil (2 of 3) Since oil is an important input in many sectors, high oil prices—or oil shocks—hurt many American industries. In each of the last six U.S. recessions, there was a large increase in the price of oil just prior to or coincident with the onset of recession. A 10% increase in the price of oil lowers the GDP growth rate for a little more than two years. © 2024 Worth Publishers. All Rights Reserved. Real Shocks: Oil (3 of 3) The price of oil and U.S. recessions © 2024 Worth Publishers. All Rights Reserved.  Real Shocks (2 of 2) Negative Shocks = LRAS Curve Moves Positive Shocks = LRAS Curve Moves Left Right Bad weather (important in agricultural Good weather (important in agricultural economy) economy) Higher price of oil or another important Lower price of oil or another important input input Productivity slump/technology slump Productivity boom/technology boom Higher taxes or regulation Lower taxes or regulation Disruption of production by war, Smooth production without disruption earthquake, or pandemic © 2024 Worth Publishers. All Rights Reserved.  Self-Check (3 of 5) Higher business taxes will shift the long-run aggregate supply curve: a. to the left. b. to the right. c. Higher taxes will not shift the LRAS curve. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (3 of 5) (Answer) Higher business taxes will shift the long-run aggregate supply curve: a. to the left. b. to the right. c. Higher taxes will not shift the LRAS curve. Answer: a. Higher business taxes will decrease the LRAS curve, shifting it to the left. © 2024 Worth Publishers. All Rights Reserved.  Aggregate Demand Shocks (1 of 2) In his book The General Theory of Employment, Interest and Money, John Maynard Keynes explained that when prices are not perfectly flexible, deficiencies in aggregate demand can generate recessions. John Maynard Keynes © 2024 Worth Publishers. All Rights Reserved.  Definition (4 of 7) Short-run aggregate supply (SRAS) curve: Shows the positive relationship between the inflation rate and real growth during the period when prices and wages are sticky. © 2024 Worth Publishers. All Rights Reserved.  Short-Run Aggregate Supply Curve The SRAS curve is upward sloping. In the short run, an increase in AD will increase both inflation and the growth rate. In the short run, a decrease in AD will decrease both the inflation rate and the growth rate. Each SRAS curve is associated with a particular rate of expected inflation E(π). © 2024 Worth Publishers. All Rights Reserved. Short-Run Aggregate Supply © 2024 Worth Publishers. All Rights Reserved.  Definition (5 of 7) Aggregate demand shock: A rapid and unexpected shift in the AD curve (spending). © 2024 Worth Publishers. All Rights Reserved.  Aggregate Demand Shocks (2 of 2) A positive shock to spending must increase either inflation or the real growth rate. In the short run, an increase in spending will be split between increases in inflation and increases in real growth. In the long run, the real growth rate is equal to the Solow rate, which is not influenced by inflation. In the long run, therefore, an increase in spending will increase only the inflation rate. © 2024 Worth Publishers. All Rights Reserved. An Increase in Aggregate Demand (1 of 3) If there is an  unexpected ↑ in M, both inflation and the growth rate increase in the short run (a → b). © 2024 Worth Publishers. All Rights Reserved. An Increase in Aggregate Demand (2 of 3) Workers initially mistake a nominal wage increase for a real wage increase. Prices also don't move instantly because it is costly to change prices ("menu costs"). Firms may also hold off on making price changes because they are not sure whether the change in market conditions is temporary or permanent. As prices increase throughout the economy, workers demand even higher wages to catch up to the higher inflation rate. © 2024 Worth Publishers. All Rights Reserved.  Definition (6 of 7) Menu costs: The costs of changing prices. © 2024 Worth Publishers. All Rights Reserved.  Definition (7 of 7) Nominal wage confusion: Occurs when workers respond to their nominal wage instead of to their real wage—that is, when workers respond to the wage number on their paychecks rather than to what their wage can buy in goods and services (the wage after correcting for inflation). © 2024 Worth Publishers. All Rights Reserved. An Increase in Aggregate Demand (3 of 3) Eventually, inflation expectations adjust, wages become unstuck, and the growth rate returns to the Solow rate (b → c). © 2024 Worth Publishers. All Rights Reserved.  Self-Check (4 of 5) The costs associated with changing the prices of goods and services are called: a. inflation costs. b. inflationary expectations. c. menu costs. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (4 of 5) (Answer) The costs associated with changing the prices of goods and services are called: a. inflation costs. b. inflationary expectations. c. menu costs. Answer: c. Menu costs are associated with changing the prices of goods and services. © 2024 Worth Publishers. All Rights Reserved. A Decrease in Aggregate Demand (1 of 3) When aggregate demand (AD) falls due to a fall in the money supply: – The economy shifts to a new short-run equilibrium point. – The inflation rate is reduced. – Real growth is reduced (recession). Prices and wages are especially sticky in the downward direction. It can take the economy a long time to move out of a recession. © 2024 Worth Publishers. All Rights Reserved. A Decrease in Aggregate Demand (2 of 3) A decrease in AD can induce a lengthy recession. © 2024 Worth Publishers. All Rights Reserved. A Decrease in Aggregate Demand (3 of 3) © 2024 Worth Publishers. All Rights Reserved.  Shocks to Components of AD Changes in v:  Are the same as changes in the spending rate, holding M constant. Can be broken down into changes in the growth rate of C, I, G, or NX.  Changes in  tend to be temporary. The shares of GDP devoted to C, I, G, and NX have been quite stable over time. © 2024 Worth Publishers. All Rights Reserved. A Shock to the Growth Rate of Spending © 2024 Worth Publishers. All Rights Reserved.  Factors That Shift AD Positive Shocks (Increase AD) (= Higher Negative Shocks (Decrease AD) (= Lower Growth Rate of Spending) Growth Rate of Spending) A faster money growth rate A slower money growth rate Confidence Fear Increased wealth Reduced wealth Lower taxes Higher taxes Greater growth of government spending Lower growth of government spending Increased export growth Decreased export growth Decreased import growth Increased import growth © 2024 Worth Publishers. All Rights Reserved.  Self-Check (5 of 5) A slower growth in the money supply will: a. decrease AD. b. increase AD. c. not affect AD. © 2024 Worth Publishers. All Rights Reserved.  Self-Check (5 of 5) (Answer) A slower growth in the money supply will: a. decrease AD. b. increase AD. c. not affect AD. Answer: a. A slower growth in the money supply will decrease AD. © 2024 Worth Publishers. All Rights Reserved.  The Great Recession (1 of 3) The Great Recession started with a run on "shadow banks." The deposits at shadow banks are not insured by the FDIC, and the loans they made were less regulated. By 2008, the shadow banking system was lending trillions of dollars more than the traditional banking system was doing, including subprime lending. In late 2007, housing prices began to fall and the investors in the shadow banking system feared that borrowers, especially those in the subprime mortgage market, would not be able to pay back their loans. © 2024 Worth Publishers. All Rights Reserved.  The Great Recession (2 of 3) The subprime mortgage market wasn't large, but due to securitization, it wasn't clear which shadow banking institutions were most exposed. As a result, investors grew nervous about the shadow banking system and started a run on these banks, which led to a series of financial failures and an unprecedented decline in the availability of credit. This resulted in a decrease in the aggregate demand, which plunged the economy into a deep recession. © 2024 Worth Publishers. All Rights Reserved. The Great Recession (3 of 3) © 2024 Worth Publishers. All Rights Reserved. The COVID-19 Pandemic and Recession (1 of 5) COVID-19 pandemic increased the cost of working and being with other people, which made workers less productive. School shutdowns also meant many workers had to stay home. In just two months in 2020, 17 million Americans lost their jobs and the unemployment rate shot from 3.5% to 15%. © 2024 Worth Publishers. All Rights Reserved. The COVID-19 Pandemic and Recession (2 of 5) © 2024 Worth Publishers. All Rights Reserved. The COVID-19 Pandemic and Recession (3 of 5) During the COVID-19 recession, the LRAS curve shifted to the left as productivity of labor and capital declined. The aggregate demand also shifted to the left and down as people stopped spending on many leisure activities. © 2024 Worth Publishers. All Rights Reserved. The COVID-19 Pandemic and Recession (4 of 5) The relief and stimulus programs increased aggregate demand, but many of these programs that were started under President Trump were extended or increased under President Biden. The result was a large increase in aggregate demand that increased growth to above the long-run level given by the LRAS and sharply increased inflation. © 2024 Worth Publishers. All Rights Reserved. The COVID-19 Pandemic and Recession (5 of 5) © 2024 Worth Publishers. All Rights Reserved.  Takeaway (1 of 2) The aggregate demand and supply model can be used to analyze fluctuations in the growth rate of real GDP. Real shocks are analyzed through shifts in the LRAS curve, while aggregate demand shocks are analyzed using shifts in the AD curve. Nominal wage and price confusion, sticky wages and prices, menu costs, and uncertainty create an upward- sloping short-run aggregate supply curve. © 2024 Worth Publishers. All Rights Reserved.  Takeaway (2 of 2) The Great Depression resulted from an unfortunate, concentrated, and interrelated series of aggregate demand and real shocks. It can be illustrated using the AD–AS model. © 2024 Worth Publishers. All Rights Reserved.