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Ohio Wesleyan University Goran Skosples 11. Oil Shocks of the 1970s and the Great Depression

Ohio Wesleyan University Goran Skosples 11. Oil Shocks of the 1970s and the Great Depression. Two case studies: Oil shocks of the 1970s The Great Depression. Supply shocks. A supply shock alters production costs, affects the prices that firms charge. (also called ____ shocks )

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Ohio Wesleyan University Goran Skosples 11. Oil Shocks of the 1970s and the Great Depression

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  1. Ohio Wesleyan UniversityGoran Skosples11. Oil Shocks of the 1970s and the Great Depression

  2. Two case studies: • Oil shocks of the 1970s • The Great Depression

  3. Supply shocks A supply shock alters production costs, affects the prices that firms charge. (also called ____ shocks) Examples of adverse supply shocks: Bad weather reduces crop yields, pushing ____ __________. Workers unionize, negotiate ______________. New environmental regulations require firms to reduce emissions. Firms ________________ to help cover the costs of compliance. Favorable supply shocks _______ costs and prices.

  4. CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in 1973 68% in 1974 16% in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

  5. CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS ____, causing output and employment to ___. LRAS P SRAS1 AD Y In absence of further price shocks, prices will ___ over time and economy moves ______________ ______________. A A

  6. CASE STUDY: The 1970s oil shocks Predicted effects of the oil shock: inflation __ output __ unemployment _ …and then a gradual recovery.

  7. CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

  8. CASE STUDY: The 1980s oil shocks 1980s: A favorable supply shock--a significant fall in oil prices. As the model predicts, inflation and unemployment ______:

  9. CASE STUDY: The 1970s oil shocks What is the prediction about interest rates?

  10. Exercise An oil cartel effectively increases the price of oil by 100 percent, leading to an adverse supply shock in both Country A and Country B. Both countries were in long-run equilibrium at the same level of output and prices at the time of the shock. The central bank of Country A takes no stabilizing-policy actions. After the short-run impacts of the adverse supply shock become apparent, the central bank of Country B increases the money supply to return the economy to full employment. a. Describe the short-run impact of the adverse supply shock on prices and output in each country. b. Compare the long-run impact of the adverse supply shock on prices and output in each country.

  11. r r LM0(M0/P0) LM0(M0/P0) r0 r0 IS1 IS1 Y Y Y0 Y0 LRAS LRAS P P SRAS0 SRAS0 Po Po AD0 AD0 Y Y Y0 Y0 Exercise B A

  12. U.S. Unemployment, Output Growth, Prices, and Money, 1929 to 1942 Year UnemploymentRate (%) Output Growth Rate (%) Price Level Nominal Money Stock 1929 3.2 9.8 100.0 26.6 1930 8.7 7.6 97.4 25.7 1931 15.9 14.7 88.8 24.1 1932 23.6 1.8 79.7 21.1 1933 24.9 9.1 75.6 19.9 1934 21.7 9.9 78.1 21.9 1935 20.1 13.9 80.1 25.9 1936 16.9 5.3 80.9 29.5 1937 14.3 5.0 83.8 30.9 1938 19.0 8.6 82.2 30.5 1939 17.2 8.5 81.0 34.1 1940 14.6 16.1 81.8 39.6 1941 9.9 12.9 85.9 46.5 1942 4.7 13.2 95.1 55.3 The Great Depression

  13. Shocks to the IS curve an exogenous fall in the demand for goods & services – a leftward shift of the IScurve. Stock market crash  exogenous C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71% Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits.

  14. A shock to the LM curve a huge fall in the money supply. evidence: M1 fell 25% during 1929-33. The relation between the money stock, M1, and the monetary base (physical money) is given by: M1 = monetary base x money multiplier

  15. A shock to the LM curve but, P also fell 25% during 1929-33.  the effect on the LM curve should be neutral What was the problem then? recall: r = i -  e

  16. r r LM2 LM1 L(i-2e,Y1) L(i-1e,Y1) Y M/P Y1 How e shifts the LM curve (a) The market for real money balances (b) The LM curve r2 r2 r1 r1 M1/P1 e _r (for the same i) _ L  __LM

  17. r P LM0(M0/P0) r0 IS0 Y Y LRAS SRAS0 P0 AD0 Y0 The effects of falling prices r = i -  e • IS AD shifts __ Y1Y0  P • LM should shift __ • but, M   LM const • AD shifts ___ • At the same time •  P e •  eLM shifts ___ • AD shifts ___ Result:  __ P, __ Y, __ r Y0

  18. Why another Depression is unlikely Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let __ fall so much, especially during a contraction. Fiscal policymakers know better than to raise ______ or cut __________ during a contraction. Federal deposit insurance makes widespread bank failures very unlikely. Automatic ___________ make fiscal policy expansionary during an economic downturn.

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