Chapter Twenty-Two

1. Chapter Twenty-Two

2. Introduction • While the economy can and does move away from long-run equilibrium, it has a natural self-correcting mechanism. • It returns it to the point where resources are being used at their normal rates and • Gaps between current and potential output disappear.

3. Introduction • Why is it that output and inflation vary from quarter to quarter and year to year? • What determines the extent of the fluctuations? • Figure 22.1 illustrates the long-run trends in the U.S. inflation rate over the past 50 years. • It also displays a series of shaded bars representing recessions.

4. Introduction • While there is no apparent relationship between the level of inflation and these recessions, it does appear that the inflation rate: • Falls when the economy is contracting. • Rises when it is expanding. • At least that is what happens most of the time. • But in general there appears to be a connection between growth and changes in inflation.

5. Introduction

6. Introduction • In recent years, the frequency of recessions has fallen. • Recessions used to occur once every five years. • Now they occur on average about every eight years. • This reduction in the volatility of real growth has been called the “Great Moderation.”

7. Introduction • In this chapter we will: • Catalogue the various reasons that the dynamic aggregate demand curve and the aggregate supply curve shift. • Examine what happens during the transition as the economy moves to long-run equilibrium. • Use the model to understand how central bankers work to achieve their stabilization objectives.

8. Introduction • We will also examine: • How policymakers work to achieve their stabilization goals; • The appropriate actions to take when potential output changes; and • The difficulty central bankers have figuring out why output has fallen.

9. Sources of Fluctuations in Output and Inflation • Remember that long-run equilibrium means: • Y = YP output = potential output. •  = T inflation = target inflation. •  = e inflation = expected inflation. • Short-run equilibrium means: • The dynamic aggregate demand curve (AD) and the short-run aggregate supply (SRAS) curve cross.

10. Sources of Fluctuations in Output and Inflation • Immediately after either the SRAS curve or AD curve shift, the economy will move away from its long-run equilibrium. • Understanding short-run fluctuations in output and inflation requires that we study shifts in AD and SRAS.

11. Sources of Fluctuations in Output and Inflation • In this chapter we will be looking at shocks. • Economists define shocks as something unexpected, for example, an increase in oil prices or change in consumer confidence. • A shock shifts the AD or SRAS curve. • Because it affects costs of production, the oil price increase is a supply shock. • A change in consumer confidence affects consumption expenditure so it is a demand shock.

12. Shifts in the Dynamic Aggregate Demand Curve • Recall that a shift in the AD curve can be cause by either: • A shift in the monetary policy reaction curve or • A change in components that are not sensitive to the interest rate that shifts aggregate expenditure, for example, government spending.

13. A Decline in the Central Bank’s Inflation Target • Over the past several decades, numerous countries have succeeded in reducing their inflation rates from fairly high levels to the modest ones we see today. • All of these changes involved permanent declines in inflation that must have been a result of a decrease in the central bank’s inflation target.

14. A Decline in the Central Bank’s Inflation Target • To analyze this, we begin with the monetary policy reaction curve. • A fall in T shifts the monetary policy reaction curve to the left. • The decrease in the inflation target raises the real interest rate policymakers set at each level of inflation. • This reduces aggregate expenditure shifting the AD curve to the left as well. • The economy moves to a new short-run equilibrium.

15. A Decline in the Central Bank’s Inflation Target

16. A Decline in the Central Bank’s Inflation Target • The new short-run equilibrium at 2 has inflation and current output lower than they were prior to the monetary policy tightening. • This creates a recessionary gap: Y < YP. • There is now downward pressure on production costs. • This shifts SRAS to the right. • The new long-run equilibrium at 3 is where inflation equals the central bank’s new target and output equals potential output.

17. A Decline in the Central Bank’s Inflation Target

18. An Increase in Government Purchases • What are the macroeconomic implications of a large expansionary move in fiscal policy? • An increase in G shifts the AD curve to the right. • The economy moves from the original short-run equilibrium point 1 to a new short-run equilibrium point 2. • The immediate impact is to raise both current output and inflation.

19. An Increase in Government Purchases

20. An Increase in Government Purchases • Because potential output has not changed, this is not the long-run effect. • The higher level of current output means that there is an expansionary gap: Y > YP. • Firms increase both their product prices and wages more than they would at normal output. • This shifts the SRAS curve to the left, driving inflation even higher.

21. An Increase in Government Purchases • As inflation increases, monetary policymakers raise the real interest rate, moving the economy along the AD curve. • Output begins to fall back toward its long-run equilibrium level, potential output. • The economy settles at point 3. • Note, however, that inflation is higher at 3 than it was at 1. • This is above the policymakers’ original inflation target, T.

22. An Increase in Government Purchases

23. An Increase in Government Purchases • So long as monetary policymakers remain committed to their original inflation target, they need to do something to get the economy back to the point where it began. • In this case, tighter monetary policy shifts the AD curve to the left. • This brings the economy back to the long-run equilibrium where output equals potential output and inflation equals the central bank’s target.

24. An Increase in Government Purchases • Without a change in target inflation, an increase in government purchases causes a temporary increase in both output and inflation.

25. A Decline in Aggregate Expenditure • A decline in aggregate expenditure has the opposite effect of an increase in government spending. • The AD curve shifts to the left, driving output down. • A decline in aggregate expenditure causes a temporary decline in both output and inflation. • In the absence of any monetary policy response, the recessionary output gap causes the SRAS curve to shift to the right.

26. A Decline in Aggregate Expenditure • The shift in the SRAS curve drives inflation down future and current output begins to rise toward potential. • If policymakers do not react, inflation and output will return to their original long-run levels.

27. Shifts in the Dynamic Aggregate Demand Curve - Examples • In response to increases in government spending during the escalation of the Vietnam War in the late 1960s, • The Fed simply allowed inflation to rise. • What could have been a temporary increase in inflation became a permanent one.

28. Shifts in the Dynamic Aggregate Demand Curve • Large tax cuts in 2001 and rise in defense spending associated with the war in Iraq did not have the same impact at in the 1960s. • The fiscal stimulus came at a time when the economy was weakening for other reasons. • The Fed had learned the important lesson that it may need to raise interest rates to counter the risk of inflation from expansionary fiscal policy.

29. Summary of Impact of Increase in Dynamic Aggregate Demand

30. Shifts in Short-Run Aggregate Supply • Changes in production costs shift the SRAS curve. • What are the effects of an increase in the costs of production - a negative supply shock? • Ex: Increase in price of oil. • Immediately the SRAS curve shifts left. • These are bad consequences: higher inflation and lower growth

31. Shifts in Short-Run Aggregate Supply • The short-run equilibrium moves to point 2 where the new SRAS curve meets AD. • This creates a condition referred to as stagflation. • Economic stagnation coupled with increased inflation. • The recessionary gap puts downward pressure on production costs and inflation.

32. Shifts in Short-Run Aggregate Supply

33. Shifts in Short-Run Aggregate Supply • As a result of the recessionary gap, the SRAS curve begins to shift right. • This drives inflation down and output up. • This continues until the economy returns to potential output and the central bank’s target inflation level.

34. Shifts in Short-Run Aggregate Supply • As with an increase in government purchases, a supply shock has no effect on the economy’s long-run equilibrium point. • A supply shock causes inflation to rise temporarily and then fall. • This happens at the same time that current output falls temporarily and then rises. • In the long run, the economy returns to the point where output equals potential output and inflation equals the central bank’s target.

35. Shifts in Short-Run Aggregate Supply

36. A recession is a decline in activity, not just a dip in growth rate. • Exact length is ambiguous. • Dating the peaks and troughs involves judgment. • Table 22.3 displays the results of the NBER’s analyses of the business cycle since the end of WWII. • Recessions differ along several dimensions: depth, duration, and diffusion.

39. Using the Aggregate Demand-Aggregate Supply Framework We examine the following: • How do policymakers achieve their stabilization objectives? • What accounts for the “Great Moderation”? • What happens when potential output changes? • What are the implications of globalization for monetary policy? • Can policymakers distinguish a recessionary gap from a fall in potential output? • Can policymakers stabilize output and inflation simultaneously?

40. How Do Policymakers Achieve Their Stabilization Objectives? • The aggregate demand-aggregate supply framework is useful in understanding how monetary and fiscal policymakers seek to stabilize output and inflation using stabilization policy. • When shifting their reaction curve, central bankers shift AD. • They cannot shift the SRAS curve. • This means monetary policymakers can neutralize demand shocks, but cannot offset supply shocks.

41. How Do Policymakers Achieve Their Stabilization Objectives? • Nevertheless, positive supply shocks that raise output and lower inflation provide policymakers with an opportunity. • Following a positive supply shock, central bankers can guide the economy to a new, lower inflation target without inducing a recessionary output gap.

42. How Do Policymakers Achieve Their Stabilization Objectives? • As for fiscal policy, our macroeconomic framework allows us to study the impact of changes in government taxes and expenditures as well. • The active use of fiscal policy faces great challenges. • The conclusion is that stabilization policy is usually best left to central bankers.

43. Monetary Policy • What happens if consumers and businesses suddenly become more pessimistic about the future? • This shifts the AD curve to the left. • Output falls below potential causing a recessionary gap.

44. Monetary Policy • Drop in consumer or business confidence: • AD0 AD1 • Economy 12 • Stabilization requires shifting AD back towhere it started.

45. Monetary Policy • Policymakers will conclude that the long-run real interest rate has fallen. • If the inflation target stays the same, the drop in aggregate expenditure prompts them to shift the monetary policy reaction curve to the right. • This reduces the level of the real interest rate. • The AD curve now shifts right, back to its original level. • The policy response means the economy will be back at long run equilibrium.

46. Monetary Policy

47. Monetary Policy • In practice, it is extremely difficult to keep inflation and output from fluctuating when aggregate expenditure changes. • There are two reasons: • It takes time to recognize what has happened. • Changes in interest rates do not have an immediate impact on the economy. • While in theory we can neutralize aggregate demand shocks, in reality they create short-run fluctuations in output and inflation.

48. Stability improves welfare. • Individuals strive to stabilize consumption, but it can be difficult. • When income falls temporarily you can: • Draw on savings (emergency funds) or • Borrow using credit. • But credit is only a stop-gap measure. • The financial crisis of 2007-2009 demonstrates how risky credit can be.

49. Discretionary Fiscal Policy • There are two types of fiscal policy: • Automatic stabilizers. • Automatic stabilizers operate without any further actions on the part of the government. • Ex: unemployment insurance and the proportional nature of the tax system. • Discretionary policy. • Discretionary policy relies on fiscal policymakers’ decisions. • Discretionary policy changes aggregate expenditures shifting the dynamic aggregate demand curve.

50. Discretionary Fiscal Policy • Fiscal policy can act just like monetary policy to offset shifts in the dynamic aggregate demand curve and stabilize inflation and output. • On closer examination, however, it has at least two shortcomings: • Discretionary fiscal policy works slowly, and • It is almost impossible to implement effectively.