Economics THIRD EDITION By John B Taylor Stanford University Copyright © 2001 by H Chapter 24 (Macro 11) The Economic Fluctuations Model Copyright © 2001 by H Overview • The main purpose of this chapter is to provide an explanation of the dynamics of economic fluctuations, particularly inflation and real GDP The economic fluctuations model is constructed by first deriving the aggregate demand/inflation curve and then the price adjustment line The model can be used to study the determination of real GDP and the price level Copyright © 2001 by H Teaching Objectives Explain that a basic set of factors causes real GDP to depart and return to potential over the business cycle Introduce interest rates and inflation into the dynamics of the business cycle Describe the important role that policy can play in altering the course of business cycles This is done through a policy rule that relates interest rates to aggregate expenditure Copyright © 2001 by H Teaching Objectives Explain the primary factors that determine location of the ADI curve This occurs through the components of aggregate spending that are sensitive to interest rates (spending balance) and the policy rule Explain the factors that shift the ADI curve: Changes of the policy rule and changes in government spending, along with autonomous shocks to aggregate spending, determine the location of the ADI curve Copyright © 2001 by H Teaching Objectives • Introduce the microeconomic basis of price adjustment Explain the PA line and the factors that cause it to shift Explain how the intersection of the ADI curve and the PA line determines the level of equilibrium real GDP and the inflation rate at some point in time in the economy Copyright © 2001 by H Key Terms • • • • • aggregate demand/inflation ( ADI ) curve target inflation rate monetary policy rule price adjustment ( PA ) line federal funds rate Copyright © 2001 by H The Aggregate Demand/Inflation Curve • The ADI curve shows that there is an inverse (negative) relationship between inflation changes and the corresponding changes in real GDP • When inflation increases, real GDP declines • When inflation slows down, real GDP goes up • Real GDP = C + I + G + X = AE Copyright © 2001 by H Figure 24.1 (Macro 11) The Aggregate Demand Curve Copyright © 2001 by H Between Inflation Interest Rate and Real GDP Copyright © 2001 by H 10 Movements along the AD curve • A change in inflation causes a movement along the demand curve • When inflation rises and the Fed raises the interest rate and real GDP declines This causes a movement up and to the left along the AD curve • When inflation decreases, there is a movement down and to the right Copyright © 2001 by H 23 Shifts of the AD curve • Besides inflation, other things affects aggregate demand • When such non-inflation determinants of AD curve changes, we say that there is a “shift” in the AD curve • Changes in government purchases, shifts in monetary policy, changes in taxes, shifts in demand for next exports, changes consumer confidence, among others, affect AD Copyright © 2001 by H 24 Figure 24.5 (Macro 11) How Government Purchases Shift the Aggregate Demand Curve Copyright © 2001 by H 25 Figure 24.6 (Macro 11) A Shift in the Monetary Policy Rule Copyright © 2001 by H 26 Figure 24.7 (Macro 11) A List of Possible Shifts in the Aggregate Demand Curve Copyright © 2001 by H 27 Inflation Adjustment Line (IA) • IA is a flat line showing the level of inflation in the economy at any point in time • It describes the behavior of firms and workers setting prices and wages in the economy Copyright © 2001 by H 28 Figure 24.8 (Macro 11) Inflation Adjustment and Changes in Inflation Copyright © 2001 by H 29 Inflation Adjustment Line (IA) • The flat IA indicates that firms and workers adjust (change) prices and wages in such a way that the inflation remains intact in the short run as real GDP changes • There are two reasons why inflation stays steady even if real GDP is changing: expectations about continuing inflation and staggered wage and price setting in the economy Copyright â 2001 by H 30 Reason #1 Pricing decisions for the whole economy require that the price expectations of other firms be taken into account Similarly, wage adjustments are made in the context of existing and future wage agreements Copyright © 2001 by H 31 Reason #1 • Expectations about the price and wage decisions of other firms lead firms to raise prices by more than expected inflation if demand is high and by less than expected inflation if demand is low A parallel process governs wage adjustments Copyright â 2001 by H 32 Reason #2 Not all wages and prices are changed at the same time Rather, they are staggered over months and even years • Staggered wages and prices act to slow down the rapid adjustment of prices This also introduces a dependency between current and past price and wage decisions • On any given day, the vast majority of wages and prices not change much Copyright © 2001 by H 33 Inflation Adjustment • Expectations, when combined with staggered decisions, make recent past inflation a factor in current inflation Moreover, because the strength of a price adjustment relative to inflation expectations will depend on whether demand is high or low across the economy, the relation between real and potential GDP determines whether inflation increases, decreases, or remains unchanged For example, if real GDP is below potential, inflation decreases Copyright © 2001 by H 34 Inflation Adjustment Line • Three assumptions about the IA line are needed First, the IA line represents the rate of inflation in the economy at a point in time It is flat, indicating that prices are sticky in the short run Second, the IA line shifts after GDP departs from potential Third, any change in expectations or materials prices will shift the IA line • These assumptions and the horizontal IA line receive statistical support in real world Copyright © 2001 by H 35 Combining the Aggregate Demand/Inflation Curve and the Price Adjustment Line • When the ADI curve and PA line are combined, as in Figure 27.10, the rate of inflation and real GDP are determined This may occur above, below, or at potential GDP • The intersection of the ADI curve and the IA line gives a pair of observations on real GDP and inflation at any point time Copyright © 2001 by H 36 Figure 24.10 (Macro 11) Determining Real GDP and Inflation Copyright © 2001 by H 37