Short-run economic fluctuations
THE BUSINESS CYCLE
WHAT DETERRMINES AGGREGATE EXPENDITURE
THE COMPLETE ECONOMY
FLUCTUATIONS IN
THE INFLATION RATE
LONG-RUN MONETARY
NEUTRALITY
output
unemployment.
Normal levels
(Average)
level of real gross domestic product (real GDP).
the percentage of the labor force without
jobs.
potential output,
natural rate
depends
levels of resources
number of workers
amount of physical capital
technologies
amount produced when resources are used with a normal intensity
normal
or average level of unemployment.
economy’s resources
labor force
Same intensity
such problems
determines the natural rate of unemployment.
Boom and recessions
Output fluctuations
unemployment fluctuations
economic
booms.
recessions
measure
output gap (Y)
above the natural rate
below the natural rate
Recessions
Booms
relationship between out-
put and unemployment.
Okun's law
Aggregate expenditure(AE)
are caused by changes in
total spending on an econ-
omy’s goods and services
By
people,
firms
governments
higher
expenditure leads to higher output.
Components of expenditure
Consumption (C)
Investment (I)
Government purchases (G)
Net exports (NX)
Role of interest rate
rise in the real interest rate reduces aggregate expenditure. Conversely, a fall in the interest rate raises AE.
Effects on Spending
Consumption
net exports
Investment
The Consumption Multiplier
A fall in spending reduces people's incomes
reduce
consumption
The Aggregate Expenditure Curve
Monetary policy
and equilibrium output
Monetary Policy and the Real Rate
in the short run, the central bank’s control of the nominal interest
rate allows it to control the real rate as well.
the real rate is the nominal rate minus expected inflation
Equilibrium Output
output depends on the AE curve and the central bank’s choice of the real interest rate.
Shifts in Monetary Policy
Outputmrises or falls when the central bank changes the real interest rate.
expenditure shock.
Any event that changes aggregate expendi-
ture for a given interest rate
Types of Expenditure Shocks
Government spending
Taxes
Consumer confidence
New technologies
Changes in bank lending
Foreign business cycles
Countercyclical monetary policy
it adjusts the interest rate to offset the effect of the expenditure shock.
Supply shocks
The effeccts of output
Expected inflation
you raise your nominal price (your price in dollars) to maintain the same
relative price (your price compared to other prices).
What determines it
Adaptive Expectations
Choosing an Assumption
Rational Expectations
classical theory of asset prices assumes rational expectations about firms’ earnings.
People expect inflation to continue at the rate they’ve seen recently.
To analyze the economy, we must choose an
assumption about expectations.
Why Output Matters
High production increases the firm’s marginal costs
The Phillips curve
What Are They?
event that
causes a major change in firms’ production costs.
An adverse supply shock
raises costs
beneficial supply shock reduces costs.
Supply Shocks and the Phillips Curve
We can capture the effects of supply
shocks in our graph of the output Phillips curve.
AE/PC model
aggregate expenditure/Phillips curve model.
assumes a negative relationship between the interest rate and output (AE curve) and a positive relationship between output and inflation (Phillips curve)
Combining the two curves
the real interest rate and the AE curve determine equilibrium output.
effects
A Rise in the Real Interest Rate
An Expenditure Shock
A Supply Shock
In this example policymakers can reduce inflation
by raising the real interest rate, but at the cost of reducing output in the short run.
shows the effects of a positive shock,such as a tax cut or a rise in consumer confidence, which raises aggregate expenditure
two possible outcomes can occur.
central bank keeps the real interest rate constant.
nonacommodative
monetary policy.
called accommodative monetary policy. The central bank responds passively to (accommodates)the supply shock, letting inflation go where the adverse shock pushes it.
prevents the shock from raising inflation, but at the cost of lower output.
The economy over time
A Rise in the Real Interest Rate
An Adverse Supply Shock
Assume the economy
starts out with output at potential and no supply shocks. time. Then the central bank raises the real interest rate.
the effects of supply shocks depend on the central bank’s response.
nonaccommodative.
accommodative policy.
Long-run output and unemployed
a permanent boom
The neutral real interest rate
Output deviates from potential
during booms and recessions, but it returns to potential in the long run.
monetary policy does not affect output and unemployed in the long run.
bank ignores this principle and tries to change output permanently.
Let’s say it lowers the real interest rate
When output exceeds potential, the inflation rate rises above its previous level.
real interest rate is independent of
monetary policy in the long run.
neutral real interest rate
unique real interest rate makes output equal potential output,
