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SHORT-RUN ECONOMIC FLUCTUATIONS - Coggle Diagram
SHORT-RUN ECONOMIC FLUCTUATIONS
THE BUSINESS CYCLE
The output and unemployment rate of an economy fluctuate throughout the business cycle.
Output
means the level of real gross domestic product (real GDP).
The unemployment rate (U) is the percentage of the labor force without a job.
The business cycle is made up of short-term movements in output and unemployment. From year to year, these variables fluctuate around their normal or average levels.
Long-run production and unemployment
The normal level of output is called potential output, and the normal rate of unemployment is the natural rate..
OUTPUT Potential output (Y*)
It is the normal level of product that an economy is capable of producing.
It depends on resource levels, such as the number of workers and the amount of physical capital (factories and machines). The potential output also depends on the technologies available to convert resources into goods and services.
The natural rate of unemployment (U*)
It is the normal or average level of unemployment. It is the unemployment rate when the economy's resources, including its workforce, are used at normal intensity.
Unemployment is at the natural rate when output equals potential output.
Booms and recessions
Potential production grows smoothly over time. Increases gradually as resources increase and technology improves, but does not increase sharply from year to year
output fluctuations
Periods when actual output exceeds potential output are called economic booms.
The economy produces more than usual given its resources, and periods with output below potential are called recessions.
Economists measure the size of booms and recessions with the output gap. This variable is the percentage difference between actual and potential output.
The output gap is positive in booms and negative in recessions.
Unemployment fluctuations
Unemployment is above the natural rate in recessions and below it in booms.
Okun's Law
This law explains the relationship between production and unemployment
https://www.youtube.com/watch?v=TNwhHLt1ciY
Aggregate Expenditure
The fluctuations are caused by changes in aggregate expenditure (AE). This variable is the total spending on goods and services in an economy by individuals, businesses, and governments.
Total spending varies over time, which causes the business cycle.
An increase in spending means higher sales for companies that produce goods and services. When companies sell more, they respond by increasing their production
WHAT DETERMINES AGGREGATE EXPENDITURE?
The components of the expense
AE can be broken down into four components that you may remember from your principles of economics course
Consumption (C) covers purchases of goods and services by people.
Investment (I) means purchases of physical capital, such as new factories, machines, and houses.
Government purchases (G) includes roads, military aircraft and salaries
of government workers
Net Exports (NX) are exports minus imports.
These four components add up to aggregate spending.
Anything that affects one of the spending components affects aggregate spending and thus affects output.
The role of the interest rate
Effects on spending
The real interest rate affects three of the four spending components, all except government purchases.
Consumption: A higher real interest rate encourages people to save.
Net exports: An increase in the real interest rate reduces a country's net capital outflows, which in turn raises the real exchange rate.
Investment: A higher real interest rate makes it more expensive for companies to finance investment projects.
The aggregate spending curve
The AE curve shows how the real interest rate affects aggregate spending and thus output.
The output can be higher or lower than the potential output (Y*), depending on the interest rate.
The consumption multiplier
The effects of a higher interest rate on aggregate spending are magnified by the consumption multiplier
A drop in spending reduces people's income, which in turn reduces their consumption
An increase in the real interest rate reduces aggregate spending.
Conversely, a fall in the interest rate raises AE.
Spending shocks
Any event that changes aggregate spending for a given interest rate is called a spending shock. A spending shock causes the AE curve to shift.
Output rises from below potential to above potential: the spending shock moves the economy from a recession to a boom.
Types of spending shocks
Changes in bank loans
If loans are reduced, companies reduce investment
consumer confidence
If consumption falls sharply, it shifts the AE curve to the left, which can cause a recession.
Public spending
An increase in government spending shifts the AE curve to the right, contributing to an economic boom
Foreign Business Cycles
A change in the production of one country affects the production of its trading partners.
Taxes
A tax increase means consumers have less income to spend.
Consumption falls, shifting the AE curve to the left.
New technologies
If investment in technology skyrockets, it shifts the AE curve to the right and raises output.
Shocks can increase spending, shifting the AE curve to the right, or reduce spending, shifting it to the left. In each case, output changes if the central bank holds the interest rate constant.
Countercyclical monetary policy
The central bank may want to keep output constant. If so, adjust the interest rate to offset the effect of the spending shock
https://www.youtube.com/watch?v=fVkQlpXpNtg
Monetary Policy and Equilibrium Product
Changes in monetary policy
Output rises or falls when the central bank changes the real interest rate.
"Puede ser necesaria una recesión para controlar la inflación"
In the short term, what determines the real interest rate is the central bank.
Balance output
Output depends on the AE curve and the central bank's choice of real interest rate. In effect, the central bank chooses a point on the AE curve.
Output could be at or above potential if the central bank chose a lower interest rate.
FLUCTUATIONS IN THE INFLATION RATE
Expected inflation
The rate of inflation that companies expect becomes the rate that actually occurs.
Where Pi is the actual inflation that becomes the expected inflation
What determines expected inflation?
Adaptive expectations
Expectations are not based on all available information.
Instead, expected inflation is determined by only one thing: past inflation.
People expect inflation to continue at the pace it has seen recently.
Where (-1) indicates the previous year low, the expected inflation for the current year is the actual inflation during the previous year
Supply shocks
Supply shocks and the Phillips curve
The effects of supply shocks can be captured on the graph of the Phillips curve of output
An adverse supply shock raises inflation for any expected level of inflation and output
As shown in the figure, the Phillips curve shifts up from PC1 to PC2.
A beneficial supply shock has the opposite effect, shifting the Phillips curve down.
The Phillips curve of output with supply shocks
1 more item...
The Output Phillips Curve with Adaptive Expectations and Supply Shocks
1 more item...
It is an event that causes an important change in the production costs of companies.
An adverse supply shock increases costs and a beneficial supply shock reduces costs.
In the short term, these shocks cause changes in the inflation rate.
choose a guess
To analyze the economy, one assumption about expectations must be chosen, and this assumption helps keep our analysis simple.
For each survey, the figure plots the average of reported inflation expectations against the actual inflation rate during the previous year.
This assumption does not fit the data perfectly, but it is a reasonable approximation.
The effect of the output
Why does output matter?
This curve shows the short-run relationship between output and inflation. It captures our assumptions that inflation equals expected inflation when output is at potential, and that higher output raises inflation.
This version of the curve involves unemployment rather than output and reveals a negative relationship. Inflation equals expected inflation if unemployment equals its natural rate
Inflation rises if unemployment falls below the natural rate, and falls if unemployment rises.
When output is below potential, lower marginal costs push inflation below
expected inflation.
When output exceeds potential, rising marginal costs give firms additional incentives to raise prices. As a result, inflation rises above expected inflation.
The inflation rate falls 1 percentage point when unemployment is 1 point above the natural rate.
However, the Phillips curve relationship is far from perfect.
rational expectations
The classical theory of asset prices assumes rational expectations about the earnings of companies.
Because monetary policy affects inflation, expectations depend on the central bank's actions and statements.
https://www.youtube.com/watch?v=TOVvFXR3jA8
https://www.youtube.com/watch?v=Chx1vbLynFY
THE COMPLETE ECONOMY
The economy over time
The link between the present and the future occurs through the Phillips curve.
With our assumption of adaptive expectations, the Phillips curve says
that the current inflation rate depends on last year's inflation
An adverse supply shock
the effects of supply shocks depend on the response of the central bank. Figure 12.22 shows an accommodative policy.
The central bank holds the interest rate constant despite the shock, so output remains constant.
With output at potential and no further shocks, the change in inflation is zero.
An accommodative monetary policy allows a supply shock to raise inflation permanently.
Figure 12.23 shows the effects of a supply shock when policy is not accommodative.
The central bank raises the real interest rate in 2020 and output falls. Inflation remains constant in 2020, as the effect of lower production offsets the shift in the Phillips curve
As with the accommodative policy, inflation remains constant after 2020, but here it remains constant at its original level.
Non-accommodative policy prevents inflation from skyrocketing.
An increase in the real interest rate
Assuming that the economy starts with potential output and no supply shocks, the Phillips curve implies that inflation is constant over time.
The central bank then raises the real interest rate.
The figure shows the movements in the interest rate
Shows output behavior, a higher interest rate moves the economy along the AE curve, reducing output
It shows the behavior of inflation over the previous ones.
This scenario exemplifies disinflationary monetary policy, a temporary increase in the real interest rate that reduces inflation
A central bank adopts such a policy if it believes that the rate of inflation is too high. The cost of disinflation is lower production.
A temporary drop in output reduces inflation permanently. Once inflation reaches an acceptable level, the central bank can reverse the interest rate increase (Figure A). At that point, output returns to potential (Figure B) and inflation remains low (Figure C).
Combining the two curves
An increase in the real interest rate
In Figure 12.17A, the central bank raises the real interest rate from r1 to r2. This action moves the economy along the AE curve, pushing output below potential.
Policymakers can reduce inflation by raising the real interest rate, but at the cost of reducing output in the short run.
In Figure 12.17B, lower output moves the economy along the Phillips curve, reducing inflation below expected inflation.
We can use the AE and Phillips curves to see how various events affect
the economy
In each, we initially assume that output is at its potential level and that inflation equals expected inflation.
Here output and the Phillips curve determine inflation
Here the real interest rate and the AE curve determine the equilibrium output.
A spending shock
Figure 12.18 shows the effects of a positive shock, such as a tax cut or an increase in consumer confidence, that increases aggregate spending.
The impact shifts the AE curve to the right
Assuming that the central bank holds the real interest rate constant, output rises above potential.
Higher output moves the economy along the Phillips curve toward a higher rate of inflation.
A supply shock
The central bank chooses a non-accommodative monetary policy. It acts to keep inflation constant by raising the real interest rate,
which reduces production.
The Phillips curve shifts up, but the effect of this shift on inflation is offset by the effect of lower output
Non-accommodative policy prevents the shock from increasing inflation, but at the cost of lower output.
The central bank holds the real interest rate constant. Because the shock does not affect the AE curve, output remains at its potential.
The adverse supply shock causes the Phillips curve to shift up, leading to higher inflation.
The behavior of the central bank in this case is called accommodative monetary policy. The central bank passively responds to (accommodates) the supply shock, letting inflation go where the adverse shock pushes it.
The two curves are put together to get a complete picture of short-term economic fluctuations: the aggregate spending/Phillips curve model.
This model assumes a negative relationship between the interest rate and output (the AE curve) and a positive relationship between output and inflation (the Phillips curve).
LONG-TERM MONETARY, NEUTRALITY
By changing the nominal interest rate, the Federal Reserve can change the real interest rate, which in turn affects output, unemployment, and inflation.
In the long run, monetary policy does not usually affect real variables, those that are adjusted for inflation, such as real GDP and real interest rates.
A permanent boom?
When output exceeds potential, the inflation rate rises above its previous level. As long as production remains high, inflation will continue to rise.
The rate of inflation reaches higher and higher levels and eventually becomes astronomical. A central bank is not likely to allow this to happen.
Accelerating inflation forces the central bank to abandon the goal of increasing output permanently
The neutral real interest rate
Like output and unemployment, the real interest rate is independent of monetary policy in the long run.
Given the AE curve, a single real interest rate makes output equal to potential output, Y*
This interest rate is called the neutral real interest rate (rn), because it implies neither a boom nor a recession.
An exception to the rule?
a recession can make the labor force less employable, raising the natural rate of unemployment.
The principle of long-run monetary neutrality is a central tenet of economic theory.
Economists who hold this view argue that a tightening of monetary policy can cause a deep recession and that unemployment during a recession
it leaves scars on the labor force, scars that raise the natural rate of unemployment.
This because the natural rate rises, unemployment remains high even after the recession ends.
The devastating effects of prolonged unemployment can take many forms.
Long-run production and unemployment
Output deviates from potential during booms and recessions, but returns to potential in the long run.
Potential output is the normal level of output that the economy produces.and it depends on factors such as labor, capital stock, and technology.
Potential output is not influenced by monetary policy. When the central bank changes the interest rate, it affects aggregate spending but not the productive capacity of the economy.
Therefore, the central bank's action affects Y but not Y
.
Since Y
determines output in the long run, monetary policy does not affect output in the long run.
The unemployment rate is also independent of monetary policy in the
long term.
