ECON 311 GMU Intermediate Macroeconomics Inflation Journal Exercise

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Intermediate Macroeconomics
ECON 311
Fall 2021
The purpose of the journal exercise is twofold: (1) to encourage you to follow current events and
(2) to provide you the opportunity to apply the concepts discussed in the readings and class.
The journals work as follows. Over the course of the semester students are responsible for
finding two separate current events related to the topics discussed in the class and readings.
Each journal is 3-4 pages typed, double spaced, 12 font, Times New Roman, 1-inch margins.
The first paragraph should summarize the event, while the rest of the journal should discuss how
the concepts in class readings/lectures/discussion can provide insight to the event being
discussed. The only reference needed is a link or reference to the source of the article(s). This is
not a research paper or analysis, but rather an exploratory exercise in order to become familiar
with applying economic concepts to current events. Your journal entry should sketch how the
class concepts relate to the event being considered and shed light on those events. Summaries of
the readings or current event, extensively paraphrasing or quoting others, etc. are not permitted.
DUE DATE:
The 2 journal entries are due respectively on October 29th and the day of the final exam
(Tuesday, December 14, 2021) by 11:59pm.
You will submit your journal entries on Blackboard.
Late journals submitted within 24 hours of the deadline will receive half credit as detailed in the
course syllabus. Students will be graded on the relevance of the topic selected as well as their
ability to express the connection between the event and macroeconomics in a clear and coherent
manner.
PLAGARISM:
Please read the GMU Honor Code as it pertains to plagiarism, available here:
http://mason.gmu.edu/~montecin/plagiarism.htm. I am available to answer any related questions.
ASSIGNMENT GRADING:
Your journals constitute 20% of your overall grade (10% each).
1
GRADING CRITERIA:
The following rubric will be applied in grading your journal entries and will provide you a guide
of the criteria for grading. Each category is worth up to 25 points:
1. The entry identifies a clear issue and offers a concise summary.
Excellent (25 pts)
Satisfactory (20 pts)
Unsatisfactory (10 pts)
Clearly identifies a current
Partially identifies a current
Fails to identify a clear
issue and provides a wellissue and has a partial
current issue and lacks a
defined summary of the key summary of the key themes
clear summary of the key
themes of the article.
of the article.
themes of the article.
2. The entry is written in a clear, engaging and logically structured manner free of
grammatical errors, typos, etc.
Excellent (25 pts)
Satisfactory (20 pts)
Unsatisfactory (10 pts)
The paper flows in a clear
Parts of the paper lack clarity The paper lacks a clear
and linear manner. The thesis due to a lack of structure.
structure and is therefore
is carried throughout the
Portions of the text are not
confusing and hard to follow.
paper. The text is free of
linked to the thesis. There are There are significant
grammatical errors and
some grammatical errors or
grammatical errors and
typos. The paper is written in typos. The paper is only
typos. The paper lacks
an engaging manner.
somewhat engaging.
engaging writing.
3. The entry incorporates and accurately engages relevant supporting data and evidence,
where necessary.
Excellent (25 pts)
Accurately and completely
engages the relevant data and
evidence related to the issue
being discussed.
Demonstrates the ability to
synthesize that data/evidence
into a broader analytical
discussion.
Satisfactory (20 pts)
Partially engages the relevant
data and evidence related to
the question, or makes minor
mistakes in discussing and
engaging the data/evidence.
Demonstrates a partial, above
average, ability to synthesize
data and evidence into a
broader analytical discussion.
Unsatisfactory (10 pts)
Fails to engage the relevant
data and evidence related to
the question, or makes major
mistakes in discussing and
engaging the data/evidence.
Demonstrates an inability to
synthesize data and evidence
into a broader analytical
discussion.
2
4. The entry clearly identifies the conclusions and implications of the analysis, where
necessary.
Excellent (25 pts)
Clearly and accurately
identifies conclusions and
implications resulting from
the analysis provided in the
paper. Shows a strong ability
to identify and communicate
the relationship between
theory, evidence, and
implications.
Satisfactory (20 pts)
Partially identifies
conclusions and implications
related to the argument
provided. Shows an above
average ability to identify the
relationship between theory,
evidence, and implications.
Unsatisfactory (10 pts)
Fails to identify conclusions
and implications related to
the argument provided. Fails
to identify the relationship
between theory, evidence,
and implications.
Grading Process:
Each journal entry will be read in the context of the four criteria in the rubric above and graded
on a 100-point scale, adding up the points from each category. Examples:
An “A+” (100/100) journal entry is one that earns scores of “Excellent” in the four
categories of criteria. It provides a clear, has a clear summary of the key issues. The text
is well-structured and demonstrates the student’s ability to independently evaluate the
ideas presented in the course. The entry is free of grammatical or spelling errors and
awkward language.
A “B” (80/100) journal entry is one that earns “Satisfactory” scores in the four categories
above. It contains a partial summary of the event. The structure is somewhat confusing
and/or does not provide creative, independent analysis. There are some grammatical or
spelling errors and awkward language.
A “C” (70/100) journal entry is one that earns two “Unsatisfactory” scores and two
“Excellent” scores in the four categories above. The entry presents information relevant
to the current event without any clear organizing principle, or contains significant
weaknesses in expression.
An entry that earns three or more “Unsatisfactory” scores will earn a failing grade, “F”
(at most, 55/100). The entry generally fails to address the thrust of the assignment,
contains numerous grammatical errors, and generally lacks coherence.
3
Chapter 13
Stabilization Policy and the
AS/AD Framework
13.1 Introduction
In this chapter, we learn
• that the IS and MP curves combine to get the AD
curve.
• that the Phillips curve can be shown as the AS curve.
• that movements in the economy can be shown in the
AS/AD model.
• modern monetary policy theories.
• the appropriate policy response to shocks.
13.2 Monetary Policy Rules and Aggregate Demand
The short-run model consists of the
IS curve:
MP curve:
Phillips:
The central bank chooses ????
High short-run output increases inflation.
The central bank faces this trade-off and chooses the
interest rate.
Simple Monetary Policy Rule
Real
interest
rate
Long-run
interest rate
Current
inflation
Governs how aggressively
monetary policy responds
to inflation
Inflation
target
The AD Curve—1
Substitute the policy rule into the IS curve:
Policy rule:
IS curve:
To get the aggregate demand (AD) curve:
AD curve:
• Short-run output is a function of the inflation rate.
The AD Curve—2
AD
The AD Curve—3
The AD curve
• is built from the demand side (IS curve).
• describes how the central bank sets short-run
output for each rate of inflation.
Change in inflation
• A movement along the AD curve
Changes in
• Alters the slope of the AD curve
The AD Curve after an Inflation Shock

B
A
?
AD
~

0
~
Output,Y
An Aggressive Monetary Policy Rule
?’
B
A
?
AD
~
Y’
0
~
Output, Y
Shifts of the AD Curve
AD curve shifts are caused by:
• Changes in the parameter
• Changes in the target rate of inflation
13.3 The Aggregate Supply Curve
The aggregate supply (AS) curve is
• the price-setting equation used by firms.
• the Phillips curve with a new name.
AS curve equation:
The Aggregate Supply Curve—1
AS
? t– 1
0
~
Output, Y
The Aggregate Supply Curve—2
The AS curve will shift due to
• the inflation rate changing over time.
• change in the inflation shock parameter.
13.4 The AS/AD Framework
Combining the AS and AD curve
• Two equations
• Two unknowns: inflation rate and short-run output
• AD curve
• AS curve
The Steady State—1
In the steady state
• The endogenous variables are constant over time
• No shocks to the economy
From the AS curve:
Therefore,
The Steady State—2
From the AD curve:
So, in the steady state,
The AS/AD Framework
13.5 Macroeconomic Events: Event 1—An Inflation Shock
The economy begins in steady state.
Suppose there is an oil price increase.
• The parameter is positive for one period.
• The price level rises permanently.
• The AS curve will shift up as a result.
Stagflation
• Combination of a recession and inflation
The Initial Response to an Inflation Shock
AS1
AS
?1
B
A
?
AD
~
Y1
0
~
Output, Y
Event 1: An Inflation Shock—1
In period 2,
• returns to normal.
The AS curve does not shift back because
Inflation is now:
In the steady state,
So,
Event 1: An Inflation Shock—2
High inflation from the oil shock
Raises expected inflation
Slows the adjustment of the AS
curve back to its initial position
Inflation slowly falls
The model returns to its original
steady state
Two Periods after an Inflation Shock
?1
AS1
AS1
AS2
AS2
AS
AS
B
?
?1
?2
?
A
B
C
A
AD
AD
~
Y1
0
~
Output,Y
~
Y1
~
Y2
0
~
Output, Y
Three Periods after an Inflation Shock
AS1
AS2
AS3
AS
?1
?2
?3
?
B
C
D
A
AD
~
Y1
~ ~
Y2 Y3 0
~
Output, Y
Event 1: An Inflation Shock—3
Transition dynamics:
• Movement back to the steady state is fastest when
the economy is furthest from its steady state.
In summary, a price shock
• raises inflation directly.
• keeps inflation higher for a longer period of time
due to sticky inflation.
• results in a prolonged slump.
• causes the economy to suffer from stagflation.
The Effects of an Inflation Shock: Summary
Event 2: Disinflation—1
The economy begins in steady state.
Suppose policymakers decide to lower the inflation
target.
• The AD curve shifts down.
• The new rule calls for an increase in interest rates.
The Initial Response to Disinflation
AS
A
?
?1
B
?
AD
AD1
The Dynamics of Disinflation
AS
A
?
?1
AS1
B
C
?
AD
AD1
~
Y1
0
~
Output, Y
Event 2: Disinflation—2
Change in the rate of inflation
Firms adjust expectations of
inflation (lower)
AS curve shifts to the right
Inflation is still above the target;
Output remains below potential
Inflation rate falls further
Event 2: Disinflation—3
Note:
• If the classical dichotomy holds in the short run, the
AD and AS curves would reach the new steady state
immediately.
If there is sticky inflation, a recession is needed to
adjust expectations down.
Event 3: A Positive AD Shock—1
The economy begins in steady state.
Suppose there is a temporary increase in the aggregate
demand parameter,
• The AD curve will shift out.
• Prices increase.
A Positive AD Shock
AS
B
?1
?
A
AD1
AD
0
~
Y1
~
Output, Y
Event 3: A Positive AD Shock—2
Increase
increases
and inflation
Firms expect higher future
inflation
Increased demand for goods
Firms increase prices
AS shifts upward
Dynamics as the AS Curve Shifts
AS8
?8
AS
C
B
?1
A
?
AD1
AD
0
~
Y1
~
Output, Y
The Unraveling after the AD Shock Ends
AS8
C
?8
? 1 = ? 10
D
AS
B
A
?
AD1
AD = AD10
~
Y10
0
~
Y1
~
Output, Y
Event 3: A Positive AD Shock—3
The AD shock implies that booms are matched by
recessions.
• The economy benefits from a boom but inflation
rises.
• The way to reduce inflation is by a recession.
The costs of inflation:
• The economy would have been better off at the
original steady state.
Further Thoughts on Aggregate Demand Shocks
In theory, monetary policy
• can be used to insulate an economy from AD shocks.
• responds only to inflation and not output changes.
What are the empirical predictions of the short-run
model?
13.6 Empirical Evidence: Predicting the Fed Funds Rate
Use the Fisher equation to write the monetary policy
rule in terms of the nominal interest rate:
Policy rule:
Fisher equation:
The Fed Funds Rate, Actual and Predicted
Inflation-Output Loops
Vertical axis: inflation
Horizontal axis: output
• Following shocks,
• the economy moves in counterclockwise loops.
• positive short-run output leads to rising inflation.
• a rise in inflation leads policymakers to reduce
output.
Inflation-Output Loops in the U.S. Economy
Case Study: Forecasting and the Business Cycle
• Economic forecasts are made regularly by professional
economists.
• Economists study a large number of economic variables that
have proved useful in predicting the future path of the
economy, called leading economic indicators.
• Fed fund rates (FFR)
• Term structure of interest rates
• Unemployment claims
• Number of new houses being built
• Will “Big Data” help improve forecasting in the future?
Case Study: Forecasting and the Business Cycle
13.7 Modern Monetary Policy
The short-run model captures many features of
monetary policy.
Central banks are now more explicit about policies and
targets.
Inflation rates in industrialized countries have been
well-behaved for the last 25 years.
Inflation in the OECD
More Sophisticated Monetary Policy Rules
Richer monetary policy rules that use short-run output
create results similar to the simpler model.
The simple policy rule we used implicitly weights
short-run output.
Rules versus Discretion
The time consistency problem
• Even though agents support a particular policy, once
the future comes, they have incentives to renege on
their promises.
Firms and workers form expectations about inflation.
• Expectations are built into prices and contracts.
• Central bankers pursue an expansionary policy.
• Firms and workers anticipate the policy and build it
in.
• No benefit to output
The Paradox of Policy and Rational Expectations—1
The goal of macroeconomic policy
• Full employment
• Output at potential
• Low, stable inflation
The presence of a policymaker willing to generate a
large recession to fight inflation makes policy use less
likely.
The Paradox of Policy and Rational Expectations—2
Under adaptive expectations, we assume
We assume the equation does not change with policy
rule changes.
• Due to sticky inflation
The Paradox of Policy and Rational Expectations—3
Rational expectations
• People use all information at their disposal to make
their best forecast of the rate of inflation.
This information may include the costs resulting in
sticky inflation but may also add the target rate of
inflation.
The Paradox of Policy and Rational Expectations—4
The central bank’s willingness to fight inflation is a key
determinant of expected inflation.
If firms know the bank will fight aggressively to keep
inflation low,
• they are less likely to raise prices after an inflation
shock.
Managing Expectations in the AS/AD Model—1
We can drop the assumption of adaptive expectations
and rewrite the AS curve in terms of the expected rate
of inflation:
Expected
rate of
inflation
Managing Expectations in the AS/AD Model—2
If the Federal Reserve lowers the inflation target, the
AD curve shifts down.
• If expectations adjust immediately and people use
all information, the AS curve shifts down
immediately to the new target.
If the central bank can control expectations of inflation,
it can be kept low without recessions
Costless Disinflation by Coordinating Expectations
Case Study: Rational Expectations and the Lucas Critique
The Lucas critique
• It is inappropriate to build a macroeconomic model
based on equations in which expectations are not
consistent with the statistical properties of the
economy.
Models should incorporate the theory of rational
expectations.
Inflation Targeting
Managing expectations
Explicit inflation targets
• Anchor inflation expectations
• Easier to stimulate output
Constrained discretion
• Maintaining flexibility to respond to shocks
• Commitment to particular inflation rate in the long
run
13.8 Conclusion
A credible, transparent commitment to a low rate of
inflation is one of the key factors in taming inflation.
• Anchors inflation expectations so that shocks are
deflected quickly
• Stabilizes economy
The period after the 1980–1982 recession
• “The Great Moderation”
• Relative stability of the macroeconomy
Chapter 12
Monetary Policy and the
Phillips Curve
12.1 Introduction
In this chapter, we learn
• how the central bank effectively sets the real
interest rate in the short run.
• This rate is the MP curve in our short-run model.
• that the Phillips curve describes how firms set their
prices over time, pinning down the in?ation rate.
• how the IS curve, the MP curve, and the Phillips
curve make up our short-run model.
• how to analyze the evolution of the macroeconomy
in response to changes in policy or economic
shocks.
Introduction
The federal funds rate
• Overnight lending rate between banks
The short-run model summary:
Through the…
MP curve
The nominal interest rate determines the real
interest rate.
IS curve
The real interest rate influences short-run GDP.
Phillips curve
The relationship between short-run GDP and
inflation is shown.
The Structure of the Short-Run Model
12.2 The MP Curve
Banks borrowing from each other must match the
central bank lending rate.
• Banks cannot charge a higher rate.
• Everyone would use the central bank.
• Banks cannot charge a lower rate.
• Everyone would borrow at the lower rate and
lend it back to the central bank at a higher rate
(arbitrage).
• The lender would run out of resources quickly.
The Federal Funds Rate
From Nominal to Real Interest Rates
Fisher equation:
Nominal
interest
rate
Real
interest
rate
Inflation
From Real to Nominal Interest Rates
Sticky inflation assumption
In the short run, inflation
• displays inertia, or stickiness.
• adjusts slowly over time.
• does not respond directly to monetary policy.
Central banks can set the real interest rate in the short
run.
The IS-MP Diagram—1
The MP curve
• Illustrates the central bank’s ability to set the real
interest rate at a particular value (horizontal line)
The IS curve
• Recall: Illustrates the negative relationship between
interest rates and short-run output
The MP Curve in the IS-MP Diagram
The IS-MP Diagram—2
The economy is at potential when
• Real interest rate = MPK
• No aggregate demand shocks
• Short-run output = 0
If the central bank raises the interest rate above the
MPK
Inflation is
sticky
Real interest
rate ?
Investment
?
Raising the Interest Rate in the IS-MP Diagram
The End of a Housing Bubble
Housing
prices ?
• Then, a shock occurs
Housing
prices ?
• AD parameter ?
IS curve
shifts left
• In response,
the central
bank
? Nominal
interest
rate
• Since
inflation is
sticky
? Real
interest
rate
Stabilizing the Economy after a Housing Bubble
r
B
A
MP
r
B
C
R
-2%
0
(a)
A
MP
MP
IS
IS
IS
IS
-2%
0
(b)
Case Study: The Term Structure of Interest Rates
Interest rates on investments of different lengths of
time should yield the same return.
When the Fed changes the overnight rate,
• financial markets expect the change will persist.
• it signals information about likely changes in the
future.
• interest rates at longer magnitudes change.
Case Study: The Term Structure of Interest Rates
12.3 The Phillips Curve
Recall: The inflation rate is the percent change in the
overall price level.
Firms set their prices on the basis of
• their expectations of the economy-wide inflation
rate.
• the state of demand for their product.
The Phillips Curve—1
Expected inflation
• where
represents demand conditions
Adaptive expectations
• Firms expect next year’s inflation rate to be the
same as this year’s inflation rate.
• Firms adjust their forecasts of inflation slowly.
• Embodies the sticky inflation assumption
The Phillips Curve—2
The Phillips curve
• Describes how inflation evolves over time as a
function of short-run output
If output is below potential, prices rise more slowly
than usual.
If output is above potential, prices rise more rapidly
than usual.
The Phillips Curve—3
Using the equations:
Therefore, the Phillips curve can be expressed as:
The Phillips Curve—4
Phillips curve
Slumping economy
Booming economy
Price Shocks and the Phillips Curve
We can add shocks to the Phillips curve:
Rewrite:
Inflation depends on:
• Expectations of inflation
• Demand conditions
• Shocks to inflation
Oil Price Shock
Temporary upward shift in the Phillips curve
Cost-Push and Demand-Pull Inflation
Price shocks to an input in production
• Cost-push inflation
• Tends to push the inflation rate up
Changes in short-run output
• Demand-pull inflation
• Increases in AD pull up the inflation rate.
Case Study: The Phillips Curve and the Quantity Theory
The quantity theory:
• An ? in the growth rate of real GDP would ? inflation.
The Phillips curve:
• An ? in GDP causes the rate of inflation to ?.
Which one is correct?
The quantity theory:
• Long-run model
The Phillips curve:
• Part of our short-run model
12.4 Using the Short-Run Model
Disinflation
• Sustained lower and stable rate of inflation
The Great Inflation of the 1970s
• Misinterpreting the productivity slowdown
contributed to rising inflation.
Inflation in the United States
The Volcker Disinflation—1
In the long run, reducing the level of inflation requires tight
monetary policy.
• A sharp reduction in the rate of money growth
Since inflation is sticky,
• The classical dichotomy is unlikely to hold in the short
run.
• A decrease in the money growth rate may not slow
inflation.
The real interest rate increase induces a recession.
• The recession causes negative changes in inflation.
• As demand falls, firms raise their prices slower to sell
more.
Tightening Monetary Policy
B
MP’
A
MP
IS
A Recession and Falling Inflation
Phillips curve
A
B
The Volcker Disinflation—2
Lowering the inflation rate
• At the cost of a slumping economy
• High unemployment and lost output
Once inflation has declined sufficiently
• Real interest rate can be raised back to MPK,
allowing output to rise back to potential
The Disinflation over Time
The Great Inflation of the 1970s—1
Inflation rose in the 1970s for three reasons:
• OPEC coordinated oil price increases: Oil shock
• U.S. monetary policy was too loose.
• Policymakers thought that reducing inflation
required permanent increases in unemployment.
• In reality, disinflation requires only a temporary
recession.
The Great Inflation of the 1970s—2
Inflation rose in the 1970s for three reasons:
• The Federal Reserve did not have perfect
information.
• Thought the productivity slowdown was a
recession
• The Fed lowered interest, which increased output
above potential and generated more inflation.
• However, the slowdown was a change in potential
output.
Mistaking a Slowdown in Potential for a Recession
The Short-Run Model in a Nutshell
Case Study: The 2001 Recession
12.5 Microfoundations: Understanding Sticky Inflation
The short-run model
• Changes in the nominal interest rate affect the real
interest rate.
The classical dichotomy
• Changes in nominal variables have only nominal
effects.
• If monetary policy affects real variables, the classical
dichotomy fails in the short run.
The Classical Dichotomy in the Short Run—1
Can the classical dichotomy hold at all points in time?
• All prices, including wages and rental prices, must
adjust in the same proportion immediately.
The Classical Dichotomy in the Short Run—2
Reasons that the classical dichotomy fails in the short
run:
• Imperfect information
• Costs of setting prices
• Contracts set prices and wages in nominal terms
• Bargaining costs
• Social norms and money illusion
Case Study: The Lender of Last Resort
Central banks ensure a stable financial system by
• Making and enforcing rules, including reserve
requirements
• Acting as the lender of last resort
• Lending money when banks experience financial
distress
• Having deposit insurance, although this can increase
risky behavior
12.6 Microfoundations: How Central Banks Control Nominal Interest
Rates
The central bank controls the level of the nominal
interest rate by supplying the money that is demanded
at that rate.
The nominal interest rate
• The opportunity cost of holding money
Quantity demanded of money is negatively related to
the nominal interest rate.
How the Central Bank Sets the Nominal Interest Rate
Ms
Md
Money Supply and Demand
The demand for money
• Decreasing function of the nominal interest rate
• Downward sloping
The supply of money
• The level of money the central bank provides
• Vertical line
Changing the Interest Rate
To raise the interest rate
? MS
QMD>QMS
?i
? QMD
New
equilibrium
Higher i
Raising the Nominal Interest Rate
Why it instead of Mt?—1
The interest rate is crucial even when central banks
focus on the money supply.
The money demand curve is subject to many shocks,
which shift the curve.
• Changes in price level
• Changes in output
If the money supply is constant,
• the nominal interest rate fluctuates, resulting in
changes in output.
Why it instead of Mt?— 2
The money supply schedule is effectively horizontal at
a targeted interest rate.
An expansionary (loosening) monetary policy
• Increases the money supply
• Lowers the nominal interest rate
A contractionary (tightening) monetary policy
• Reduces the money supply
• Increases the nominal interest rate
Targeting the Nominal Interest Rate
12.7 Inside the Federal Reserve
Reserves
• Deposits held in accounts with the central bank
• Pay no interest
Reserve requirements
• Banks required to hold a certain fraction of their
deposits
Discount rate
• Interest rate charged by the Federal Reserve on
loans made to commercial banks
Open-Market Operations
Open-market operations
• The central bank trades interest-bearing
government bonds in exchange for currency or noninterest-bearing reserves.
To increase the money supply, the Fed buys
government bonds in exchange for currency or
reserves.
• The price at which the bond sells determines the
nominal interest rate.
12.8 Conclusion
Policymakers exploit the stickiness of inflation.
• Changes in the nominal interest rate change the real
interest rate.
Through the Phillips curve, booms and recessions alter
the evolution of inflation.
Because inflation evolves gradually, the only way to
reduce it is to slow the economy.
Additional Figures for Worked Exercises: The Great Inflation—1
The Great Inflation—2
Chapter 9
An Introduction to the Short
Run
9.1 Introduction
In this chapter, we learn
• how the gap between actual GDP and potential GDP
measures the economy’s performance in the short
run.
• how costly fluctuations in economic activity can be.
• that the rate of inflation tends to decline when the
economy is in a recession.
• a simple version of the short-run model that will
help us understand these patterns.
9.2 The Long Run, the Short Run, and Shocks
The long-run model is a guide to how the economy
behaves on average.
• Determines potential output and long-run inflation
Potential output
• Amount of production if all inputs were utilized at
their long-run sustainable levels
At any given time, the economy is unlikely to exactly
equal the long-run average.
The short-run model:
• Determines current output and current inflation
The Long Run, the Short Run, and Shocks
In the short-run model
• The current level of output and inflation are
endogenous.
• Current output deviates from potential output
because of economic shocks.
• Assume the long run is given.
• Potential output and the long-run inflation rate
are exogenous.
Trends and Fluctuations
Actual output is equal to the long-run trend plus shortrun fluctuations:
• Long-run trend: potential output (????? )
• Short-run fluctuations: percentage deviations from
?????
Short-Run Fluctuation
“Detrended output” or short-run output:
• The difference in actual and potential output,
expressed as a percentage of potential output:
Economic Fluctuations and Short-Run Output
Short-Run Output in the United States
Fluctuations in U.S. GDP:
• Difficult to see graphically over a long period of time
• Have mostly been between + or –4% since 1950
The Great Depression:
• Negative gap during the 1930s
• Actual output was well below potential.
U.S. Real GDP, Actual and Potential
Short Run
A recession
• begins when actual output falls below potential.
• Short-run output becomes negative.
• ends when short-run output starts to rise.
• Short-run output becomes less negative.
Typically, during a recession,
• output is below potential for approximately 2 years.
• Loss of about $3,000 per person
• between 1.5 million and 3 million jobs are lost.
U.S. Economic Fluctuations
Changes in U.S. Employment
Case Study: The Great Depression
1930s worldwide calamity
• 25 percent of Americans were unemployed.
• Industry production declined more than 60 percent.
The beginning of modern macroeconomics
Measuring Potential Output
There is no directly observable measure of potential
output in an economy.
Ways to measure potential output:
• Assume a perfectly smooth trend passes through
quarterly movements of real GDP.
• Take averages of the surrounding actual GDP
numbers.
Annualized rate:
• Rate of change that would apply if the growth rate
persisted for an entire year
The Inflation Rate
The rate of inflation typically
• peaks at the start of a recession.
• falls during the recession.
9.3 The Short-Run Model
The short-run model is based on three premises:
• The economy is constantly being hit by shocks.
• Shocks: factors that cause fluctuations
• Monetary and fiscal policies affect output.
• Policymakers can neutralize shocks to the
economy.
• There is a dynamic trade-off between output and
inflation.
• Shown by the Phillips curve
A Graph of the Short-Run Model
The Phillips curve shows
• a boom increases inflation.
• a recession decreases inflation.
• a positive relationship between the change in
inflation and short-run output.
Empirically, the slope is about 1?3.
• If output exceeds potential by 3 percent, the
inflation rate increases one percentage point.
Works in a “Cycle”
• Firms raise prices.
• The inflation rate increases.
• There is less demand for products.
• Firms cut costs and lay off workers.
• Inflation rate falls to previous levels.
The Phillips Curve
How the Short-Run Model Works
Assume policymakers can select short-run output
through monetary policy.
Example:
• 1979: inflation was increasing due to oil prices.
• Monetary policy raises interest rates.
• What happens?
• Recession!
Measuring the Phillips Curve
9.4 Okun’s Law: Output and Unemployment
Natural rate of unemployment:
• The rate of unemployment that exists in the long
run
Cyclical unemployment:
• Current unemployment minus the natural rate of
unemployment
Okun’s Law
Cyclical
unemployment
Current rate of
unemployment
Natural rate of
unemployment
Short-run
output
Okun’s Law for the U.S. Economy
Macroeconomic Forecasts of Presidential Elections
Chapter 14
The Great Recession and the
Short-Run Model
14.1 Introduction
In this chapter, we learn
• financial considerations—financial friction.
• deflation, bubbles, and the Fed’s balance sheet.
• various policy responses to the financial crisis.
• contributors to a very large negative shock in AD.
• Gap between the fed funds rate and market
interest rates
• A household balance sheet crisis
• Substantial uncertainty
• unconventional actions of the Fed.
14.2 Financial Considerations in the Short-Run Model
Financial frictions
• Low business lending and increased interest rates
Interest rate spread widened
• Interest rates moving in the wrong direction
• Deepening instead of mitigating the downturn
The Spread between Corporate Bonds and 10-Year Treasuries
Interest Rate Spread
Add financial frictions to our short-run model
Real interest Real interest rate at which
rate
firms borrow in financial
markets
During normal times,
During a financial crisis, increases
Financial
friction
Financial Frictions in the IS/MP Framework
To stabilize the economy after the bursting of a
housing bubble
• The Fed may lower the interest rate.
• Counteracts the negative AD shock
A Housing Bubble and a Financial Crisis—1
B
A
MP
r
C
Rff
MP
IS
IS
2%
0
(a)
~
Output, Y
A Housing Bubble and a Financial Crisis—2
Rff + f
D
MP
B
r
A
C
Rff
MP
MP
IS
IS
4%
2%
0
(b)
~
Output, Y
Financial Frictions in the AS/AD Framework—1
Financial friction
• Works through investment in the IS curve
• Shifts the AD curve inward, just like a negative
demand shock
Two other factors shift the AD curve down and to the
left:
• A decline in hou