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Mankiw 5_e Chapter 1_ The Science of Macroeconomics

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					macro   Macroeconomics of
         Business Cycles
                     Growth rates of real GDP, consumption
 Percent    10                             Real GDP
 change                                    growth rate
  from 4
quarters    8
                                                          Consumption
  earlier
                                                           growth rate
            6


Average     4
 growth
    rate    2


            0


            -2


            -4
              1970    1975   1980   1985    1990   1995   2000   2005    2010
            Growth rates of real GDP, consumption, investment
 Percent
                                            Investment
 change     40                              growth rate
  from 4
quarters
  earlier   30


            20
                                            Real GDP
                                           growth rate
            10


             0
                                                     Consumption
                                                      growth rate
            -10


            -20


            -30
               1970   1975   1980   1985     1990   1995   2000   2005   2010
                           Unemployment
Percent    12
of labor
   force
           10


           8


           6


           4


           2


           0
            1970   1975   1980   1985   1990   1995   2000   2005   2010
                                 Okun’s Law
Percentage 10                                           Y
 change in
                                     1966
                                                            3  2 u
  real GDP 8            1951                            Y
                     1984
           6
                                                  2003
           4
                                                        1971
                             1987
           2                                                   2008

           0                                                          1975
                                       2001
           -2                                    1991      1982

           -4
                -3          -2      -1       0      1        2        3      4
                                 Change in unemployment rate
   Facts about the business cycle
 GDP growth averages about 3 percent per year over
 the long run with large fluctuations in the short run.
 Consumption and investment fluctuate with GDP,
 but consumption tends to be less volatile and
 investment more volatile than GDP.
 Unemployment rises during recessions and falls
 during expansions.
 Okun’s Law: the negative relationship between
 GDP and unemployment.
 Index of Leading Economic Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity 6-9
  months into the future.
 Used in planning by businesses and govt, despite not
  being a perfect predictor.
      Components of the LEI index
   Average workweek in manufacturing
   Initial weekly claims for unemployment insurance
   New orders for consumer goods and materials
   New orders, nondefense capital goods
   Vendor performance
   New building permits issued
   Index of stock prices
   M2
   Yield spread (10-year minus 3-month) on Treasuries
   Index of consumer expectations
     Index of Leading Economic Indicators
                120

                110

                100
   2004 = 100




                 90

                 80

                 70

                 60

                 50

                 40

Source: 30
Conference 1970       1975   1980   1985   1990   1995   2000   2005   2010
Board
Time horizons in macroeconomics
  Long run
  Prices are flexible, respond to changes in
  supply or demand.
  Short run
  Many prices are “sticky” at a
  predetermined level.

        The economy behaves much
     differently when prices are sticky.
             AD/AS Model
 The paradigm most mainstream economists
 and policymakers use to think about economic
 fluctuations and policies to stabilize the
 economy
 Shows how the price level and aggregate
 output are determined
 Shows how the economy’s behavior is different
 in the short run and long run
        Aggregate demand
 We use a simple theory of AD based on the
  quantity theory of money.
 Recall the quantity equation
      MV = PY

 For given values of M and V,
 this equation implies an inverse relationship
 between P and Y :

       Y = (M V) / P
     The downward-sloping AD curve

                       P
An increase in the
price level causes a
fall in real money
balances (M/P ),
causing a decrease
in the demand for
goods & services.
                              AD
                                     Y
             Shifting the AD curve

                    P

An increase in
the money
supply shifts the
AD curve to the
right.                                     AD2
                                     AD1
                                             Y
  Aggregate supply in the long run

 Recall from Chapter 3:
 In the long run, output is determined by
 factor supplies and technology
         Y  F (K , L )
 Y is the full-employment or natural level of
    output, at which the economy’s resources are
    fully employed.
         “Full employment” means that
  unemployment equals its natural rate (not zero).
The long-run aggregate supply curve

                P     LRAS
 Y does not
 depend on P,
 so LRAS is
 vertical.




                                   Y
                        Y
                     F (K , L )
 Long-run effects of an increase in M

                     P   LRAS
                                An increase
                                in M shifts
                                AD to the
                                right.
In the long run,    P2
this raises the
price level…        P1                  AD2
                                  AD1

 …but leaves                              Y
 output the same.
                          Y
The short-run aggregate supply curve
                   P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined
level, and firms               SRAS
                   P
sell as much as
buyers demand.
                                  Y
Short-run effects of an increase in M

In the short run    P
                             …an increase in
when prices are
                             aggregate demand…
sticky,…



                                     SRAS
                    P
                                       AD2
                                     AD1
                                         Y
   …causes output       Y1      Y2
   to rise.
 From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
       In the short-run   then over time,
       equilibrium, if    P will…
           Y  Y                 rise
           Y  Y                  fall

           Y  Y            remain constant

    The adjustment of prices is what moves
    the economy to its long-run equilibrium.
      The SR & LR effects of M > 0

A = initial        P    LRAS
   equilibrium

B = new short-
    run eq’m      P2         C
    after Fed                    B    SRAS
    increases M   P      A              AD2
                                      AD1
C = long-run
    equilibrium                           Y
                         Y       Y2
 The effects of a negative demand shock
AD shifts left,      P        LRAS
depressing output
and employment
in the short run.
                          B        A     SRAS
Over time,          P
prices fall and
                    P2             C     AD1
the economy
moves down its                         AD2
demand curve                                   Y
toward full-             Y2    Y
employment.
                  Supply shocks
 A supply shock alters production costs, affects the
 prices that firms charge (also called price shocks)
 Examples of adverse supply shocks:
  – Bad weather reduces crop yields, pushing up food prices
  – Workers unionize, negotiate wage increases
  – New environmental regulations require firms to reduce emissions

 Favorable supply shocks lower costs and prices
             CASE STUDY:
       The 1970s oil shocks
 Early 1970s: OPEC coordinates a
 reduction in the supply of oil
 Oil prices rose
      11% in 1973
       68% in 1974
        16% in 1975
                      CASE STUDY:
                 The 1970s oil shocks
The oil price shock    P         LRAS
shifts SRAS up,
causing output and
employment to fall.
                             B                   SRAS2
                      P2
In absence of
                                        A        SRAS1
further price         P1
shocks, prices will                         AD
fall over time and
economy moves
                                                     Y
back toward full            Y2      Y
employment.
                        CASE STUDY:
                    The 1970s oil shocks
                       70%
                                                                       12%
Predicted effects      60%
of the oil shock:      50%                                             10%
 • inflation          40%
 • output             30%
                                                                       8%
 • unemployment 
                       20%
                                                                       6%
…and then a            10%
gradual recovery.
                        0%                                              4%
                          1973   1974       1975        1976         1977

                                 Change in oil prices (left scale)
                                 Inflation rate-CPI (right scale)
                                 Unemployment rate (right scale)
                         CASE STUDY:
                     The 1970s oil shocks
                        60%                                             14%

Late 1970s:             50%
                                                                        12%
 As economy
                        40%
was recovering,                                                         10%
oil prices shot up      30%
again, causing          20%
                                                                        8%

another huge
                                                                        6%
supply shock!!!         10%

                         0%                                             4%
                          1977   1978       1979         1980        1981

                                 Change in oil prices (left scale)
                                 Inflation rate-CPI (right scale)
                                 Unemployment rate (right scale)
                         CASE STUDY:
                     The 1980s oil shocks
                        40%                                               10%
1980s:                  30%
A favorable             20%                                               8%

supply shock--          10%
                                                                          6%
a significant fall       0%

in oil prices.          -10%
                                                                          4%
                        -20%
As the model
                        -30%
predicts,                                                                 2%
                        -40%
inflation and
                        -50%                                              0%
unemployment               1982   1983    1984     1985      1986      1987
fell:
                                   Change in oil prices (left scale)
                                   Inflation rate-CPI (right scale)
                                   Unemployment rate (right scale)
       Stabilization policy
 def: policy actions aimed at reducing the
 severity of short-run economic
 fluctuations.
 Example: Using monetary policy to
 combat the effects of adverse supply
 shocks…
         Stabilizing output with
            monetary policy
                P         LRAS

The adverse
supply shock
                     B               SRAS2
moves the      P2
economy to
                               A     SRAS1
point B.       P1
                                   AD1

                                         Y
                     Y2    Y
            Stabilizing output with
               monetary policy
But the Fed             P        LRAS
accommodates
the shock by
raising agg.
                            B         C     SRAS2
demand.                P2
                                      A
results:               P1                       AD2
P is permanently                          AD1
higher, but Y
remains at its full-                                  Y
employment level.           Y2    Y
Aggregate Demand I:
The IS-LM Model

   The IS-LM model determines
   income and the interest rate in
   the short run when P is fixed
             The Big Picture
Keynesian     IS
Cross        curve
                     IS-LM
                     model               Explanation
Theory of     LM                         of short-run
Liquidity    curve                       fluctuations
Preference
                      Agg.
                     demand
                      curve   Model of
                                Agg.
                              Demand
                      Agg.
                              and Agg.
                     supply
                               Supply
                     curve
         The Keynesian Cross
 A simple closed economy model in which
 income is determined by expenditure.

 Notation:
  I = planned investment
  PE = C + I + G = planned expenditure
  Y = real GDP = actual expenditure
 Difference between actual & planned
 expenditure = unplanned inventory investment
Elements of the Keynesian Cross
consumption function:               Y
                             C  C ( T )
 govt policy variables:      G  G , T T
for now, planned
investment is exogenous:         I I

planned expenditure:              Y
                          PE  C (  T )  I  G

 equilibrium condition:
    actual expenditure = planned expenditure
                    Y  PE
The equilibrium value of income
            PE
       planned                      PE =Y
    expenditure
                                          PE =C +I +G




                                income, output, Y
                  Equilibrium
                   income
 An increase in government purchases
                    PE
At Y1,                                    PE =C +I +G2
there is now an
unplanned drop                            PE =C +I +G1
in inventory…

                   G
…so firms
increase output,
and income                                     Y
rises toward a
new equilibrium.        PE1 = Y1   Y   PE2 = Y2
              Solving for Y
Y  C  I  G             equilibrium condition

Y  C  I  G         in changes

        C      G      because I exogenous

     MPC  Y  G       because C = MPC Y

Collect terms with Y       Solve for Y :
on the left side of the
equals sign:                        1   
                          Y             G
(1  MPC) Y  G              1  MPC 
The government purchases multiplier

   Definition: the increase in income resulting
   from a $1 increase in G.
   In this model, the govt         Y       1
                                      
   purchases multiplier equals     G   1  MPC

Example: If MPC = 0.8, then

 Y      1                       An increase in G
              5                causes income to
 G   1  0.8
                                 increase 5 times
                                     as much!
Why the multiplier is greater than 1
 Initially, the increase in G causes an equal
  increase in Y:       Y =  G.
 But Y  C
           further Y
           further C
           further Y
 So the final impact on income is much
  bigger than the initial G.
              An increase in taxes
                     PE
Initially, the tax
increase reduces                        PE =C1 +I +G
consumption, and                         PE =C2 +I +G
therefore PE:

      C = MPC T                   At Y1, there is now
                                     an unplanned
                                     inventory buildup…
  …so firms
  reduce output,
  and income falls                            Y
  toward a new
                     PE2 = Y2   Y   PE1 = Y1
  equilibrium
              Solving for Y
                             eq’m condition in
Y  C  I  G
                             changes
     C                     I and G exogenous

     MPC   Y  T    
Solving for Y :   (1  MPC)Y   MPC  T


                           MPC 
  Final result:     Y             T
                          1  MPC 
            The tax multiplier

def: the change in income resulting from
a $1 increase in T :
                 Y      MPC
                     
                 T    1  MPC

If MPC = 0.8, then the tax multiplier equals

           Y        0.8     0.8
                                  4
           T      1  0.8    0.2
             The IS curve
def: a graph of all combinations of r and
Y that result in goods market equilibrium
   i.e. actual output = planned expenditure

The equation for the IS curve is:

                   Y
            Y  C (  T )  I (r )  G
                                              J.R. Hicks
    Deriving the IS curve
           PE            PE =Y PE =C +I (r )+G
                                          2

r  I                            PE =C +I (r1 )+G

   PE   I

   Y              Y1   Y2          Y
               r
               r1

               r2
                              IS
                    Y1   Y2          Y
             Shifting the IS curve: G
                       PE             PE =Y PE =C +I (r )+G
At any value of r,                                     1    2

G  PE  Y                                    PE =C +I (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal              Y1        Y2           Y
                       r
distance of the
IS shift equals        r1

        1
Y         G                   Y
     1 MPC                                IS1    IS2
                            Y1        Y2           Y
The Theory of Liquidity Preference
 Due to John Maynard Keynes
 A simple theory in which the interest rate
  is determined by money supply and
  money demand
                Money supply
                         r
                             M   P
                                   s
The supply of     interest
real money            rate
balances
is fixed:
M   P M P
      s




                                            M/P
                             M P
                                       real money
                                         balances
              Money demand
                            r
                                M   P
                                      s
Demand for           interest
real money               rate
balances:
M   P
      d
           L (r )


                                             L (r )

                                               M/P
                                M P
                                          real money
                                            balances
               Equilibrium
                       r
The interest    interest     M   P
                                   s

rate adjusts        rate
to equate
the supply
and demand
for money:           r1
                                          L (r )
M P  L(r )
                                            M/P
                             M P
                                       real money
                                         balances
How the Fed raises the interest rate
                        r
                 interest
To increase r,       rate
Fed reduces M
                      r2

                      r1
                                         L (r )

                                           M/P
                            M2   M1   real money
                            P    P      balances
              The LM curve

Now let’s put Y back into the money demand
function:
                M   P
                       d
                            L (r ,Y )
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
                   M P  L (r ,Y )
             Deriving the LM curve
     (a) The market for
                                         (b) The LM curve
         real money balances
 r                                   r
                                                        LM

r2                                  r2

                     L ( r , Y2 )
r1                                  r1
                   L ( r , Y1 )
            M1            M/P              Y1     Y2         Y
            P
      How M shifts the LM curve
     (a) The market for
                                        (b) The LM curve
         real money balances
 r                                  r
                                                       LM2

                                                           LM1
r2                                 r2

r1                                 r1
                     L (r , Y1 )

         M2     M1        M/P                 Y1            Y
         P      P
        The short-run equilibrium

The short-run equilibrium is         r
the combination of r and Y
                                              LM
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:


       Y
Y  C (  T )  I (r )  G                      IS
  M P  L (r ,Y )                                      Y
                       Equilibrium
                       interest          Equilibrium
                       rate              level of
                                         income
Policy analysis with the IS -LM model

Y  C (  T )  I (r )  G
       Y                         r
                                          LM
    M P  L (r ,Y )

 We can use the IS-LM
 model to analyze the           r1
 effects of
  • fiscal policy: G and/or T
                                          IS
  • monetary policy: M
                                               Y
                                     Y1
   An increase in government purchases
1. IS curve shifts right           r
      by
              1
                  G                              LM
           1 MPC
   causing output &              r2
   income to rise.          2.
                                 r1
2. This raises money
   demand, causing the                       1.         IS2
   interest rate to rise…                         IS1
3. …which reduces investment,                             Y
                                       Y1 Y2
   so the final increase in Y
                                        3.
                        1
   is smaller than            G
                     1 MPC
                  A tax cut
Consumers save                  r
(1MPC) of the tax cut,                         LM
so the initial boost in
spending is smaller for T
than for an equal G…         r2
                           2.
                              r1
and the IS curve shifts by
        MPC                               1.     IS2
  1.          T                                IS1
       1 MPC
                                                        Y
                                    Y1 Y2
2. …so the effects on r
                                      2.
    and Y are smaller for T
    than for an equal G.
  Monetary policy: An increase in M

1. M > 0 shifts            r
                                        LM1
   the LM curve down
   (or to the right)                      LM2

2. …causing the            r1
   interest rate to fall   r2

3. …which increases                      IS
   investment, causing                          Y
                                Y1 Y2
   output & income to
   rise.
 The Fed’s response to G > 0

 Suppose Congress increases G.
 Possible Fed responses:
   1. hold M constant
   2. hold r constant
   3. hold Y constant
 In each case, the effects of the G
  are different…
Response 1: Hold M constant

If Congress raises G,         r
the IS curve shifts right.                LM1

If Fed holds M constant,
                             r2
then LM curve doesn’t
                             r1
shift.
                                            IS2
Results:
                                          IS1
    Y  Y 2  Y 1                                Y
                                  Y1 Y2
     r  r2  r1
Response 2: Hold r constant

If Congress raises G,         r
the IS curve shifts right.                   LM1
                                                   LM2
To keep r constant,
                             r2
Fed increases M              r1
to shift LM curve right.
                                               IS2
Results:                                     IS1
    Y  Y 3  Y 1                                   Y
                                  Y1 Y2 Y3

     r  0
Response 3: Hold Y constant

If Congress raises G,         r           LM2
the IS curve shifts right.                  LM1

To keep Y constant,          r3
                             r2
Fed reduces M
                             r1
to shift LM curve left.
                                             IS2
Results:                                   IS1
     Y  0                                        Y
                                  Y1 Y2
     r  r3  r1
Estimates of fiscal policy multipliers
       from the DRI macroeconometric model
                            Estimated   Estimated
 Assumption about            value of    value of
 monetary policy             Y / G     Y / T

 Fed holds money
                              0.60        0.26
 supply constant
 Fed holds nominal
                              1.93        1.19
 interest rate constant

 Romer & Bernstein (2009)     1.55           0.90
 Barro & Redlick (2010)       0.90        1.10
 Shocks in the IS -LM model

IS shocks: exogenous changes in the
demand for goods & services.
Examples:
 – stock market boom or crash
      change in households’ wealth
      C
 – change in business or consumer
   confidence or expectations
      I and/or C
 Shocks in the IS -LM model

LM shocks: exogenous changes in
the demand for money.
Examples:
 – a wave of credit card fraud increases
   demand for money.
 – more ATMs or the Internet reduce
   money demand.
             CASE STUDY:
  The U.S. recession of 2001
 During 2001,
  – 2.1 million jobs lost,
    unemployment rose from 3.9% to 5.8%.
  – GDP growth slowed to 0.8%
    (compared to 3.9% average annual
    growth during 1994-2000).
                                      CASE STUDY:
                        The U.S. recession of 2001
  Causes: 1) Stock market decline  C

                     1500
Index (1942 = 100)




                                      S&P 500
                     1200

                      900

                      600

                      300
                        1995   1996   1997   1998   1999   2000   2001   2002   2003
            CASE STUDY:
  The U.S. recession of 2001
Causes: 2) 9/11
  – increased uncertainty
  – fall in consumer & business confidence
  – result: lower spending, IS curve shifted
   left
Causes: 3) Corporate accounting scandals
  – Enron, WorldCom, etc.
  – reduced stock prices, discouraged
   investment
             CASE STUDY:
  The U.S. recession of 2001
 Fiscal policy response: shifted IS curve
 right
  – tax cuts in 2001 and 2003
  – spending increases
      • airline industry bailout
      • NYC reconstruction
      • Afghanistan war
                CASE STUDY:
        The U.S. recession of 2001
 Monetary policy response: shifted LM curve right

    7
    6
                          Three-month
                           T-Bill Rate
    5
    4
    3
    2
    1
    0
         Deriving the AD curve
                       r         LM(P2)
Intuition for slope                       LM(P1)
                       r2
of AD curve:
                       r1
P  (M/P )
                                      IS
     LM shifts left        Y2   Y1        Y
                       P
     r
                       P2
     I
                       P1
     Y
                                      AD
                            Y2   Y1        Y
Monetary policy and the AD curve
                       r         LM(M1/P1)
The Fed can increase
                       r1             LM(M2/P1)
aggregate demand:
                       r2
M  LM shifts right
                                       IS
     r
                            Y1   Y2         Y
                       P
     I
     Y at each       P1
         value of P
                                        AD2
                                      AD1
                            Y1   Y2     Y
   Fiscal policy and the AD curve
                         r              LM
Expansionary fiscal
policy (G and/or T )   r2
increases agg. demand:   r1               IS2
T  C                             IS1
                              Y1   Y2           Y
     IS shifts right    P
     Y at each
          value of P     P1

                                            AD2
                                          AD1
                              Y1   Y2       Y
        IS-LM and AD-AS
   in the short run & long run
Recall from Chapter 9:   The force that moves
the economy from the short run to the long run
is the gradual adjustment of prices.

      In the short-run     then over time, the
       equilibrium, if       price level will
         Y  Y                     rise
         Y  Y                      fall

         Y  Y              remain constant
The SR and LR effects of an IS shock
                     r     LRAS LM(P )
                                    1

A negative IS
shock shifts IS
and AD left,                             IS1
                                  IS2
causing Y to fall.
                           Y             Y
                     P     LRAS
                     P1                 SRAS1


                                     AD1
                                    AD2
                           Y         Y
The SR and LR effects of an IS shock
                       r    LRAS LM(P )
                                     1


In the new short-run
equilibrium, Y  Y                        IS1
                                   IS2
                            Y             Y
                       P    LRAS
                       P1                SRAS1


                                      AD1
                                     AD2
                            Y         Y
  The SR and LR effects of an IS shock
                           r    LRAS LM(P )
                                         1


    In the new short-run
    equilibrium, Y  Y                        IS1
                                       IS2
                                Y             Y
Over time, P gradually
falls, causing             P    LRAS
• SRAS to move down        P1                SRAS1

• M/P to increase,
  which causes LM                         AD1
  to move down                           AD2
                                Y         Y
  The SR and LR effects of an IS shock
                         r    LRAS LM(P )
                                       1
                                            LM(P2)

                                            IS1
                                     IS2
                              Y             Y
Over time, P gradually
falls, causing           P    LRAS
• SRAS to move down      P1                SRAS1

• M/P to increase,       P2                SRAS2
  which causes LM                       AD1
  to move down                         AD2
                              Y         Y
   The SR and LR effects of an IS shock
                            r    LRAS LM(P )
                                          1
                                               LM(P2)

This process continues                         IS1
until economy reaches a                 IS2
long-run equilibrium with
                                 Y             Y
         Y Y               P    LRAS
                            P1                SRAS1

                            P2                SRAS2
                                           AD1
                                          AD2
                                 Y         Y
                    NOW YOU TRY:
   Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS       r    LRAS LM(M /P )
                                                1  1
  diagrams as shown here.
b. Suppose Fed increases M.
  Show the short-run effects                   IS
  on your graphs.
c. Show what happens in the            Y       Y
  transition from the short run   P    LRAS
  to the long run.
d. How do the new long-run
                                  P1          SRAS1
  equilibrium values of the
  endogenous variables
                                              AD1
  compare to their initial
  values?                              Y       Y
                                    The Great Depression
                           240                                             30
                                                     Unemployment
                                                      (right scale)
billions of 1958 dollars




                           220                                             25




                                                                                percent of labor force
                           200                                             20

                           180                                             15

                           160                                             10

                           140                       Real GNP              5
                                                     (left scale)
                           120                                             0
                             1929    1931   1933   1935    1937     1939
      THE SPENDING HYPOTHESIS:
        Shocks to the IS curve
 asserts that the Depression was largely due
 to an exogenous fall in the demand for goods
 & services – a leftward shift of the IS curve.
 evidence:
 output and interest rates both fell, which is
 what a leftward IS shift would cause.
       THE SPENDING HYPOTHESIS:
        Reasons for the IS shift
 Stock market crash  exogenous C
  – Oct-Dec 1929: S&P 500 fell 17%
  – Oct 1929-Dec 1933: S&P 500 fell 71%

 Drop in investment
  – “correction” after overbuilding in the 1920s
  – widespread bank failures made it harder to obtain
    financing for investment
 Contractionary fiscal policy
  – Politicians raised tax rates and cut spending to
    combat increasing deficits.
        THE MONEY HYPOTHESIS:
       A shock to the LM curve
 asserts that the Depression was largely due
 to huge fall in the money supply.
 evidence:
  M1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
  – P fell even more, so M/P actually rose
    slightly during 1929-31.
  – nominal interest rates fell, which is the
    opposite of what a leftward LM shift would
    cause.
    THE MONEY HYPOTHESIS AGAIN:
     The effects of falling prices
 asserts that the severity of the Depression
 was due to a huge deflation:
    P fell 25% during 1929-33.
 This deflation was probably caused by the fall
  in M, so perhaps money played an important
 role after all.
 In what ways does a deflation affect the
 economy?
    THE MONEY HYPOTHESIS AGAIN:
     The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
    P        (M/P )
              consumers’ wealth 
              C
              IS shifts right
              Y
      THE MONEY HYPOTHESIS AGAIN:
      The effects of falling prices
 The destabilizing effects of expected
 deflation:
   E
     r  for each value of i
     I  because I = I (r )
     planned expenditure & agg. demand 
     income & output 
    THE MONEY HYPOTHESIS AGAIN:
     The effects of falling prices
 The destabilizing effects of unexpected
 deflation: debt-deflation theory
P (if unexpected)
   transfers purchasing power from borrowers
      to lenders
   borrowers spend less,
      lenders spend more
   if borrowers’ propensity to spend is larger
      than lenders’, then aggregate spending falls,
      the IS curve shifts left, and Y falls
Why another Depression is unlikely
 Policymakers (or their advisors) now know
 much more about macroeconomics
 Federal deposit insurance makes widespread
 bank failures very unlikely.
 Automatic stabilizers make fiscal policy
 expansionary during an economic downturn.
        The Great Recession
                  2008-2009

 NBER: December 2007 to June 2009
  – Real GDP fell by 4%, u-rate hit 10.6%
 Important factors in the crisis:
                            Interest rates and house prices
                                      Federal Funds rate
                    9                 30-year mortgage rate
                                                                                  190
                                      Case-Shiller 20-city composite house price index
                    8




                                                                                         House price index, 2000=100
                                                                                 170
                    7
interest rate (%)




                    6                                                            150

                    5
                                                                                 130

                    4
                                                                                 110
                    3
                                                                                 90
                    2

                                                                                 70
                    1

                    0                                                            50
                     2000      2001   2002         2003         2004         2005
                         Change in U.S. house price index
                       and rate of new foreclosures, 1999-2009
                                 14%
                                           US house price index                        1.4
                                 12%
                                           New foreclosures
Percent change in house prices




                                 10%                                                   1.2
    (from 4 quarters earlier)




                                                                                             New foreclosure starts
                                                                                             (% of total mortgages)
                                 8%
                                                                                       1.0
                                 6%
                                                                                       0.8
                                 4%

                                 2%                                                    0.6

                                 0%
                                                                                       0.4
                                 -2%
                                                                                       0.2
                                 -4%

                                 -6%                                                   0.0
                                    1999    2001       2003       2005   2007   2009
                        House price change and new
                       foreclosures, 2006:Q3 – 2009Q1
                     20%

                     18%      Nevada
                                             Florida         Illinois
                     16%
                                                                        Ohio
% of all mortgages




                                                    Michigan
New foreclosures,




                     14%
                              California                                        Georgia
                     12%
                                       Arizona                                    Colorado
                     10%
                                   Rhode Island
                     8%                                                               Texas
                                     New Jersey
                     6%
                                                 Hawaii                               S. Dakota
                     4%
                                                          Oregon
                                                                                      Wyoming
                     2%                                        Alaska
                                                                             N. Dakota
                     0%
                       -40%       -30%      -20%          -10%          0%      10%       20%
                                     Cumulative change in house price index
                          U.S. bank failures by year, 2000-2010
                          180

                          160
Number of bank failures




                          140

                          120

                          100

                           80

                           60

                           40

                           20

                            0
                                2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
                                         0%




             -80%
                           -40%
                                  -20%
                                              20%
                                                    40%
                                                          60%
                                                                80%




                    -60%
                                                                      100%
                                                                                120%
 12/6/1999                                                                                  140%

 8/13/2000


 4/21/2001


12/28/2001


  9/5/2002


 5/14/2003


 1/20/2004


 9/27/2004


  6/5/2005
                                                                                                                                 Major U.S. stock indexes




 2/11/2006
                                                                                              (% change from 52 weeks earlier)




10/20/2006


 6/28/2007
                                                                                              DJIA




  3/5/2008
                                                                                  S&P 500
                                                                       NASDAQ




11/11/2008


 7/20/2009
                                      Consumer sentiment and growth in consumer
                                          durables and investment spending
                                       20%
                                                                                                   110




                                                                                                         Consumer Sentiment Index, 1966=100
                                       15%
% change from four quarters earlier




                                       10%                                                         100

                                       5%
                                                                                                   90
                                       0%

                                       -5%                                                         80


                                      -10%
                                                                                                   70

                                      -15%
                                               Durables
                                                                                                   60
                                      -20%     Investment
                                               UM Consumer Sentiment Index
                                      -25%                                                         50
                                          1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                                  Real GDP growth and Unemployment
                                  10%                                                                10
                                            Real GDP growth rate (left scale)
                                                                                                     9
                                  8%        Unemployment rate (right scale)
% change from 4 quaters earlier




                                                                                                     8

                                  6%                                                                 7




                                                                                                          % of labor force
                                                                                                     6
                                  4%
                                                                                                     5
                                  2%
                                                                                                     4

                                  0%                                                                 3

                                                                                                     2
                                  -2%
                                                                                                     1

                                  -4%                                                                0
                                     1995   1997     1999     2001     2003     2005   2007   2009
              The Great Recession
                          2008-2009
 NBER: December 2007 to June 2009
  – Real GDP fell by 4%, u-rate hit 10.6%
 Important factors in the crisis:
  –   early 2000s Federal Reserve interest rate policy
  –   sub-prime mortgage crisis
  –   bursting of house price bubble, rising foreclosure rates
  –   falling stock prices
  –   failing financial institutions
  –   declining consumer confidence, drop in spending on
      consumer durables and investment goods
             Policy Responses to
              Great Recession
 Fiscal Policy
   –   Economic Stimulus Act of 2008
   –   TARP (2008)
   –   American Recovery and Reinvestment Act of 2009
   –   Cash for Clunkers (2009)
   –   Additional UI
 Monetary Policy
   – Quantitative Easing I, II
   – New Credit Facilities

 Financial Regulation
   – Stress tests
   – Dodd-Frank (2010)

 International Trade Policy
Clicker Review
Over the business cycle, investment spending
______ consumption spending.
a) is inversely correlated with
b) is more volatile than
c) has about the same
    volatility as
d) is less volatile than
Most economists believe that prices are:

a) flexible in the short run but many
    are sticky in the long run.
b) flexible in the long run but many
    are sticky in the short run.
c) sticky in both the short and long
    runs.
d) flexible in both the short and long
    runs.
The vertical long-run aggregate supply curve satisfies
the classical dichotomy because the natural rate of
output does NOT depend on:

a) the labor supply.
b) the supply of capital.
c) the money supply.
d) technology.
If the short-run aggregate supply curve is horizontal,
then a change in the money supply will change ______
in the short run and change ______ in the long run.

 a) only output; only prices
 b) only prices; only output
 c) both prices and output; only
     prices
 d) both prices and output; both
     prices and output
Assume that the economy is initially at point A with aggregate
demand given by AD2. A shift in the aggregate demand curve to
AD0 could be the result of either a(n) ______ in the money supply or
a(n) ______ in velocity.
a)   increase; increase
b)   increase; decrease
c)   decrease; increase
d)   decrease; decrease
In the IS-LM model, which two variables are
influenced by the interest rate?
a) supply of nominal money balances
    and demand for real balances
b) demand for real balances and
    government purchases
c) supply of nominal money balances
    and investment spending
d) demand for real money balances
    and investment spending
The equilibrium condition in the Keynesian-
cross analysis in a closed economy is:
a)   income equals consumption plus investment
     plus government spending.
b)   planned expenditure equals consumption plus
     planned investment plus government
     spending.
c)   actual expenditure equals planned
     expenditure.
d)   actual saving equals actual investment.
In the Keynesian-cross model with a given MPC, the
government-expenditure multiplier ______ the tax
multiplier.

a) is larger than
b) equals
c) is smaller than
d) is the inverse of the
An increase in taxes shifts the IS curve, drawn with
income along the horizontal axis and the interest rate
along the vertical axis:
a) downward and to the left.
b) upward and to the right.
c) upward and to the left.
d) downward and to the right.
A decrease in the price level, holding nominal
money supply constant, will shift the LM curve:
a) upward and to the right.
b) downward and to the right.
c) downward and to the left.
d) upward and to the left.
In the Keynesian-cross analysis, if the consumption
function is given by C = 100 + 0.6(Y – T), and planned
investment is 100, G is 100, and T is 100, then equilibrium
Y is:
 a) 350
 b) 400
 c) 600
 d) 750
Based on the graph, starting from equilibrium at interest
rate r1 and income Y1, a tax cut would generate the new
equilibrium combination of interest rate and income:
a) r2, Y2
b) r3, Y2
c) r2, Y3
d) r3, Y3
Based on the graph, starting from equilibrium at interest rate r3,
income Y2, IS1, and LM1, if there is an increase in government
spending that shifts the IS curve to IS2, then in order to keep the
interest rate constant the Federal Reserve should _____ the money
supply shifting to _____.

  a)   increase; LM2
  b)   decrease; LM2
  c)   increase; LM3
  d)   decrease; LM3
Based on the graph, if the economy starts from a short-
term equilibrium at A, then the long-run equilibrium will
be at ____ with a _____ price level.
a)   B; higher
b)   B; lower
c)   C; higher
d)   C; lower
A tax cut combined with tight money, as was the case in
the United States in the early 1980s, should lead to a:

a) rise in the real interest rate and a
    fall in investment.
b) fall in the real interest rate and a
    rise in investment.
c) rise in both the real interest rate
    and investment.
d) fall in both the real interest rate
    and investment.

				
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