Chapter 12: Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model Bill Gibson
EC 11, Spring 2011
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth Solow growth rate: is an economys potential growth rate,
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth Solow growth rate: is an economys potential growth rate, Would occur given flexible prices and existing real factors of production.
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth Solow growth rate: is an economys potential growth rate, Would occur given flexible prices and existing real factors of production. The Real Business Cycle (RBC) model combined with New Keynesian model
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth Solow growth rate: is an economys potential growth rate, Would occur given flexible prices and existing real factors of production. The Real Business Cycle (RBC) model combined with New Keynesian model Example Will the economy ever grow at this rate?
Bill Gibson
University of Vermont
Big ideas of the chapter Growth in postwar period averaged about 3% but not smooth Growth rate not smooth Solow growth rate: is an economys potential growth rate, Would occur given flexible prices and existing real factors of production. The Real Business Cycle (RBC) model combined with New Keynesian model Example Will the economy ever grow at this rate? Answer: : Yes, if markets are working well and prices are perfectly flexible. This is the straight line on the graph on the class web-site Bill Gibson
University of Vermont
Potential GDP
Bill Gibson
University of Vermont
Growth not smooth
Bill Gibson
University of Vermont
Employment
Bill Gibson
University of Vermont
Solow Growth Curve
Inflation Rate
Solow growth curve
3%
Real GDP growth rate Slide 5 of 51
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks:
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks: Factors that increase the fundamental ability of the economy to produce goods and services.
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks: Factors that increase the fundamental ability of the economy to produce goods and services. Negative productivity shocks:
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks: Factors that increase the fundamental ability of the economy to produce goods and services. Negative productivity shocks: Factors that decrease the fundamental ability of the economy to produce goods and services.
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks: Factors that increase the fundamental ability of the economy to produce goods and services. Negative productivity shocks: Factors that decrease the fundamental ability of the economy to produce goods and services. Example What are the parameters of the Solow model that can cause it to shift?
Bill Gibson
University of Vermont
What causes the Solow curve to shift?
Positive productivity shocks: Factors that increase the fundamental ability of the economy to produce goods and services. Negative productivity shocks: Factors that decrease the fundamental ability of the economy to produce goods and services. Example What are the parameters of the Solow model that can cause it to shift? Answer: A, s, δ, β
Bill Gibson
University of Vermont
Shifting the Solow curve
Inflation Rate
Solow growth curve
Negative shock
-1%
3%
Real GDP growth rate Slide 5 of 51
Bill Gibson
University of Vermont
Shifting the Solow curve
Inflation Rate
Solow growth curve
Positive shock
3%
7%
Real GDP growth rate Slide 5 of 51
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth For a given level of spending growth:
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth For a given level of spending growth: AD curve shows the combinations of inflation and real growth that add up to that spending growth.
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth For a given level of spending growth: AD curve shows the combinations of inflation and real growth that add up to that spending growth. Can be combined with the Solow curve to give an equilibrium
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth For a given level of spending growth: AD curve shows the combinations of inflation and real growth that add up to that spending growth. Can be combined with the Solow curve to give an equilibrium Example Is it common to put growth rates on axes?
Bill Gibson
University of Vermont
Dynamic Aggregate Demand Curve Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth ˆ + vˆ = Pˆ + Yˆr M Spending = inflation + real growth For a given level of spending growth: AD curve shows the combinations of inflation and real growth that add up to that spending growth. Can be combined with the Solow curve to give an equilibrium Example Is it common to put growth rates on axes? Answer: No! This is why this model of chpt 12 is called a dynamic AS-AD model Bill Gibson
University of Vermont
The aggregate demand growth curve
Inflation 7% 5%
5% + 0% = 5%
2%
0% -2%
2% + 3% = 5%
0%
2%
3%
5%
7%
Real Growth Slide 11 of 51 43
Bill Gibson
University of Vermont
The aggregate demand growth curve
Inflation 7% 5%
5% + 2% = 7%
2%
0% -2%
2% + 5% = 7%
0%
2%
5%
7%
Real Growth Slide 11 of 51 43
Bill Gibson
University of Vermont
AD and Solow curve determine the equilibrium
Inflation
Solow growth curve
2%
AD 3%
Real growth Slide 16 of 51 43
Bill Gibson
University of Vermont
AD and Solow curve determine the equilibrium
Inflation
7%
2%
Solow growth curve
b a
AD
3%
Real growth Slide 16 of 51 43
Bill Gibson
University of Vermont
Short run aggregate supply
Right: Upward sloping steeply
The New Keynesian Model Inflation
Solow growth curve
SRAS
2%
AD 3%
Real growth Slide 22 of 51 43
Bill Gibson
University of Vermont
Short run aggregate supply
Right: Upward sloping steeply
The New Keynesian Model Inflation
Solow growth curve
Left: Flatter because of “endowment effect” SRAS
2%
AD 3%
Real growth Slide 22 of 51 43
Bill Gibson
University of Vermont
Short run aggregate supply
Right: Upward sloping steeply
The New Keynesian Model Inflation
Solow growth curve
Left: Flatter because of “endowment effect” Three curves to determine 2 variables?
SRAS
2%
AD 3%
Real growth Slide 22 of 51 43
Bill Gibson
University of Vermont
Short run aggregate supply
Right: Upward sloping steeply
The New Keynesian Model Inflation
Solow growth curve
Left: Flatter because of “endowment effect” Three curves to determine 2 variables? Wage stickiness different in two directions
Bill Gibson
SRAS
2%
AD 3%
Real growth Slide 22 of 51 43
University of Vermont
If inflation = 2% and expected inflation is 2%
• TheNew Short-Run Aggregate Supply Curve (cont.) The Keynesian Model Inflation
Solow growth curve SRAS with expected inflation = 2%
2%
a
3%
Real growth Slide 28 of 51 43
Economy stays at point a Bill Gibson
University of Vermont
If inflation = 4% and expected inflation is 2%
• TheNew Short-Run Aggregate Supply Curve (cont.) The Keynesian Model Inflation
Solow growth curve SRAS with expected inflation = 2%
4% 2%
b a
3%
7%
Real growth Slide 27 of 51 43
Economy moves to point b Bill Gibson
University of Vermont
If inflation = 4% and expected inflation is 4%
• TheNew Short-Run Aggregate Supply Curve (cont.) The Keynesian Model Inflation
Solow growth curve
d
6% 4% 2%
c
SRAS with expected inflation 4%
SRAS with expected inflation 2%
b
a
3%
7%
Real growth Slide 26 of 51 43
Economy moves to point c Bill Gibson
University of Vermont
Demand shock-short run
• TheNew Short-Run Aggregate Supply Curve (cont.) The Keynesian Model Inflation
Solow growth curve
SRAS with expected inflation 2%
b 2%
Initial shift in AD
a
3% 5%
Real growth Slide 26 of 51 43
Economy moves to point b Bill Gibson
University of Vermont
Demand shock-long run
• TheNew Short-Run Aggregate Supply Curve (cont.) The Keynesian Model Inflation
Solow growth curve
SRAS with expected inflation 4% SRAS with expected inflation 2%
c 4%
b 2%
Initial shift in AD
a
3% 5%
Real growth Slide 27 of 51 43
Economy moves to point c Bill Gibson
University of Vermont
Depression
Bill Gibson
University of Vermont
Depression
• The Great Depression the Great Fall in AD Understanding theand Great Depression Solow growth curve
