Goal: To develop a model of economic fluctuations

• Two key ideas: economic fluctuations are – (1) departures of real GDP from potential GDP– (2) caused by changes in demand

• Last time First steps: showed how real GDP moves away from potential GDP

• This time Forces of adjustment: changes in interest rates and prices (inflation) bring real GDP back to potential GDP

What happens to inflation during a typical economic fluctuation?

27_01

1987 1988 1989 1990 1991 1992 1993 1994

5.0

4.5

4.0

3.5

3.0

2.5

PERCENT

1987 1988 1989 1990 1991 1992 1993 1994

Inflation rate

'89

'87

'88

'90 '91

'92

'93 '94

BILLIONS OF1992 DOLLARS

6,750

6,500

6,250

6,000

5,500

5,750

'87

'88

'89

'90

'91

'92

'93

'94

Real GDP

Potential GDP

Summarize the inflation and real GDP observations in one diagram

27_02

Potential GDP

'89'90'91

'92 '87

'93'94

'88

–2 –1 0 1 2 3

INFLATION RATE

(PERCENT)

REAL GDP (PERCENT DEVIATION FROM POTENTIAL GDP)

5

4

3

2

Model will be developed in graphical form

• Use a diagram with the same axes (sketch it by hand)– inflation rate on the

vertical axis

– real GDP on the horizontal axis

• But put curves in the diagram to explain the observations

27_02

Potential GDP

'89'90'91

'92 '87

'93'94

'88

–2 –1 0 1 2 3

INFLATION RATE

(PERCENT)

REAL GDP (PERCENT DEVIATION FROM POTENTIAL GDP)

5

4

3

2

The graphical representation of this macro

model is analogous to a micro model • Economic fluctuations

model– aggregate

demand/inflation curve– Price adjustment line– equilibrium at the

intersection of the two curves

– diagram with inflation and real GDP

• Supply and demand model– demand

curve

– supply curve

– equilibrium at the intersection of the two curves

– diagram with price and quantity of peanuts

Let’s derive the aggregate demand inflation curve

in three stages.27_03

–2 –1 0 1 2

INFLATION RATE

(PERCENT)

5

4

3

2

REAL GDP

(PERCENT DEVIATION FROM POTENTIAL GDP)

Aggregate demand/inflation curve

Stage one: real GDP is negatively related to the interest rate.

• WHY?– consumption (C) negatively related to interest rate– investment (I) negatively related to interest rate– net export (X) negatively related to interest rate

•Nothing new here

You can show the negative effect of the interest rate on real GDP with the

45-degree line diagram27_04

45-degree line

AE line with

lower interest

rate

AE line with

higher interest

rate

SPENDING

INCOME OR REAL GDP

A higher interest rate lowers real GDP.

Stage two: the interest rate is positively related to inflation

• The Fed tends to – raise the interest rate when inflation rises and– lower the interest rate when inflation falls

• It does this by open market operations

• this is a behavioral description of the the people at the Fed, much like a demand curve is a behavioral description of consumers

• Call this response a monetary policy rule

Monetary policy rule in a graph

27_05

Monetary policy rule

7

6

5

4

3

2

1

0 1 2 3 4 5 6

INFLATION RATE (PERCENT)

INTEREST RATE (PERCENT)

Interest rate when inflation is on target

Inflation target

Stage three: putting the first two stages together

• Suppose that inflation increases– the Fed will raise the interest rate– the higher interest rate will decrease real GDP

• Suppose that inflation decreases– the Fed will lower the interest rate– the lower interest rate will increase real GDP

• In sum, there is a negative relationship, which is simply the ADI curve

More details of the three stages27_06

6. which is also noted in this diagram.

5. resulting in a decline in real GDP of this amount...

1. Suppose the inflation rate rises by this amount...

7. The ADI curve is then drawn through the resulting inflation and real GDP points.

INTEREST RATE

SPENDING

INFLATION RATE

INFLATION RATE REAL GDP

REAL GDP

Monetary policy rule 45-degree line

Old AE line

New AE line

ADI curve

3. Then the Fed raises the interest rate by this amount...

4. causing the AE line to shift down by this amount...

2. which is also noted in this diagram.

A little bit of that fancy animated graphics would be real nice now

Shifts versus movements along the ADI curve

• Movements along the ADI curve:– when changes in the

inflation rate cause real GDP to change

• Shifts of the ADI curve:– when changes in

anything else cause real GDP to change

• change in government purchases

• change in net exports (Asian financial crisis)

• change in monetary policy rule

Example: a shift in ADI curve due to increase in G

27_07

INFLATION

RATE

REAL GDP

New ADI curve

Old ADI curve

An increase in governmentspending causes real GDPto rise by this amount inthe short run.

A change in the monetary policy rule also causes a shift in the ADI curve

27_08

7

6

5

4

3

2

1

0 1 2 3 4 5 6INFLATION RATE

INTERESTRATE

A change in themonetary policyrule toward a higherinflation target...

...initially impliesa decline in theinterest rate, whichshifts the ADI curve

Inflation and the price adjustment line

• Prices and wages adjust slowly in many markets– Thus inflation does not usually change

immediately (PA line is flat)

• But inflation does change over time– real GDP above potential GDP

• inflation rises (PA line rises)

– real GDP below potential GDP• inflation falls (PA line falls)

The price adjustment line27_10

INFLATION RATE

REAL GDP (PERCENT DEVIATION FROM POTENTIAL GDP)

Potential GDP

When real GDP is below potential GDP, the PA line shifts down.

INFLATION RATE

Price adjustment (PA) line

Price adjustment (PA) line

Potential GDP

REAL GDP (PERCENT DEVIATION FROM POTENTIAL GDP)

When real GDP is above potential GDP, the PA line shifts up.

Historical evidence consistent with the price adjustment line

27_11

1975

1983

1992

1982

1986

1991

1976

1980

1974 1979

1973

1988 1990 1989

– 6 – 4 – 2 0 2 4

REAL GDP(PERCENT DEVIATION FROM POTENTIAL GDP)

2

4

6

8

10

12

INFLATION RATE(PERCENT)

Intersection of ADI and PA gives a prediction of real GDP and inflation

27_12

INFLATION RATE INFLATION RATEINFLATION RATE

PA

PA

PA

Potential GDP

Potential GDP

Potential GDP

ADIADIADI

REAL GDP REAL GDP

Real GDP below potential GDP

Real GDP equal to potential GDP

Real GDP above potential GDP

REAL GDP

How about a little more of that fancy animated graphics?

Next Time

Using the forces of adjustment we see how the economy

recovers

and maybe find out who that narrator is

END OF

LECTURE