Economic Fluctuations III

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Economic Fluctuations III
RECOVERY
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Recovery from what?

• From the short-run (first steps) to the
  long-run (back to potential GDP)
• Four scenarios today
• (1) Reduction in government purchases
• (2) Shift to more inflationary monetary policy
• (3) Shift to a less inflationary monetary policy
• (4) Combo of (2) and (3) Boom-Bust Cycle

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The short-run and the long-run effects of a
change in G

• Suppose that there is a sudden, big, decline in
  government purchases
• A reduction in demand
• We know that in the short run real GDP will fall
  below potential GDP
• Now we want to see how real GDP recovers--moves
  back to potential GDP

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Starting point in the main diagram
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Cut in government purchases causes real GDP to
decline as shown by shift of ADI
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But now real GDP is lower than potential GDP, so
inflation starts to fall (PA moves down)
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Could you go over that again, sketching the
diagram by hand?
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FYI Here is what is happening in the supporting
diagrams
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What happens to C, I, X in the short run (SR) and
the long run (LR)?
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The LR is the same as SAM.

• In the long run, real GDP is back to potential,
  but with G down and
• I up, X up, C up
• The spending allocation model (SAM) predicted the
  same thing when G/Y down
• I/Y up, X/Y up, C/Y up
• But with ADIPA we now we have the short run story
  to go with the long run story

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In the long run, real GDP returns to potential
GDP, but (with more I) the growth rate of
potential GDP may be higher as shown here
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A Lesson for Prospective Central Bankers

• We want to suppose there is a shift in monetary
  policy
• This shift is a common tactical mistake
• What are the short run and the long run economic
  effects?
• What are the political implications?
• To learn this lesson lets first observe some
  Textbook Maneuvers

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WELCOME TOA school for central
bankers.Dedicated to teaching the science and
art of monetary policy.
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Key Dialogue

• Tom Cruise
• You dont have time to think up there. If you
  think your dead.
• Kelly McGillis
• Thats a big gamble with a 30,000,000 plane
  Lieutenant. Let me teach you about the gain
  then pain scenario. It starts with the Fed
  cutting interest rates when inflation is not too
  low and real GDP is just about equal to potential
  GDP.

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Gain then pain scenario

• Start inflation rate 2, real GDP potential
  GDP
• Fed cuts interest rate
• buys bonds
• Economy booms---the gain
• real GDPgt potential GDP
• Inflation starts to rise
• Fed must raise interest rate
• End Economy returns to potential
• real GDP potential GDP
• inflation is higher than 2---the pain

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Could you sketch the pain then gain scenario by
hand?
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A disinflation

• The Fed decides that inflation is too high
• Or Jimmy Carter appoints Paul Volcker to chair
  the Fed and says reduce inflation, Paul
• The monetary policy must shift towards lower
  inflation
• Fed raises the interest rate,
• ADI shifts to left,
• and then...

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A Disinflation in a Graph
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A boom-bust cycle

• First, the Fed lowers the interest rate when it
  shouldnt have (the mistake Kelly McGillis warned
  Tom Cruise about)--this causes a boom
• Then the Fed undoes the mistake by shifting
  monetary policy back towards a lower inflation
  rate
• Now look at what happens over time

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Any animated graphics for the boom-bust cycle?
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END OF LECTUREand BEAT CAL