Goal: To develop a model of economic fluctuations

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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

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What happens to inflation during a typical
economic fluctuation?
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Summarize the inflation and real GDP observations
in one diagram
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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

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The graphical representation of this macro model
is analogous to a micro model

• Supply and demand model
• demand curve
• supply curve
• equilibrium at the intersection of the two curves
• diagram with price and quantity of peanuts

• Economic fluctuations model
• aggregate demand/inflation curve
• Price adjustment line
• equilibrium at the intersection of the two curves
• diagram with inflation and real GDP

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Lets derive the aggregate demand inflation
curve in three stages.
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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 ?

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You can show the negative effect of the interest
rate on real GDP with the 45-degree line diagram
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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

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Monetary policy rule in a graph
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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

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More details of the three stages
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A little bit of that fancy animated graphics
would be real nice now
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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

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Example a shift in ADI curve due to increase in G
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A change in the monetary policy rule also causes
a shift in the ADI curve
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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)

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The price adjustment line
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Historical evidence consistent with the price
adjustment line
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Intersection of ADI and PA gives a prediction of
real GDP and inflation
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How about a little more of that fancy animated
graphics?
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Next Time Using the forces of adjustment we see
how the economy recoversand maybe find out who
that narrator is
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END OF LECTURE