Matching History and Theory
Keynesian Stimulus
1) Keynesian Stimulus – 1930’s
1) Fine tuning in the 1960’s
Keynesian Economics and the Keynesian Short-Run Aggregate
Supply Curve (cont'd)
• Keynesian Short-Run Aggregate Supply Curve
– The horizontal portion of the aggregate supply
curve in which there is excessive unemployment
and unused capacity in the economy
Figure 11-7 Demand-Determined Equilibrium Real GDP at Less
Than Full Employment
Keynes assumed
prices will not fall
when aggregate
demand falls
Keynesian Economics and the Keynesian Short-Run Aggregate
Supply Curve (cont'd)
• Real GDP and the price level, 1934–1940
– Keynes argued that in a depressed economy, increased aggregate
spending can increase output without raising prices.
– Data showing the U.S. recovery from the Great Depression seem to
bear this out.
– In such circumstances, real GDP is demand driven.
Figure 11-8 Real GDP and the Price
Level, 1934–1940
Managing Economic “Fluctuations”
“Fine-tuning” the economy – can it be done?
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How the Phillips curve is related to the model of aggregate
demand and aggregate supply
(b) The Phillips Curve
(a) The Model of AD and AS
Price
level
Short-run
aggregate
supply
B
106
A
102
Inflation
Rate
(percent
per year)
6%
B
High aggregate
demand
Low aggregate
demand
2
A
Phillips curve
Quantity
15,000 16,000
Unemployment
0
7%
4%
unemployment unemployment of output
output Rate (percent)
output
=7% =4%
=16,000 =15,000
This figure assumes price level of 100 for year 2020 and charts possible outcomes for the year 2021. Panel (a)
shows the model of aggregate demand & aggregate supply. If AD is low, the economy is at point A; output is low
(15,000), and the price level is low (102). If AD is high, the economy is at point B; output is high (16,000), and
the price level is high (106). Panel (b) shows the implications for the Phillips curve. Point A, which arises when
aggregate demand is low, has high unemployment (7%) and low inflation (2%). Point B, which arises when
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aggregate demand is high, has low unemployment (4%) and high inflation (6%).
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Shifts in Phillips Curve: Role of Expectations
• Natural experiment for natural-rate
hypothesis
• Natural-rate hypothesis
– Unemployment - eventually returns to its
normal/natural rate
– Regardless of the rate of inflation
• Late 1960s (short-run), policies:
– Expand AD for goods and services
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Shifts in Phillips Curve: Role of Expectations
• Natural experiment for natural-rate hypothesis
– Expansionary fiscal policy
• Government spending rose
– Vietnam War
– Great Society Programs
– Monetary policy
•
•
•
•
•
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The Fed – try to hold down interest rates
Money supply – rose 13% per year
High inflation (5-6% per year)
Unemployment decreased
Trade-off (Short-run AS)
Shifts in Phillips Curve: Role of Expectations
• The long-run Phillips curve
– Expression of the classical idea of monetary
neutrality
– Increase in money supply
• Aggregate-demand curve – shifts right
– Price level – increases
– Output – natural rate
• Inflation rate – increases
– Unemployment – natural rate
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The Phillips Curve in the 1960s
This figure uses annual data from 1961 to 1968 on the unemployment rate and on
the inflation rate (as measured by the GDP deflator) to show the negative
relationship between inflation and unemployment.
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7
The breakdown of the Phillips Curve
This figure shows annual data from 1961 to 1973 on the unemployment rate and on the
inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks
down in the early 1970s, just as Friedman and Phelps had predicted. Notice that the points
labeled A, B, and C in this figure correspond roughly to the points in Figure 5.
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4
How the long-run Phillips curve is related to the model of
aggregate demand and aggregate supply
(b) The Phillips Curve
(a) The Model of AD and AS
Price
level
Inflation
Rate
Long-run
aggregate supply
B
P2
A
P1
2. . . . raises
the price
level . . .
0
Long-run
Phillips curve
B
1. An increase in
the money supply
increases aggregate
demand . . .
3. . . . and
increases the
inflation rate . . .
A
AD2
Aggregate demand, AD1
Natural rate
of output
Quantity of output
0
Natural rate Unemployment
Rate
of output
4. . . . but leaves output and unemployment
at their natural rates.
Panel (a) shows the model of AD and AS with a vertical aggregate-supply curve. When expansionary monetary
policy shifts the AD curve to the right from AD1 to AD2, the equilibrium moves from point A to point B. The price
level rises from P1 to P2, while output remains the same. Panel (b) shows the long-run Phillips curve, which is
vertical at the natural rate of unemployment. In the long run, expansionary monetary policy moves the economy
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from lower inflation (point A) to higher inflation (point B) without changing the rate of unemployment
The Cost of Reducing Inflation
• The Volker disinflation
– Paul Volker – chairman of the Fed, 1979
– Peak inflation: 10%
• Sacrifice ratio = 5 (5% dec in GNP for 1% dec in inflation)
– Reducing inflation – great cost
• Rational expectations
– Reducing inflation – smaller cost
– 1984 inflation :
• Drops to 4% due to tightening monetary policy
– High unemployment: 10%
– Low output
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11
The Volcker Disinflation
This figure shows annual data from 1979 to 1987 on the unemployment rate and on the
inflation rate (as measured by the GDP deflator). The reduction in inflation during this period
came at the cost of very high unemployment in 1982 and 1983. Note that the points labeled
A, B, and C in this figure correspond roughly to the points in Figure 10.
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The Cost of Reducing Inflation
• The Greenspan era
• Alan Greenspan – chair of the Fed, 1987
– Favorable supply shock (OPEC, 1986)
• Falling inflation & falling unemployment
– 1989-1990: high inflation & low unemployment
• The Fed – raised interest rates
– Contracted aggregate demand
– 1990s – economic prosperity
• Prudent monetary policy
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Figure 11-9 Real GDP Determination with Fixed versus
Flexible Prices
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The Volcker Disinflation
This figure shows annual data from 1979 to 1987 on the unemployment rate and on the
inflation rate (as measured by the GDP deflator). The reduction in inflation during this period
came at the cost of very high unemployment in 1982 and 1983. Note that the points labeled
A, B, and C in this figure correspond roughly to the points in Figure 10.
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The Cost of Reducing Inflation
• The Greenspan era
• 2001: recession
– Depressed aggregate demand
– Expansionary fiscal and monetary policy
• Bernanke’s challenges
– Ben Bernanke – chair, the Fed, 2006
– 1995-2006: booming housing market
• New homeowners: subprime (high risk of default)
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Friedman – steady growth rate of M1/M2
“Fine-tuning” the economy – can’t be done?
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The Greenspan Era
This figure shows
annual data from
1984 to 2006 on the
unemployment rate
and on the inflation
rate (as measured by
the GDP deflator).
During most of this
period, Alan
Greenspan was
chairman of the
Federal Reserve.
Fluctuations in
inflation and
unemployment were
relatively small.
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Neo-Keynesian Models
Real GDP Determination with Fixed and Flexible Prices
The Cost of Reducing Inflation
• Bernanke’s challenges
• 2006-2008: housing & financial crises
– Housing prices declined > 15%
• The new homeowners: underwater
– Value of house < balance on mortgage
– Mortgage defaults
– Home foreclosures
– Financial institutions – large losses
– Depressing the aggregate demand
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The Cost of Reducing Inflation
• Bernanke’s challenges
• 2004-2008: rising commodity prices
– Increased demand from rapidly growing emerging
economies
– Prices of basic foods – rose significantly
• Droughts in Australia
• Demand increase from emerging economies
• Increased use of agricultural products – biofuels
– Contracting aggregate supply
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