Chapter 22
Understanding Business
Cycle Fluctuations
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008
Understanding Business Cycle
Fluctuations: The Big Questions
1. Why do aggregate demand curve and
aggregate supply curves shift?
2. How do central bankers achieve their
stabilization objectives?
22-2
Inflation and Business Cycles
22-3
Understanding Business Cycle
Fluctuations: Roadmap
• Sources of Fluctuations
• Using the Aggregate DemandAggregate Supply Framework
22-4
Sources of Fluctuations:
Preliminaries
•
Long-run equilibrium
1. Y = YP output = potential
2.  = T inflation = target
3.  = e inflation = expected
• Shocks
– Supply shock: affects cots
– Demand shock: affects expenditure
22-5
Sources of Fluctuations
• Shifts in Aggregate Demand
– Change in the inflation target (T)
– Change in Government Purchases
• Shifts in Short-Run Aggregate Supply
– Changes in costs of production
22-6
Decline in Inflation Target:
Monetary Policy Reaction Curve
When T , MPRC shifts to the left.
22-7
Decline in Inflation Target:
Short-Run Equilibrium
T 
AD shifts left
Economy 12
22-8
Decline in Inflation Target:
Adjustment
At point 2, Y<YP
SRAS shifts right
Until economy
reaches point 3,
the new long-run
equilibrium
22-9
Decline in Inflation Target:
Summary
1. Output falls and inflation falls.
2. With Y<YP, output starts to rise and
inflation continues to fall.
3. At the new equilibrium, Y=YP and
inflation equals the new target
22-10
Increase in Government Purchases
Short-Run Equilibrium
G
Shifts AD to the right
Economy 12
22-11
Increase in Government Purchases
Adjustment
At point 2, Y>YP
SRAS shifts left
Until economy
reaches long-run
equilibrium at
point 3
22-12
Increase in Government Purchases
Summary
• Output initially rises and inflation rises
• With Y>YP, output and inflation fall
• The economy returns to its initial
equilibrium.
An increase in G causes Y and  to
increase temporarily.
22-13
Summary of Impact of Increase in
Dynamic Aggregate Demand
22-14
Shifts in
Short-Run Aggregate Supply
Increase in production
cost changes shift
SRAS left
Economy 1 2
22-15
Summary of Impact of Decline in
Short-Run Aggregate Supply
22-16
Recession:
• Decline in activity, not just a dip in growth
• Exact length is ambiguous.
• Determination involves judgment
22-17
22-18
A Shift in Aggregate Demand
Drop in consumer or
business confidence:
AD0 AD1
Economy 12
Stabilization requires
shifting AD back to
where it started
22-19
A Shift in Aggregate Demand:
Policy Response
• Drop in consumer or
business confidence
lowers r*
• Policymakers shift
MPRC right, lowering
the interest rate at
every level of inflation
22-20
A Shift in Aggregate Demand:
Stabilization
To stabilize the
economy following a
drop in confidence,
policymakers shift AD
back to where it started
22-21
• Stabilization improves welfare
• Individuals strive to stabilize consumption
• When income falls temporarily you can
– Draw on savings (emergency funds)
– Borrow
22-22
Fiscal Policy
• Two types
– Automatic stabilizers
– Discretionary policy
• Discretionary increase in G
– Drives up aggregate expenditure
– Shifts dynamic aggregate demand right
– Elicits a monetary policy response: higher
interest rates at every level of inflation
22-23
Positive Supply Shock
Fall in Production
Costs:
Shifts SRAS Right
Economy 12
22-24
Positive Supply Shock:
Policy Options
1. T unchanged
2. Lower T
22-25
Positive Supply Shock:
Policy Option 1
T unchanged
At point 2, Y>YP
SRAS shifts left until
Y=YP at point 1
22-26
Positive Supply Shock:
Policy Option 2
Policymakers take
advantage and
lower T
Shifts MPRC left
22-27
Positive Supply Shock:
Policy Option 2
New, lower T
AD shifts left
Economy 23
22-28
The Great Moderation
Growth is much less volatile after 1984 than before.
22-29
The Great Moderation:
Candidate Explanations
1. Luck
But there were lots of shocks in the 1990s
2. Improved technology, especially for
inventory management
But the biggest inventory problems are in the hightechnology sector
3. Better monetary policy
22-30
Increase in Potential Output
• Source:
Technological Improvement
• How to think about it:
An Increase in Trend Growth
• Using the model:
Shifts both LRAS and SRAS
22-31
Increase in Potential Output:
Shifts in Aggregate Supply
An increase in YP
shifts SRAS right
shifts LRAS right
But SRAS still crosses
LRAS where = e
22-32
Increase in Potential Output:
Short-Run Equilibrium
Following YP increase:
Economy 12
where AD crosses
new SRAS1
22-33
Increase in Potential Output:
Long-Run
• In the short-run output and inflation fall
• In the long-run the economy goes to the
new, higher YP
• Policymakers have two options:
– T unchanged
– T lower (opportunistic disinflation)
22-34
Increase in Potential Output:
Unchanged Inflation Target
With T unchanged:
Policymakers shift AD
right, economy moves
to the new level of
potential output and the
original T at point 3.
22-35
Increase in Potential Output:
Lower Inflation Target
With a new, lower T:
Policymakers allow the
economy to move to
point 4
22-36
Globalization and Inflation
• What is Globalization?
– Globalization is about trade
– Improved trade is the same as a
technological advance
– This is the same as an increase in
potential output
22-37
Globalization and Inflation
• How big is the effect on inflation?
– 8% of household purchases are imports
– Domestic content of imports = 1/3
– Imported goods prices account for 6% of
household spending
22-38
Distinguishing a Recessionary Gap
from a Fall in Potential Output
When output falls is it
1. A recessionary gap
2. A fall in potential output
How can you tell the difference?
22-39
Recessionary Output Gap
Recessionary output gap
caused by supply shock
Policymakers focus on
returning inflation to
target, raise the interest
rate along an
unchanged MPRC
22-40
Fall in Potential Output
Fall in potential output requires policymakers to shift MPRC.
This shifts AD so that inflation returns to target at point 3.
22-41
You can measure GDP by either counting production or income.
They should be the same, but they are not. The difference is
called the “Statistical discrepancy” and it can be very large.
22-42
The Volatility Tradeoff
• Can Policymakers Stabilize
Output and Inflation Simultaneously?
22-43
The Volatility Tradeoff
• Demand Shocks can be neutralized
• Supply Shocks create a tradeoff
22-44
The Volatility Tradeoff:
Slope of MRPC
22-45
The Volatility Tradeoff:
Slope of the AD curve
22-46
The Volatility Tradeoff
• Can Policymakers Stabilize
Output and Inflation Simultaneously?
NO!
• Keeping  near T means Y volatile
• Keeping Y near YP means  volatile
22-47
Chapter 22
End of Chapter
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2008