MEAP

Sessions:13-15
Prof. Biswa Swarup Misra
These two sessions address
▪ What are economic fluctuations? What are their
characteristics?
▪ Real Business Cycle Theory
▪ Leading Indicator Approach to Business Cycles
▪ How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
▪ Why does the Aggregate-Demand curve slope
downward?
▪ What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in
the short run?
Sessions 11-12 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1
These two sessions address
• How does the Aggregate-Supply curve look like in
the long run?
• What shifts the AS curve(s)?
• Determination of equilibrium GDP and Price level
• Characterizing Stagflation using AS-AD framework
• Characterizing an overheated economy using AS-AD
framework
• How does the self correcting mechanism work to
kick start an economy from a recession/depression

AGGREGATE DEMAND AND AGGREGATE SUPPLY 2

 Introduction
▪ Over the long run, real GDP grows about
3% per year on average.
▪ In the short run, GDP fluctuates around its trend.
• recessions: periods of falling real incomes
and rising unemployment
• depressions: severe recessions (very rare)
▪ Short-run economic fluctuations are often called
business cycles.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 3

 Three Facts About Economic Fluctuations
FACT 1: Economic fluctuations are
irregular and unpredictable.
$ 11,000
10,000 U.S. real GDP,
9,000 billions of 2000 dollars
8,000
7,000
6,000
The shaded
5,000 bars are
4,000 recessions
3,000
2,000
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Three Facts About Economic Fluctuations
FACT 2: Most macroeconomic
quantities fluctuate together.
$ 1,800

1,600 Investment spending,

1,400 billions of 2000 dollars
1,200

1,000

800

600

400

200
1965 1970 1975 1980 1985 1990 1995 2000 2005
Three Facts About Economic Fluctuations

FACT 3: As output falls,

unemployment rises.

12
Unemployment rate,
10 percent of labor force

0
1965 1970 1975 1980 1985 1990 1995 2000 2005
 Introduction, continued
▪ Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.
▪ Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.
▪ This model differs from the classical economic
theories economists use to explain the long run.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

 Facts about the business cycle
▪ GDP growth averages 3-3.5 percent per year over the
long run with large fluctuations in the short run.
▪ Consumption and investment fluctuate with GDP, but
consumption tends to be less volatile and investment
more volatile than GDP.
▪ Unemployment rises during recessions and falls during
expansions.
▪ Okun’s Law: the negative relationship between GDP
and unemployment.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 8

 Growth rates of real GDP, consumption
Percent 10 Real GDP
change growth rate
from 4 8
quarters Consumption
earlier growth rate
6

Average 4
growth
rate 2

-2

-4
1970 1975 1980 1985 1990 1995 2000 2005 2010 92015
Growth rates of real GDP, consump., investment
Percent
change 40 Investment
from 4 growth rate
quarters 30
earlier
20
Real GDP
10 growth rate

0
Consumption
-10 growth rate

-20

-30
1970 1975 1980 1985 1990 1995 2000 2005 2010 10
2015
 Unemployment
Percent 12
of labor
force
10

0
1970 1975 1980 1985 1990 1995 2000 2005 2010 11
2015
 Okun’s Law
▪ Okun’s law is an empirical relationship between
changes in aggregate output (relative to its
potential trend) and changes in the unemployment
rate (relative to its natural rate)
▪ It tell us how much of a country’s GDP may be lost
when the unemployment rate is above its natural
rate.
▪ Many economists have argued that Okun’s law is a
useful guide for monetary policy.
▪ http://research.stlouisfed.org/publications/es/article/
9295
AGGREGATE DEMAND AND AGGREGATE SUPPLY 12
 Okun’s Law
▪ Each dot in the next chart represents the observed
changes in GDP and unemployment in a particular
year.
▪ The vertical axis shows the percentage change in real
GDP relative to its long-run trend.
▪ The x-axis shows the change in the unemployment
rate relative to its natural rate (also defined as its
long-run trend)
▪ The solid line through the dots is the fitted value of
the relationship, which captures the average slope (–
2) of the two variables.
AGGREGATE DEMAND AND AGGREGATE SUPPLY 13
 Okun’s Law
Percentage 10 Y
change in
1951 1966 = 3 − 2 u
real GDP 8 Y
1984
6
2003

4 1971
1987
2

2001 1975
0

-2 2008 2009
1991 1982
-4
-3 -2 -1 0 1 2 3 4
Change in unemployment rate14
 Okun’s Law
▪ Thus, this empirically estimated Okun’s law states
that for each 1-percentage-point increase (decrease)
in the unemployment rate from its natural rate, total
output on average will be lowered (raised) by nearly
2 percent relative to its long-run HP trend.
▪ For example, suppose the natural rate of
unemployment is 6 percent in 2012; then the current
8.1 percent unemployment rate implies that real
GDP is about 4 percent below its potential trend.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 15

 Real Business Cycle Theory
▪ Transmission mechanisms-are economic
forces that can amplify the impact of
shocks on the economy.
• They work by transmitting these shocks
across times and sectors of the economy.

16
 Shocks
▪ Shocks-are rapid changes in economic
conditions that have large effects on the
productivity of capital and labor.
▪ We will examine the following shocks.
• Weather shocks
• Oil shocks
• Other possible shocks

17
 Shocks
▪ Weather shocks
• In many economies agriculture is the single
largest contributor to real GDP.
- Shocks to the weather are important.
- As economies become less dependent on
agriculture, weather shocks have less impact.
- India is a good example
– % of real GDP accounted for by agriculture
has fallen from 40% in 1970 to 20% in 1990.
– Since 1980, rainfall shocks have become
less important.
– The next figure shows this…
18
 Shocks
▪ Weather shocks (cont.)

19
 Shocks
▪ Oil Shocks
• An economy with a large manufacturing sector
is sensitive to reductions in oil supplies.
• Let’s look at the first major oil shock to the U.S.
economy.
- 1973 OPEC oil embargo.
– Price of oil more than tripled
» Because oil is an important input in many sectors, sharp
increases in its price can disrupt the economy as a
whole. The following figure shows this.
• The link with U.S. recessions is shown next…

20
 Shocks

•In each of these recessions, there was a large increase in the price of oil just
prior to or coincident with the onset of recession.
•This is especially true in the first three recessions where wars caused a
decrease in the supply of oil.
21
 Shocks
▪ Oil Shocks (cont.)
• It is easy to see the impact of a large
increase in the price of oil. It is harder to
eyeball the effect of smaller shocks.
- Careful statistical analysis can
disentangle the effect of oil shocks from
other shocks.
- The following figure shows the results of
this analysis…

22
 Shocks
▪ Oil Shocks (cont.)

• After the oil price increase, the economy slows for

5 quarters—15 months.
• After 10 quarters–2½ years, the economy has fully
adjusted and the growth rate has returned to normal. 23
 Shocks
▪ Oil Shocks (cont.)
• Starting in 2002 the price of oil dramatically
increased, and by 2009 in real terms it was as
high as ever.
- Did not immediately cause a recession. Let’s look at
three reasons why.
1. The American economy has become less dependent on oil
than it was in the 1970s.
» American producers have learned to protect themselves.
» Economy uses oil more efficiently.
» The following figure shows this…

24
 Shocks
▪ Oil Shocks (cont.)

25
 Shocks
▪ Oil Shocks (cont.)
2. Oil shocks were offset by positive
productivity shocks.
» Advances in computers and information
technology.
» Some positive shocks outweighed other
negative shocks.
3. The Federal Reserve responded more
appropriately to recent oil shocks than in
the past.

26
 Shocks
▪ Shocks, Shocks, Shocks
• Other shocks:
- Wars and terrorist attacks
- Major new regulations → increase in costs.
- Tax rate changes → spending and incentives.
- Mass labor strikes → disrupts production.
- New technologies → “creative destruction.”
• Important points
1.Typical year: good shocks outweigh the bad →
economy grows.
2.Bad year: big negative shock or small shocks,
more negative than positive.
27
 Index of Leading Economic Indicators

▪ Published monthly by the Conference Board.

▪ Aims to forecast changes in economic activity
6-9 months into the future.
▪ Used in planning by businesses and govt,
despite not being a perfect predictor.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 28

 Components of the LEI index
▪ Average workweek in manufacturing
▪ Initial weekly claims for unemployment insurance
▪ New orders for consumer goods and materials
▪ New orders, nondefense capital goods
▪ Vendor performance
▪ New building permits issued
▪ Index of stock prices
▪ M2
▪ Yield spread (10-year minus 3-month) on Treasuries
▪ Index of consumer expectations

AGGREGATE DEMAND AND AGGREGATE SUPPLY 29

 Index of Leading Economic Indicators,
1970-2012
120
110
100
90
2004 = 100

80
70
60
50
40
30
20
10
Source: 0
Conference
1970 1975 1980 1985 1990 1995 2000 2005 201030
Board
 Ingredients of a Composite Leading
Indicator for India
▪ Money Supply Growth
▪ Deposit Growth in Banks
▪ Non Food Credit Growth
▪ Exports Growth
▪ Fiscal Deficit
▪ Growth in IIP
▪ Cargo Handled
▪ Freight Loading of Railways
Source: Business cycles and leading indicators of industrial activity in India by Mohanty,
Jaya, Singh, Bhupal and Jain, Rajeev Reserve Bank of India

AGGREGATE DEMAND AND AGGREGATE SUPPLY 31

 Yield Spread as Indicator of Real Economic
Activity
▪ Expectation of financial market participants regarding
future growth is embodied in the yield curve
▪ If there are expectations of a recession in the near
future it is likely to result in a fall in long term nominal
interest rates since during period of low real growth,
inflation rates tend to fall.
▪ If there are expectations of a boom in the near future it
is likely to result in a rise in long term nominal interest
rates since during period of high real growth, inflation
rates tend to rise.
▪ Thus one might observe an empirical regularity that a
negative yield spread is likely to be associated with
future recession
AGGREGATE DEMAND AND AGGREGATE SUPPLY 32
 Frequency of Price Adjustment

Q:How often firms change prices in a typical year?

33
34
 Time horizons in macroeconomics
▪ Long run:
Prices are flexible, respond to changes in supply
or demand.
▪ Short run:
Many prices are “sticky” at some predetermined
level.

The economy behaves much

differently when prices are sticky.

35
The Model of Aggregate Demand and
Aggregate Supply
P
The price
level
SRAS
“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD

and eq’m output Y

Y1
(real GDP).
Real GDP, the
quantity of output
36
 The Aggregate-Demand (AD) Curve
P
The AD curve
shows the P2
quantity of
all g&s
demanded
in the economy P1
at any given AD
price level.
Y
Y2 Y1

37
 Why the AD Curve Slopes Downward

Y = C + I + G + NX P

Assume G fixed
P2
by govt policy.
To understand
the slope of AD,
P1
must determine
how a change in P AD
affects C, I, and NX.
Y
Y2 Y1

38
 The Wealth Effect (P and C )
Suppose P rises.
▪ The dollars people hold buy fewer g&s,
so real wealth is lower.
▪ People feel poorer.
Result: C falls.

39
 The Interest-Rate Effect (P and I )
Suppose P rises.
▪ Buying g&s requires more dollars.
▪ To get these dollars, people sell bonds or other
assets.
▪ This drives up interest rates.
Result: I falls.
(Recall, I depends negatively on interest rates.)

40
 What Are Exchange Rates?
• Exchange Rate Determination in the Short Run
$/¥
Supply of Yen

Exchange rate is
determined
by supply and
demand just
$0.0085
like any other
commodity.

Demand for Yen

Market for Yen Quantity of Yen

41
The Foreign Exchange Market and Exchange
Rates
Equilibrium in the Market for Foreign Exchange

Equilibrium in
the Foreign
Exchange
Market

42
 What Are Exchange Rates?
• Factors that Shift the Demand Curve
1. An increase (decrease) in the demand for a
country’s exports increases (decreases) the
value of its currency.
2. The more desirable (undesirable) a country is
for foreign investment, the higher (lower) the
value of that country’s currency.
3. An increase in the demand to hold dollar
reserves boosts the value of the dollar.
• Let’s use the supply and demand model to
illustrate each of these…

43
 What Are Exchange Rates?
1a. U.S. residents order more Toyotas
$/¥
Supply of yen

↑ demand for Japan’s

exports → ↑ value of
the yen
$0.0090
$0.0085 Demand for yen
w/↑ orders of
Toyotas

Demand for yen

Market for Yen Quantity of Yen

44
 What Are Exchange Rates?
1b. U.S. residents order fewer Toyotas
$/¥
Supply of yen

↓ demand for Japan’s

exports → ↓ value of
the yen

$0.0085 Demand for yen

$0.0080 w/↓ orders of
Toyotas

Demand for yen

Market for Yen Quantity of Yen

45
 What Are Exchange Rates?
2. Mexico becomes a better investment
$/peso
Supply of pesos

The Mexican peso

↑ in value
0.090

0.075 Demand for peso

w/↑ foreign
investment

Demand for pesos

Market for Pesos Quantity of Pesos

46
The Exchange-Rate Effect (P and NX )
Suppose P rises.
▪ India’s interest rates rise (the interest-rate effect).
▪ Foreign investors desire more Indian bonds.
▪ Higher demand for Rupees in foreign exchange market.
▪ India’s exchange rate appreciates.
▪ India’s exports more expensive to people abroad, imports
cheaper to Indian residents.
Result: NX falls.

47
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded P2
because:
• the wealth effect
(C falls)
P1
• the interest-rate
AD
effect (I falls)
• the exchange-rate Y
Y2 Y1
effect (NX falls)

48
Why the Aggregate Demand Curve is
Downward-Sloping?

49
Why the Aggregate Demand Curve is
Downward-Sloping?

50
Why the Aggregate Demand Curve is
Downward-Sloping?

51
Shifts in the Aggregate Demand Curve
(Continued)

Factors That Factors That

Increase Decrease
Aggregate Aggregate
Demand Demand
A decrease in An increase in
taxes taxes
An increase in A decrease in
government government
spending spending
An increase in A decrease in
the money the money
supply supply
Other factors Other factors
52
Factors That Change Aggregate Demand

53
Factors That Change Aggregate Demand
(Continued)

54
 Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX P
– except a change in P –
will shift the AD curve.

Example: P1
A stock market boom
makes households feel
wealthier, C rises, AD2
AD1
the AD curve shifts right.
Y
Y1 Y2

55
 Why the AD Curve Might Shift
▪ Changes in C
• Stock market boom/crash
• Preferences re: consumption/saving tradeoff
• Tax hikes/cuts
▪ Changes in I
• Firms buy new computers, equipment, factories
• Expectations, optimism/pessimism
• Interest rates, monetary policy
• Investment Tax Credit or other tax incentives

56
 Why the AD Curve Might Shift
▪ Changes in G
• Federal spending, e.g. defense
• State & local spending, e.g. roads, schools
▪ Changes in NX
• Booms/recessions in countries that buy our
exports.
• Appreciation/depreciation resulting from
international speculation in foreign exchange
market

57
ACTIVE LEARNING 1:
Exercise
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.

58
ACTIVE LEARNING 1:
Answers
A. A ten-year-old investment tax credit expires.
I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealth-effect).

59
 The Aggregate-Supply (AS) Curves

The AS curve shows P LRAS

the total quantity of
g&s firms produce and SRAS
sell at any given price
level.

AS is:
▪ upward-sloping
in short run
▪ vertical in Y
long run

60
 The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of P LRAS

output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment Y
YN
output.

61
 Why LRAS Is Vertical

YN determined by the P LRAS

economy’s stocks of
labor, capital, and
natural resources, and
on the level of P2
technology.
An increase in P P1

does not affect

any of these,
so it does not Y
YN
affect YN.

62
 Why the LRAS Curve Might Shift

P LRAS1 LRAS2
Any event that changes
any of the
determinants of YN
will shift LRAS.
Example: Immigration
increases L,
causing YN to rise.

Y
YN Y’
N

63
 Why the LRAS Curve Might Shift

▪ Changes in L or natural rate of unemployment

• Immigration
• Baby-boomers retire
• Govt policies reduce natural u-rate
▪ Changes in K or H
• Investment in factories, equipment
• More people get college degrees
• Factories destroyed by a hurricane

64
 Why the LRAS Curve Might Shift
▪ Changes in natural resources
• discovery of new mineral deposits
• reduction in supply of imported oil
• changing weather patterns that affect
agricultural production
▪ Changes in technology
• productivity improvements from technological
progress

65
 Using AD & AS to Depict LR Growth and
Inflation
LRAS2000
Over the long run, P LRAS1990
tech. progress shifts LRAS1980
LRAS to the right
and growth in the P2000
money supply shifts
P1990
AD to the right.
AD2000
P1980
Result:
ongoing inflation AD1990
and growth in AD1980
Y
output. Y1980 Y1990 Y2000

66
 Short Run Aggregate Supply (SRAS)

The SRAS curve P

is upward sloping:
SRAS
Over the period
of 1-2 years, P2
an increase in P
causes an P1
increase in the
quantity of g & s
supplied. Y
Y1 Y2

67
 Why the Slope of SRAS Matters
P LRAS
If AS is vertical,
fluctuations in AD Phi
SRAS
do not cause
fluctuations in output Phi
or employment.
ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output ADlo
Y
and employment. Ylo Y1 Yhi

68
 Three Theories of SRAS
In each,
• some type of market imperfection
• result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.

69
 1. The Sticky-Wage Theory
▪ Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
▪ Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.

70
 1. The Sticky-Wage Theory
▪ If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
▪ Hence, higher P causes higher Y,
so the SRAS curve slopes upward.

71
 2. The Sticky-Price Theory
▪ Imperfection:
Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting
prices.
• Examples: cost of printing new menus,
the time required to change price tags.
▪ Firms set sticky prices in advance based
on PE.

72
 2. The Sticky-Price Theory
▪ Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
▪ In the short run, firms without menu costs can
raise their prices immediately.
▪ Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
▪ Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

73
 3. The Misperceptions Theory
▪ Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
▪ If P rises above PE, a firm sees its price rise
before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
▪ So, an increase in P can cause an increase in
Y,
making the SRAS curve upward-sloping.

74
 What the 3 Theories Have in Common:
In all 3 theories, Y deviates from YN when
P deviates from PE.

Y = YN + a (P – PE)
Output Expected
price level
Natural rate
of output
a > 0,
measures Actual
(long-run) price level
how much Y
responds to
unexpected
changes in P

75
 What the 3 Theories Have in Common:

Y = YN + a(P – PE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN
 SRAS and LRAS
▪ The imperfections in these theories are
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
▪ In the LR,
• PE = P
• AS curve is vertical

77
 SRAS and LRAS
Y = YN + a(P – PE)
P LRAS

SRAS
In the long run,
PE = P
PE
and
Y = Y N.

Y
YN
78
 Why the SRAS Curve Might Shift
Everything that shifts
LRAS shifts SRAS, too.
P LRAS
Also, PE shifts SRAS: SRAS
If PE rises, SRAS
workers & firms set PE
higher wages.
At each P, PE
production is less
profitable, Y falls,
SRAS shifts left. Y
YN

79
 The Long-Run Equilibrium

In the long-run P LRAS

equilibrium,
SRAS
PE = P,
Y = YN ,
PE
and unemployment
is at its natural rate.
AD
Y
YN

80
Changes in Short-Run Aggregate Supply

81
Short-Run Equilibrium

82
Changes in Short-Run Equilibrium in
the Economy

83
How a Factor Affects the Price Level, Real GDP,
and the Unemployment Rate in the Short Run

84
Supply Shocks

▪ Supply shocks are

external events that shift
the aggregate supply
curve.
▪ Adverse supply shocks can
cause a recession (a fall in
output) with increasing
prices. This phenomenon
is known as stagflation.

85
A Summary Exhibit of AD and SRAS

86
 How to Study the Impact of
Economic Fluctuations
▪ Caused by events that shift the AD and/or
AS curves.
▪ Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.

87
 The Effects of a Shift in AD
Event: stock market crash
1. affects C, AD curve P LRAS
2. C falls, so AD shifts left SRAS1
3. SR eq’m at B.
P and Y lower, P1 A SRAS2
unemp higher
P2 B
4. Over time, PE falls,
AD1
SRAS shifts right, P3 C
until LR eq’m at C. AD2
Y and unemp back Y
Y2 YN
at initial levels.

88
 Two Big AD Shifts:
1. The Great Depression
From 1929-1933, U.S. Real GDP,
billions of 2000 dollars
• money supply fell 900
28% due to problems 850
in banking system 800
• stock prices fell 90%, 750
reducing C and I 700

• Y fell 27%
650
600
• P fell 22% 550
• 1929

1930

1931

1932

1933

1934
u-rate rose
from 3% to 25%
89
 Two Big AD Shifts:
2. The World War II Boom
U.S. Real GDP,
From 1939-1944,
billions of 2000 dollars
• govt outlays rose 2,000

from $9.1 billion 1,800

to $91.3 billion 1,600
• Y rose 90% 1,400

• P rose 20% 1,200

• unemp fell 1,000

from 17% to 1% 800

1939

1940

1941

1942

1943

1944
90
ACTIVE LEARNING 2:
Exercise
▪ Draw the AD-SRAS-LRAS diagram
for the U.S. economy,
starting in a long-run equilibrium.
▪ A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.

91
ACTIVE LEARNING 2:
Answers
Event: boom in Canada
P LRAS
1. affects NX, AD curve SRAS2
2. shifts AD right
3. SR eq’m at point B. P3 C SRAS1
P and Y higher,
P2 B
unemp lower
P1 A AD2
4. Over time, PE rises,
SRAS shifts left, AD1
until LR eq’m at C. Y
Y and unemp back YN Y2
at initial levels.
92
 The Effects of a Shift in SRAS
Event: oil prices rise
1. increases costs, P LRAS
shifts SRAS
(assume LRAS constant) SRAS2
2. SRAS shifts left SRAS1
3. SR eq’m at point B. B
P2
P higher, Y lower,
unemp higher P1 A
From A to B,
stagflation, AD1
a period of Y
falling output Y2 YN
and rising prices.
93
Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall,
SRAS2
SRAS shifts right,
until LR eq’m at A. P3 C SRAS1
B
Or, policymakers could P2
use fiscal or monetary P1 A
policy to increase AD AD2
and accommodate the
AS shift: AD1
Y
Y back to YN, but Y2 YN
P permanently higher.
94
The 1970s Oil Shocks and Their Effects

1973-75 1978-80

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

persons million million

95
 MEAP

Aggregate and Aggregate Supply

Aggregate and Aggregate Supply in Q&A Format
Overheating
Soft Landing vs Hard Landing
Demand Pull vs Cost Push Inflation
Tulip Mania
SAP

Sessions 11 AGGREGATE DEMAND AND AGGREGATE SUPPLY 97

Aggregate and Aggregate Supply
in Q&A Format

98
What is the Aggregate supply curve?
Shows the level of real GDP produced at different price
levels during a time period, ceteris paribus
Why did Keynes assume fixed product prices and wages?
During a deep recession or depression, there are many
idle resources in the economy
Why do idle resources mean fixed prices?
Producers are willing to sell additional output at current
prices because there is plenty of resources to go around
for everyone who wants them
Why do idle resources mean fixed wages?
Unemployed workers willing to work for the prevailing
wage diminishes the power of workers to increase their
wages
What kind of supply curve would explain fixed prices and
wages?
A horizontal supply curve
99
 The Keynesian Horizontal
Aggregate Supply Curve

200 Price Level (CPI)

full employment
150
E1 E2
100 AS
50 AD2
Real GDP AD1
2 4 6 8 10 12
100
 Price level remains
constant, while real GDP
and employment rise

Aggregate demand
increases and the
economy moves from E1
to E2

Government
spending (G)
increases
Session 13 and 14 Biswa Swarup Misra 101
According to Keynes, what will a shift in aggregate
demand do?
It will restore a depressed economy to full employment

What is the Classical view of the aggregate supply

curve?
It is a vertical line at the full employment output

According to the Classical economists, where does the

economy normally operate?
The economy normally operates at its full
employment level
How do the Classical economists view prices and
costs?
The price level of products and production costs change
by the same percentage in order to maintain full
employment
102
 The Classical Aggregate Supply Curve

AS Surplus
200 Price Level (CPI)

150
Full employment
100
AD1
50
AD2
Real GDP
2 4 6 8 10 12 14 16 17
103
 The economy moves to a
level of full employment

Unemployment causes a
decrease in prices

Aggregate demand
decreases at full
employment
Session 13 and 14 Biswa Swarup Misra 104
Three Ranges of the Aggregate Supply Curve
AS

Classical
Price Level

Range
Full
Employment

Keynesian
Range

Real GDP YK YF
105
 Increasing Demand
AS
$200 Full Employment

$150
AD6
$100 AD5

AD4
$50
AD2 AD3
AD1
0 2 4 6 8 10 12
106
A Rightward Shift in the Aggregate Supply Curve
AS1
200 E1 AS2
150
Price Level

E2
full employment
100
AD
50
Real GDP
2 4 6 8 10 12 14 16 17
107
What are the two types of inflation?

Cost push
Demand pull

What is cost push inflation?

A rise in the general price level resulting from an
increase in the cost of production
What is demand pull inflation?

A rise in the general price level resulting from an

excess of total spending

108
 Cost Push Inflation
AS2 AS1
200 Price Level

150 E2
full
employment
100 E1

50 AD
Real GDP
2 4 6 8 10 12 14 16 17
109
 Demand Pull Inflation

200 Price Level AS

full
150 E2 employment

100 E1 AD2
50 AD1
Real GDP
2 4 6 8 10 12 14 16 17
110
What is stagflation?

High unemployment and rapid inflation exist

simultaneously
What determines the business cycle?

Shifts in the aggregate demand and aggregate supply

curves
What happens when both curves increase?
That depends on how much each increases

111
 Rightward Shift in Demand and Supply
AS1
200
AS2
Price Level

150

100 AD2

50 AD1
Real GDP
2 4 6 8 10 12 14 16 17
112
 Increase in price
level

Increase in real GDP

Increase in aggregate
demand and supply
Session 13 and 14 Biswa Swarup Misra 113
 John Maynard Keynes, 1883-1946
• The General Theory of Employment,
Interest, and Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading guide
to current affairs. In the long run,
we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
114
 Tulip Mania
▪ The first recorded nationwide bubble is the "Tulip
mania". A period in Dutch history during which
contract prices for tulip bulbs reached
extraordinarily high levels and then suddenly
collapsed.
▪ At the peak of the tulip mania in February 1637, tulip
contracts sold for more than 10 times the annual
income of a skilled craftsman, which is above the
value of a furnished luxury house in seventeenth-
century Amsterdam.
▪ Figure 1 shows the tulip price index during the 1636-
37 period.
115
Tulip Mania

116
 The Tulip Mania
▪ Mackay (1841, p. 107), people sold their other possessions to speculate in the
tulip market:

▪ ... [T]he population, even to its lowest dregs, embarked in the tulip
trade.... Many individuals grew suddenly rich. A golden bait hung
temptingly out before the people, and, one after the other, they
rushed to the tulip marts, like flies around a honey-pot. Every one
imagined that the passion for tulips would last for ever, and that
the wealthy from every part of the world would send to Holland,
and pay whatever prices were asked for them. The riches of Europe
would be concentrated on the shores of the Zuyder Zee, and
poverty banished from the favoured clime of Holland. Nobles,
citizens, farmers, mechanics, seamen, footmen, maidservants, even
chimney-sweeps and old clothes women, dabbled in tulips.
117
 Bubbles
▪ Economists’ have different views on the definition, and
indeed the existence of bubbles, however Stiglitz
outlines the basic intuition as ‘if the reason that the
price is high today is only because investors believe
that the selling price
▪ will be high tomorrow – when “fundamental” factors
do not seem to justify such a high price – then a
bubble exists’ or more simply ‘prices are high now
because they are expected to be still higher later’.

118
 Ascertaining Worth of Stocks
▪ Traditionally it was relatively easy to value shares as the
majority of companies' assets would be physical, from land to
vehicles, and markets were fairly stable.
▪ Now, more and more assets are intangible (brand names,
human capital and innovation) making them much harder to
value.
▪ For example, Enron, previously seen as a trustworthy
company, lost all market value during the scandal 2001-2002
as it lost the trust of investors and customers.
▪ The dotcom companies of the late 1990’s also stretched the
limits of intangible assets by putting a value on profits that
wouldn’t be realised until many years in the future and brand
names that weren’t established or didn’t even exist.
119
 Tulip Mania
▪ Tulip mania, Netherlands 1636-37, is one of the earliest
examples of extreme asset price fluctuations.
▪ Tulip bulbs became very popular and it was extremely
fashionable to own the rarest varieties.
▪ Price began to soar, peaking at over 5,500 florins (approx.
£25,000 today) in February 1637, before declining just as fast.
▪ Kindleberger and many other economists claim Tulip mania to
be clear evidence of a ‘bubble’ or ‘mania’ where speculators
(with no interest in tulip bulbs) began buying bulbs believing
that the high bulb price would rise even higher, therefore
profiting in the changes in price.

120
 Tulip Mania
▪ People were purchasing tulips at higher and higher prices,
intending to resell them for a profit.
▪ However,such a scheme could not last because tulip prices
were growing faster than income. Sooner or later traders
would no longer be able to find new buyers willing to pay
increasingly inflated prices.
▪ As this realization set in, the demand for tulips collapsed and
prices plummeted. The Dutch economy went into a deep
recession in 1637
▪ Although historians and economists continue to debate
whether the tulip mania was indeed a bubble caused by what
Mackay termed "Extraordinary Popular Delusions and the
Madness of Crowds"
121
 Identifying Bubbles
▪ By studying extreme asset fluctuations in recent years we can
see that there are certain factors which can be associated with
bubbles:
➢ a fall in savings rates,
➢ unusually low inflation,
➢ unusually high growth,
➢ a rise in money supply and
➢ a deteriorating current account.
▪ Bubbles can also occur as a result of technological change (e.g.
internet and the dotcom bubble) or cheap credit (unusually
low interest rates).

122