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Modern Principles: Macroeconomics See the Invisible Hand: Understand Your World Tyler Cowen and Alex Tabarrok

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The Short-Run Aggregate Supply Curve Real GDP growth rate Inflation Rate () Solow growth curve 3% 2% AD Short Run aggregate supply (SRAS)( e = 2%) Conclusions: 1.Sticky wages result in an upward sloping SRAS. 2.There is a different SRAS for every level of expected inflation, e.

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Shocks to AD in the New Keynesian Model A reduction in working through a reduction in Inflation Rate () Solow growth curve -1% 6% (SRAS 1 ) ( e = 7%) 7% 3% a b Real GDP growth rate AD 1 AD 2 Short-run: a → b 1.Real growth ↓ to -1% ↓ to 6% Long-run: b → a 1.Real growth ↑ to 3% ↑ to 7% 0%

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Understanding the Great Recession The Great Recession and the Great Fall in AD Real GDP growth rate Inflation Rate () Solow growth curve -13% 0% AD SRAS -10% 4% Narrative: 1. 2. 3.3. AD

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Monetary Policy: The Best Case Inflation Rate ( ) Real GDP growth rate Solow Growth curve SRAS ( e = 7%) c b a 6% 7% -1%3% (1)Private decrease d (2) The Fed: “undershoots” “overshoots” Gets it “just right”

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The Negative Real Shock Dilemma Inflation Rate ( ) Real GDP growth rate New SRAS c b a 8% 16% -3%3% New Solow Growth curve Old Solow Growth curve Case I: (1)Real shock: Solow growth curve shifts left, ↑, SRAS shifts left. a → b (2)Fed responds by ↑ → ↑ AD b → c Result: Lower growth, higher inflation. Old SRAS

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The Negative Real Shock Dilemma Inflation Rate ( ) Real GDP growth rate c d a 6% 9% -1%3% New Solow Growth curve Old Solow Growth curve (1) Real shock New SRAS with sticky wages 7% (2) SRAS shock (3) AD shock -6%-4% 2% 0% b New SRAS with/flexible wages Case II: (1)Real shock: a → b (2)Real shock amplified by sticky wages. b → c (3) Fear/uncertainty create AD shock. c → d Result: Lower growth, higher inflation.

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Case II: Starting at pt. d: Fed → ↓ AD d → e Result: growth of real GDP falls from -6% to -7% The Negative Real Shock Dilemma Inflation Rate ( ) Real GDP growth rate c d a 6% 9% -1%3% New Solow Growth curve Old Solow Growth curve (1) Real shock New SRAS with sticky wages New SRAS with flexible wages 7% (2) SRAS shock (3) AD shock -7%-4% 2% 0% b (4) Fed Decrease in e -6%

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Modern Principles: Macroeconomics See the Invisible Hand: Understand Your World Tyler Cowen and Alex Tabarrok

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