National Income & Business Cycles 0 Ohio Wesleyan University Goran Skosples 10. Oil Shocks of the 1970s and the Great Depression

1 Objectives Two case studies: 1. Oil shocks of the 1970s 2. The Great Depression

2 Supply shocks  A supply shock alters production costs, affects the prices that firms charge. (also called ____ shocks)  Examples of adverse supply shocks: Bad weather reduces crop yields, pushing ____ __________. Workers unionize, negotiate ______________. New environmental regulations require firms to reduce emissions. Firms ________________ to help cover the costs of compliance.  Favorable supply shocks _______ costs and prices.

3 CASE STUDY: The 1970s oil shocks  Early 1970s: OPEC coordinates a reduction in the supply of oil.  Oil prices rose 11% in % in % in 1975  Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

4 SRAS 1 Y P AD LRAS CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS ____, causing output and employment to ___. A In absence of further price shocks, prices will ___ over time and economy moves ______________ ______________. A

5 CASE STUDY: The 1970s oil shocks Predicted effects of the oil shock: inflation __ output __ unemployment _ …and then a gradual recovery.

6 CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

7 CASE STUDY: The 1980s oil shocks 1980s: A favorable supply shock-- a significant fall in oil prices. As the model predicts, inflation and unemployment ______:

8 CASE STUDY: The 1970s oil shocks What is the prediction about interest rates?

9 Exercise An oil cartel effectively increases the price of oil by 100 percent, leading to an adverse supply shock in both Country A and Country B. Both countries were in long-run equilibrium at the same level of output and prices at the time of the shock. The central bank of Country A takes no stabilizing- policy actions. After the short-run impacts of the adverse supply shock become apparent, the central bank of Country B increases the money supply to return the economy to full employment. a. Describe the short-run impact of the adverse supply shock on prices and output in each country. b. Compare the long-run impact of the adverse supply shock on prices and output in each country.

10 Exercise A B Y r Y P IS 1 LM 0 (M 0 /P 0 ) AD 0 Y0Y0 r0r0 LRAS Y0Y0 Y r Y P IS 1 LM 0 (M 0 /P 0 ) AD 0 Y0Y0 r0r0 LRAS Y0Y0 SRAS 0 PoPo PoPo

11 The Great Depression

12 Shocks to the IS curve  an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.  Stock market crash  exogenous  C Oct-Dec 1929: S&P 500 fell 17% Oct 1929-Dec 1933: S&P 500 fell 71%  Drop in investment “correction” after overbuilding in the 1920s widespread bank failures made it harder to obtain financing for investment  Contractionary fiscal policy Politicians raised tax rates and cut spending to combat increasing deficits.

13 A shock to the LM curve  a huge fall in the money supply.  evidence: M1 fell 25% during The relation between the money stock, M1, and the monetary base (physical money) is given by: - M1 = monetary base x money multiplier Money, Nominal and Real, 1929 to 1933 Year Nominal Money Stock, M1 Monetary Base Money Multiplier Real Money Stock, M1/P

14 A shock to the LM curve  but, P also fell 25% during  the effect on the LM curve should be neutral  What was the problem then? recall: r = i -  e The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929 to 1933 Year One-Year Nominal Interest Rate (%), i Inflation Rate (%),  One-Year Real Interest Rate (%), r     

15 How  e shifts the LM curve M/P r L (i-  1 e, Y 1 ) r1r1 r2r2 r Y Y1Y1 r1r1 r2r2 LM 1 (a) The market for real money balances (b) The LM curve LM 2 M 1 /P 1 L (i-  2 e, Y 1 ) e e  _ L  _ r (for the same i)  __ LM

16 The effects of falling prices Y r Y P IS 0 SRAS 0 P0P0 AD 0 LM 0 (M 0 /P 0 ) Y0Y0 r0r0  IS  AD shifts __  Y 1 Y 0  P  LM should shift __  but, M   LM const  AD shifts ___ At the same time  P   e    e  LM shifts ___  AD shifts ___ Result:  __ P, __ Y, __ r LRAS Y0Y0 r = i -  e

17 The Recovery  Monetary policy played an important role , the nominal money stock increased by 140% and the real money stock by 100%.  Other factors that played an important role were: The New Deal — a set of programs implemented by the Roosevelt administration. The creation of the Federal Deposit Insurance Corporation (FDIC). Other programs administered by the National Recovery Administration (NRA).

18 Why another Depression is unlikely  Policymakers (or their advisors) now know much more about macroeconomics: The Fed knows better than to let __ fall so much, especially during a contraction. Fiscal policymakers know better than to raise ______ or cut __________ during a contraction.  Federal deposit insurance makes widespread bank failures very unlikely.  Automatic ___________ make fiscal policy expansionary during an economic downturn.