Goal: To develop a model of economic fluctuations Two key ideas: economic fluctuations are –(1) departures of real GDP from potential GDP –(2) caused by changes in demand Last time  First steps: showed how real GDP moves away from potential GDP This time  Forces of adjustment: changes in interest rates and prices (inflation) bring real GDP back to potential GDP

What happens to inflation during a typical economic fluctuation?

Summarize the inflation and real GDP observations in one diagram

Model will be developed in graphical form Use a diagram with the same axes (sketch it by hand) –inflation rate on the vertical axis –real GDP on the horizontal axis But put curves in the diagram to explain the observations

The graphical representation of this macro model is analogous to a micro model Economic fluctuations model –aggregate demand/inflation curve –Price adjustment line –equilibrium at the intersection of the two curves –diagram with inflation and real GDP Supply and demand model –demand curve –supply curve –equilibrium at the intersection of the two curves –diagram with price and quantity of peanuts

Let’s derive the aggregate demand inflation curve in three stages.

Stage one: real GDP is negatively related to the interest rate. WHY? –consumption (C) negatively related to interest rate –investment (I) negatively related to interest rate –net export (X) negatively related to interest rate Nothing new here

You can show the negative effect of the interest rate on real GDP with the 45-degree line diagram

Stage two: the interest rate is positively related to inflation The Fed tends to –raise the interest rate when inflation rises and –lower the interest rate when inflation falls It does this by open market operations this is a behavioral description of the the people at the Fed, much like a demand curve is a behavioral description of consumers Call this response a monetary policy rule

Monetary policy rule in a graph

Stage three: putting the first two stages together Suppose that inflation increases –the Fed will raise the interest rate –the higher interest rate will decrease real GDP Suppose that inflation decreases –the Fed will lower the interest rate –the lower interest rate will increase real GDP In sum, there is a negative relationship, which is simply the ADI curve

More details of the three stages

A little bit of that fancy animated graphics would be real nice now

Shifts versus movements along the ADI curve Movements along the ADI curve: –when changes in the inflation rate cause real GDP to change Shifts of the ADI curve: –when changes in anything else cause real GDP to change change in government purchases change in net exports (Asian financial crisis) change in monetary policy rule

Example: a shift in ADI curve due to increase in G

A change in the monetary policy rule also causes a shift in the ADI curve

Inflation and the price adjustment line Prices and wages adjust slowly in many markets –Thus inflation does not usually change immediately (PA line is flat) But inflation does change over time –real GDP above potential GDP inflation rises (PA line rises) –real GDP below potential GDP inflation falls (PA line falls)

The price adjustment line

Historical evidence consistent with the price adjustment line

Intersection of ADI and PA gives a prediction of real GDP and inflation

How about a little more of that fancy animated graphics?

Next Time Using the forces of adjustment we see how the economy recovers and maybe find out who that narrator is

END OF LECTURE