1. Chapter 12
Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model

2. Introduction Economic Growth is Not a Smooth Process
Real GDP grew at an average rate of 3% over the past 50 years. Growth wasn’t smooth.
Instructor Note: The unemployment rate very often doesn’t start to increase until the economy is well into the recession. Unemployment is a lagging indicator.

3. Introduction Economic Growth is Not a Smooth Process (cont.)
We now turn to deviations from the average: booms and recessions.
Instructor Note: The unemployment rate very often doesn’t start to increase until the economy is well into the recession. Unemployment is a lagging indicator. 3

4. A Skeleton Model The Solow Growth Curve
Solow growth rate: is an economy’s potential growth rate, the rate of economic growth that would occur given flexible prices and existing real factors of production.
Important point: If markets are working well and prices are perfectly flexible, the economy will grow at the potential growth rate.
The next two slides show the Solow growth curve and how it shifts.

5. A Skeleton Model The Solow Growth Curve (cont.) Solow growth curve
Inflation
Rate (p)
Why is the Solow Growth
Curve vertical?
Potential growth does not
depend on the inflation rate.
Instructor Note:
This is an animated slide so you can explain the model as you “draw” and label the axes and curves.
The Solow growth curve is vertical because factors that cause economic growth: e.g. accumulation of labor and physical capital and technological change are unrelated to the rate of inflation.
Solow growth is long-run growth. 3%
Real GDP
growth rate

6. A Skeleton Model The Solow Growth Curve (cont) Solow growth curve
Inflation
Rate (p)
What causes the Solow Growth
Curve to shift?
Positive productivity shocks
Factors that increase the
fundamental ability of the economy to produce goods and services.
Negative productivity shocks
Factors that decrease the
Negative
shock
Positive
shock
Instructor Note:
This is a an animated graph so you can explain as you “draw”.
What is changing is the rate of growth of real GDP not just the level. The assumption is that growth is proceeding at some normal rate. Productivity shocks either increase or decrease this growth rate. It is important for students to understand the difference between supply shocks that shift the Solow growth curve and demand shocks that shift the aggregate demand curve that will be discussed later.
-1% 3% 7%
Real GDP
growth rate

7. A Skeleton Model
To understand booms and recessions, we develop two models:
The Real Business Cycle (RBC) model
The New Keynesian model
Both models will be placed within the dynamic aggregate-demand-aggregate supply framework.
Ultimately the AD-AS framework will have three curves:
Solow growth curve
Dynamic aggregate demand curve
Short-run aggregate supply curve
Instructor Note: The models are built piece by piece so students should be reminded they need to understand each piece as we go or when we get to the end they will not be able to understand either the RBC or the New Keynesian model and how they are applied.

8. A Skeleton Model The Dynamic Aggregate Demand Curve
Definition: A curve showing the combinations of inflation and real growth that are consistent with a specified rate of spending growth.
Deriving the Dynamic Aggregate Demand Curve from the quantity theory in dynamic form:
Where represents total spending growth.
Instructor Note:
The quantity theory of money identity is written growth rate form.
Because the money supply times the number of times it is spent in a year is equal to the total level of spending (also equal to nominal GDP), the sum of the growth rates of M and v equal the growth rate of total spending.
This can be easily derived as follows: Total spending = M x V. Taking the natural logarithm of both sides of the equation gives: ln(total spending) = ln(M) + ln(V). If we take the total derivative of this equation with respect to time we get: d [ln(total spending)]/dt = d[ln(M)]/dt + d[ln(v)]/dt. The result of this operation yields the following:
(d(total spending)/dt)/(total spending) = (dM/dt)/M + (dV/dt)/V
Which translates to % change in total spending = % change in M + % change in V

9. A Skeleton Model The Dynamic Aggregate Demand Curve (cont.)
The rate of spending growth = so that:
Spending growth = Inflation + Real Growth
Important: For a given level of spending growth the AD curve shows the combinations of inflation and real growth that add up to that spending growth.
This is shown in the following table.

10. A Skeleton Model The Dynamic Aggregate Demand Curve (cont.)
Plotting inflation against real growth gives a dynamic AD curve for each level of spending growth.

11. A Skeleton Model The Dynamic Aggregate Demand Curve (cont.)
AD curve when spending growth = 5%
Inflation
Rate (p)
Note: The sum of inflation and real growth will always equal spending growth, which equals money growth
plus the growth of velocity.
i.e., 7% 5%
Instructor Note:
This is an animated graph so you can explain as you “draw”.
The slope of the AD demand curve always equals -1. This can be seen by rearranging the equation and solving for the rate of inflation as a function of the real GDP growth rate:
% change in P (inflation rate) = % change in spending - % change in YR
A one percentage point change in the real growth rate causes the inflation rate to fall by one percentage point. 2%
5% + 0% = 5%
2% + 3% = 5%
AD (spending growth = 5%) 0%
-2% 0% 3% 5% 7%
Real GDP
growth rate

12. A Skeleton Model The Dynamic Aggregate Demand Curve (cont.)
AD curve when spending growth = 7%
Inflation
Rate (p)
Conclusion:
Increases in spending growth, ,
shifts the AD curve to the right.
Decreases in spending growth,
shifts the AD curve to the left. 7% 5%
Instructor Note:
This is an animated graph so you can explain as you “draw”.
An increase in the growth rate of spending shifts AD to the right.
At any point on the original AD curve the sum of the inflation rate and real growth must sum to 5%.
Now at any point on the new demand curve the sum of the inflation rate and real growth have to sum to 7%.
Increases in either the growth rate of the M or the growth rate of velocity will shift AD to the right.
Decreases in either will shift AD to the left.
AD (spending growth = 7%) 2%
AD (spending growth = 5%) 0%
-2% 0% 3% 5% 7%
Real GDP
growth rate

13. If inflation is 2 percent and the Solow growth rate is 5 percent what, if anything, happens to the Solow growth rate when inflation increases to 5 percent?
If we have a dynamic aggregate demand curve with = 7 percent and = 0 percent, what will inflation plus real growth equal? If we find out that real growth is 0 percent, what is inflation?
Increased spending growth shifts the dynamic aggregate demand curve which way: inward or outward?

14. The RBC Model: The Solow Growth Curve
Putting the AD and the Solow growth curve together.
Solow growth
curve
Inflation
Rate (p)
Equilibrium 7%
Instructor Note:
Putting the Solow growth curve and the AD together defines the equilibrium inflation rate and real GDP growth.
A shift in the AD curve will change only the rate of inflation . This leads to the conclusion that changes and spending growth only affect inflation in the long run. This results from the neutrality of money.
A shift in the Solow growth curve will change the rate of inflation and real GDP growth. This is the reason why real shocks are difficult to handle with stabilization policy that affects only spending. AD
Real GDP
growth rate 3%

15. The RBC Model: The Solow Growth Curve
Putting the AD and the Solow growth curve together (cont.)
Solow growth
curve
Conclusions:
A positive shock results in a higher real growth rate, 7%, and lower inflation, 3%.
A negative shock results in a lower real growth rate, -1%, and higher inflation, 11%.
Inflation
Rate (p)
Negative
shock
Positive
shock
11% 7% 3%
Instructor Note:
This is an animated graph so you can explain as you “draw”.
Here we see that reducing the Solow growth rate results in an increase in the inflation rate. This is because the sum of inflation and real growth must equal 10% for this dynamic aggregate demand curve. i.e. 11% + (-1%) = 10%.
For the positive shock, real growth increases to 7% and the inflation rate must fall to 3% so that 7% + 3% = 10%. AD
-1% 3% 7%
Real GDP
growth rate

16. The RBC Model: The Solow Growth Curve
Shocks to Aggregate Demand in the RBC Model
Solow growth
curve
Conclusions:
A positive demand shock, ,
results in higher inflation.
A Negative demand shock,
results in lower inflation.
Inflation
Rate (p) 7% b
Instructor Note:
This is an animated graph so you can explain as you “draw”.
In this case, and increase in spending growth increases from 5% to 10%. Because Solow growth is unchanged, the rate of inflation must rise from 2% to 7% so that 7% + 3% = 10%.
AD2 2% a
AD1 3%
Real GDP
growth rate

17. The RBC Model: The Solow Growth Curve
Final thoughts on the RBC Model
Shifts in AD do not influence real growth.
This is what is meant when we say that money is neutral.
Results from a key assumption of the RBC model: prices are perfectly flexible.
Most economists believe that changes in the growth rate of money will change real growth in the short run.
What if prices are not perfectly flexible?
This requires a new model, the New Keynesian model.

18. In what direction would a technological innovation such as the internet or cheap fusion power shift the Solow growth curve?
In the real business cycle model, what effect does a large fall in aggregate demand have on real growth?

19. The New Keynesian Model
John Maynard Keynes ( )
The General Theory of Employment, Interest, and Money, 1936.
Wrote in the context of the Great Depression.
Explained that when prices are not perfectly flexible (sticky) deficiencies in aggregate demand could cause recessions.
New Keynesian model is based on Keynes’s original work.
Key to the model: when prices are sticky, the economy can grow faster or slower than the Solow growth rate.

20. The New Keynesian Model
The Short-Run Aggregate Supply Curve
If wages are not as flexible as prices…
Inflation will result in higher profits.
Result: higher profits lead to increased output, or, real GDP growth.
Two reasons why there can be a positive relationship between the inflation rate and the growth rate of real GDP in the short run:
Sticky wages
Sticky prices
Let’s look at both of these in turn.

21. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
Sticky Wages
Expected inflation is built into labor contracts.
What happens if inflation is higher or lower than expected?
Result: An upward sloping SRAS curve.
Prices
increase
faster
than wages
Firms increase
Output and real
GDP growth
increases
Inflation higher
that expected
Profits
increase
Prices
increase
slower
than wages
Firms decrease
Output and real
GDP growth
increases
Inflation lower
that expected
Profits
decrease

22. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
Solow growth
curve
Conclusions:
Sticky wages result in an upward sloping SRAS.
There is a different SRAS
for every level of expected inflation, pe.
Inflation
Rate (p)
Short-Run aggregate
supply (SRAS)(pe = 2%)
Instructor Note:
This is an animated graph so you can explain as you “draw”.
Why do sticky wages result in an upward sloping SRAS? Let’s use a logic chain to explain:
↑ Spending growth → AD shifts right → ↑ Inflation rate, the actual inflation rate is now greater than the expected inflation rate. Because wages are based on expected inflation and wages are sticky, output prices rise faster than wages → ↑ Firms’ profits → ↑ Firms’ output →
↑ real GDP growth rate.
If wages rose as quickly as prices, firms would have no incentive to increase output and only the rate of inflation would rise. 2% AD
Real GDP
growth rate 3%

23. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
Shifting the SRAS Curve
An increase in the expected inflation rate will shift the SRAS up and to the left.
A decrease in the expected inflation rate will shift the SRAS down and to the right.
It is easier to see this if we use the model.
This is an animated graph so you can explain as you “draw”.

24. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
Inflation
Rate (p)
Solow growth
curve
(SRAS2)
(pe = 4%)
If p = 2% and pe = 2%,
economy stays at pt. a.
If p = 4% and pe = 2%,
economy moves to b.
and real growth ↑ to 7%
If p = 4% and pe = 4%,
SRAS shifts up.
economy stays at pt. c
If p = 6% and pe = 4%,
economy moves to d. d
(SRAS1)
(pe = 2%) 6% 4% b c
Instructor Note:
This is an animated graph so you can explain as you “draw”.
The effect of a rise in the inflation rate depends on whether it is expected or unexpected.
Suppose the inflation rate increases from 2% to 4%.
If it is unexpected, wages will be based on the lower 2% inflation rate, and output prices will rise faster than wages because wages are sticky. The economy will move from a to b.
If it is expected, wages will be based on the expected wages and output will not change. The economy will move from a to c.
The new SRAS reflects how the economy will respond to unexpected inflation at a higher expected inflation rate.
Now if the inflation rate rises to 6% and it is unexpected, the economy will move from c to d.
Final comment: There is a different SRAS for each expected rate of inflation. 2% a
Real GDP
growth rate 3% 7%

25. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
The SRAS is flatter to the left of the Solow growth curve.
Because prices and wages are especially sticky in the downward direction.
This is due to the endowment effect.
People attach special importance to their starting point.
Have a strong dislike for losing that position.

26. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
The SRAS is steeper to the right of the Solow growth curve.
Reasons:
Wages are less sticky in the upward direction.
The SRAS must turn vertical at some point because there is a limit to how fast the economy can grow.

27. The New Keynesian Model
The Short-Run Aggregate Supply Curve (cont.)
What causes sticky prices?
Menu costs: the costs of changing prices.
Printing costs
Loss of consumer trust
If prices are always changing, how do buyers know when they are getting a good deal?
Waste due to uncertainty about whether:
a shock is permanent or temporary.
increases in demand are nominal, caused by inflation, or real.
Again, sticky prices → upward sloping SRAS

28. Contrast wage and price flexibility in the real business cycle and new Keynesian models. Which model assumes significant price and wage stickiness?
The Solow growth curve is vertical, the short-run aggregate supply curve is not. What explains the difference?
What happens to the short-run aggregate supply curve when people expect inflation to increase from 2 percent to 3 percent?

29. Shocks to AD in the New Keynesian Model
In the Real Business Cycle model, changes in AD have no effect on real growth.
Because prices are assumed to be perfectly flexible.
We will now use the New Keynesian model with sticky prices to examine how shocks to aggregate demand can change real growth.

30. Shocks to AD in the New Keynesian Model
An Unexpected Increase In
Inflation
Rate (p)
Solow growth
curve
(SRAS2)
(pe = 7%)
Short-run: a → b
Real growth ↑ to 6%
p↑ to 4%
Long-run: b → c
Real growth ↓ to 3%
p↑ to 7%
(SRAS1)
(pe = 2%) 7% c 4% b
AD2
Instructor Note:
This is an animated graph so you can explain as you “draw”.
a → b: ↑ spending growth (AD shifts to the right) . In the short-run before wages have time to adjust to the new inflation rate profits increase and firms’ output growth increases → 6%. The inflation rate increases to 4% so that the inflation rate, 4%, plus the real GDP growth rate, 6% is equal to the new rate of growth of spending, 10%.
In the long run, wages growth catches up to the inflation rate and the expected rate of inflation rises to 7% and the SRAS shifts up.
Long –run equilibrium will now be at point c where: The inflation rate is 7%, real growth rate is 3% and the expected rate of inflation is 7%.
Note: in the long run money is neutral. i.e. has no effect of real growth. 2% a
AD1
Real GDP
growth rate 3% 6%

31. Shocks to AD in the New Keynesian Model
Changes in the rate of growth of velocity,
It is easier to think of changes in working through
Example: A reduction in working through a reduction in
Workers may become fearful of losing their jobs and reduce consumption.
We will use the New Keynesian model to work through this.

32. Shocks to AD in the New Keynesian Model
A reduction in working through a reduction in
Inflation
Rate (p)
Solow growth
curve
Short-run: a → b
Real growth ↓ to -1%
p↓ to 6%
Long-run: b → a
Real growth ↑ to 3%
p↑ to 7%
(SRAS1)
(pe = 7%) 7% a
Instructor Note:
This is an animated graph so you can explain as you “draw”.
At the beginning equilibrium note that the sum of inflation, 7%, and real GDP growth, 3% is equal to the rate of spending growth, 10%.
On September 11, 2001 the World Trade Center was destroyed by terrorists. Fear decreased consumer spending especially affecting the hospitality industry. We can show the effects of this with our New Keynesian Model:
The dynamic aggregate demand curve shifts to the left → ↓ inflation, ↓ real growth. The economy moves from a to b.
In the long-run consumption spending returns to its normal rate of growth and AD shifts back. The economy goes from b to a.
Note: In the long-run the real GDP growth rate never changes unless the Solow growth curve shifts.
It is useful to often remind our students that at every equilbrium short-run or long-run the sum of the inflation rate and the real growth rate always equals the rate of growth of spending (% change in M + % change in V) 6% b
AD1
AD2
Real GDP
growth rate
-1% 0% 3%

33. Shocks to AD in the New Keynesian Model
A reduction in working through a ↓ (cont.)
What did we learn from this example?
A negative spending shock reduces the real growth rate and inflation in the short run only.
Why?: Changes in spending growth
are temporary.
Shares of GDP devoted to C, I, G, and NX have been stable over time.
This implies that their growth rates must also be stable.
Changes in the growth rates of spending do not change the long-run rate of inflation.
Instructor Note: Students may have to be reminded that changes in velocity work through the components of aggregate demand: C, I, G, and NX.

34. Shocks to AD in the New Keynesian Model
A reduction in working through a ↓ (cont.)
A final important point.
We know now that changes in spending growth, , shift the AD curve.
A fundamental difference between and is that
can be set at any permanent rate.
Changes in are temporary.
Conclusion: Sustained inflation requires continuing increases in the money supply.
Instructor Note: Students may have to be reminded that changes in velocity work through the components of aggregate demand: C, I, G, and NX.

35. Shocks to AD in the New Keynesian Model
Other Factors that Shift the AD Curve
Fear and confidence also affect growth of investment spending, , as well as .
Fear about the future will cause business people to put off large investments in capital.
Confidence about the future will result in greater investment spending by businesses.
Wealth shocks can also increase or decrease AD.
Negative wealth shock→ ,
Positive wealth shock → ,
Instructor Note:
In September 2008 the stock market crashed wiping out trillions of dollars of household and business wealth. Falling wealth causes household spending to fall and the rate of growth of consumption falls.
The dynamic aggregate demand curve shifts to the left → ↓ inflation, ↓ real growth. The economy moves from a to b.
In the long-run consumption spending returns to its normal rate of growth and AD shifts back. The economy goes from b to a.

36. Shocks to AD in the New Keynesian Model
Other Factors that Shift the AD Curve (cont.)
Tax changes shift and
↑ (↓) in taxes can ↓ (↑) .
Taxes targeted at investment
↑ Capital gains) → ↓
Investment tax credit → ↑
Changes in government spending,
↑ (↓) → shift the AD to the right (left).
Changes in the growth of net exports,
↑↓Growth of exports → ↑↓AD
↑↓Growth of imports → ↓↑AD
The next table gives a useful summary…

37. Shocks to AD in the New Keynesian Model
Other Factors that Shift the AD Curve (cont.)

38. What always happens to unexpected inflation in the long run?
Show what happens to the dynamic aggregate demand curve if consumers fear a recession is coming and cut back on their expenditures

39. Understanding the Great Depression
Most catastrophic economic event in the history of the United States.
GDP plummeted by 30 percent.
Unemployment rates exceeded 20 percent.
Stock market fell by more than two thirds.
It was a worldwide event.
Germany: Led to a totalitarian regime (National Socialism, or, Nazis).
The Great Depression became “Great” because policy makers allowed aggregate demand to collapse.

40. Understanding the Great Depression
Shocks to AD and the Great Depression
October 1929: the stock market crashed.
Caused in part by tight monetary policy aimed at limiting a stock market bubble.
Created a wealth shock.
This along with the tight monetary policy → shifted AD curve to the left.
1930: Depositors lost confidence in their banks and they withdrew their deposits.
: Four waves of bank panics.
By 1933, 40% of all American banks failed.
Instructor Note: In an interesting juxtaposition of events, Ben Bernanke who spent much of his academic career studying the Great Depression was chairman of the Federal Reserve when the stock market crashed in September Because of his understanding that the great depression became “Great” because the Fed allowed the money supply (not the growth rate of the money supply, but the absolute level) to fall by almost a third and aggregate demand with it, Bernanke was not about to repeat history again. This explains his and the Fed support of injecting huge amounts of money into the economy.

41. Understanding the Great Depression
Shocks to AD and the Great Depression (cont.)
Between 1929 and 1933 investment spending fell by nearly 75 percent.
Spending on new capital was not enough to replace depreciated capital.
By 1940 the U.S. capital stock was lower than it was in 1930.
The Fed allowed the money supply to fall by 1/3.
This is the largest negative shock in U.S. history.

42. Understanding the Great Depression
Shocks to AD and the Great Depression (cont.)
What should the Fed have done?
Increase the money supply
To drive up AD and output.
Increase reserves of banks to stop panics.
: The Fed caused another monetary contraction.
Contracted the economy and unemployment increased.
Prolonged the “Great Depression”.
Let’s use the model again…
Instructor Note: The “Great Depression” actually consisted of two recessions. The deepest bottomed out in The second recession bottomed out in In 1933 the unemployment rate reach 25%. While it came down it never got below about 13%. The unemployment rate increased again and reached about 18% in 1937.

43. Understanding the Great Depression
The Great Depression and the Great Fall in AD
Solow growth
curve
Inflation
Rate (p)
SRAS
Narrative: 1. 2. 3. 0%
Instructor Note:
This is an animated graph so you can explain as you “draw”.
The model shows that the Great Depression resulted from a series of demand shocks. AD
-10% AD
Real GDP
growth rate
-13% 4%

44. Understanding the Great Depression
Real Shocks and the Great Depression
Real shocks played a role in the failure of the economy to recover more quickly.
We will look at three:
Bank failures reduced the efficiency of financial intermediation.
The bridge between savers and investors collapsed.
Small businesses were especially harmed because they couldn’t get credit.

45. Understanding the Great Depression
Real Shocks and the Great Depression (cont.)
Smoot-Hawley Tarrif of 1930
Intent was to boost demand for domestic goods.
What really happened:
Other countries retaliated with tarrifs and exports fell. This reduced AD.
A tariff is a negative productivity shock (shifts LRAS to the left).
Pushes capital and labor into lower productivity sectors.

46. Understanding the Great Depression
Real Shocks and the Great Depression (cont.)
The Dust Bowl: natural disasters are negative real shocks
Severe drought turned millions of acres of farmland to dust.
The Dust Bowl was a real shock

47. What happened to the U. S. money supply in the early 1930s
What happened to the U.S. money supply in the early 1930s? Did this primarily or initially affect aggregate demand or the Solow growth curve, and in which direction?
If, as was said earlier in this chapter, real shocks hit the economy all of the time, should we ignore them in explaining the Great Depression?

48. Takeaway
We have used the framework of dynamic aggregate demand and short-run aggregate supply to analyze business fluctuations.
Business fluctuations refers to the fact that the growth rate of real GDP is volatile in the short run.
The aggregate demand curve slopes downward and the short-run aggregate supply curve slopes upward.

49. Takeaway
Changes in AD can be broken up into changes in and changes in .
Changes in can be broken down into changes in
You should know what makes wages and prices sticky
menu costs
uncertainty
confusion between nominal and real values

50. Takeaway You should know and understand how…
menu costs
uncertainty
confusion between nominal and real values
Make wages and prices sticky.
We applied the models to the Great Depression.
The Great Depression resulted from concentrated and interrelated series of aggregate demand and real shocks.

51. Takeaway
The material in this chapter is the central core of macroeconomics.
If you understand where the curves come from and how to shift them…
You will have a basic toolbox for analyzing many economic questions.
You are now ready to tackle many of the core topics of macroeconomics and business cycles.