11/4/2018

1

12 THE BUSINESS CYCLE,

GOVERNMENT POLICY

INFLATION, AND DEFLATION

(Part 1)

Case Study: Great Recession 2007 - 2009

Explain how demand-pull (AD) and cost-push (AS) forces

bring cycles in inflation and output

Describe the causes and consequences of deflation –

falling prices.

Describe the short-run and long-run trade-off between

inflation and unemployment – the Phillips Curve.

Goals:

The Business Cycle

SKIP (pp.296-300)

Mainstream Business Cycle Theory

Because potential GDP grows at a steady pace while

aggregate demand grows at a fluctuating rate, real GDP

fluctuates around potential GDP.

11/4/2018

2

Y

P

AD0 AD1

Positive AD Shocks: C↑, I↑, G, T, W(wealth) ↑

Intuition: C↑, I↑, W ↑ => AE↑ => Y↑

Y

P

AD1 AD0

Shift of AD to the Left

Negative AD Shocks: C↓, I↓,G, T, W↓

Intuition: C↓, I↓, W ↓ => AE↓ => Y↓

Y

P

AD0 AD1

Example: Short-run Effect on Equilibrium Income -

Increase in Investment (I)

AS

Y0

P0

Y1

P1

A

B

11/4/2018

3

Y

P

AD1

AD0

Example: Short-run Effect on Equilibrium

Income - Decrease in Investment (I)

AS

Y1

P1

Y0

P0 A

B

Case Study Application

Housing & Financial Market Crisis 2007

W = Assets – Liabilities

W = Financial Assets (Money, Stocks, etc)

+ Durable Goods Assets (Value of House, etc.)

- Liabilities (Mortgage, etc.)

House Prices fell dramatically in 2007 - 2009

11/4/2018

4

Stock Market Prices Fell Dramatically in 2008

Dow Jones Industrial Average

Y

P

AD1

AD0

AS

Y1

P1

Y0

P0

Effects of Decline in Nominal Wealth

W↓ => C↓ => AD↓ = Y ↓

W↓ 2007- 2008

A

B

The Story Doesn't Stop at Point B

Credit Market Effects

• Tighter credit markets

– Higher Interest Rates and stiffer Terms for Borrowing

• Caused declines in – Purchases of New Houses

– Purchases of New Plant & Equipment

– Consumer Durables Spending (e.g., Autos)

• AD-AS Model Effects – Decline in Investment Spending

– Further Decline in Consumption Spending

– AD shifts further to the left

11/4/2018

5

Y

P

AD1

AD0

AS

Y1

P2

Y0

P0

Effects of Decline in Nominal Wealth and Tighter

Credit Market

AD2

P1

Y2

W↓ 2007 -2008

Tight

Credit

2008

B

C

A

Real GDP Growth Inflation

Y

P

AD0

AS

Y2 Y0

P0

The Worry: If No Stimulus – AD Would Continue to

Decline to AD3 and Recession Would be Far Worse

AD2

P2

AD3

Due to W and

Tight Credit

AD if no

Stimulus

P3

Y3

A

C

D

11/4/2018

6

Fiscal Policy

Obama Stimulus Package

• American Recovery and Reinvestment Act of 2009

(ARRA)

• Passed by Congress February 13, 2009 and signed

into law by President Obama February 17, 2009

• Size of the Stimulus = $787billion (5.5% of GDP)

• Largest Fiscal Stimulus in US History

Stimulus Package

(Billions of Dollars)

• Government Spending Increases $260 (1/3)

• Tax Cuts $260 (1/3)

• Transfer Payment Increases $260 (1/3)

• Total $787

Y

P

AD0

AS

Y2 Y0

P0

Goal of the ARRA Stimulus –

Shift AD2 to the Right

AD2

P2

AD3

C

A

AD3

D

E

$787B

11/4/2018

7

Real GDP Growth

Y

P

AD0 AD1

Expansionary Fiscal and Monetary Policy

Effect on Equilibrium Income: G↑, Ms↑, T↓, t↓

AS

Y0

P0

Y1

P1

Y

P

AD1

AD0

AS

Y1

P1

Y0

P0

Contractionary Fiscal and Monetary Policy

Effect on Equilibrium Income - G↓, Ms↓, T↑, t↑

11/4/2018

8

Policy Controversies

• Activism

• “Fine-Tuning”

• Spending v. Tax Policies

• Supply-Side Economics

Y

P

AD0 AD1

Activism: Recession – Use Expansionary Policy

AS

Y0

P0

Y1

P1

Y

P

AD1 AD0

Activism: High Prices – Use Contractionary Policy

AS

Y0

P0

Y1

P1

11/4/2018

9

Fine Tuning- Problem

• Suppose target is to increase Y by $400 billion

ΔY = $400

• Government Spending Multiplier = 2

• Government decides to increase spending by

$200 billion – problem is there are lags in conduct of fiscal

policy

–suppose investment spending increases as G

increases

Y

P

AD0

AD1

Overshoot Real Income Target

AS

Y0

P0

Ytarget

Ptarget

AD2

G↑,or

T↓

I↑

ΔY= 400

Causes of Inflation

In the long run, inflation occurs if the quantity of

money grows faster than potential GDP

– quantity theory of money.

In the short run, many factors can start an

inflation. We distinguish between two sources of

inflation:

Demand-pull inflation

Cost-push inflation

11/4/2018

10

Demand-Pull Inflation

• An inflation that starts because aggregate demand

increases is called demand-pull inflation.

• Demand-pull inflation can begin with any factor that

increases aggregate demand such as:

• monetary policy that cuts interest rates by increasing the

quantity of money,

• an increase in government expenditure or a tax cut,

• an increase in exports, or

• an increase in investment stimulated by an increase in

expected future profits.

Initial Effect of an

Increase in Aggregate

Demand starting from Full

Employment

An increase in aggregate

demand (for any reason)

shifts the AD curve

rightward.

Demand Pull Inflation

The price level rises,

real GDP increases -

have an inflationary

gap.

The rising price level

is the first step in the

demand-pull inflation.

This is short-run!

Demand Pull Inflation

11/4/2018

11

Money Wage Rate

Response (long-run)

The money wage rate rises

(“self-correcting”) and the

SAS curve shifts leftward.

The price level rises and real

GDP decreases back to

potential GDP.

With no further increase in

AD, the process ends with the

price level increasing from

110 to 121.

One shot deal! A one - time

increase in the price level.

This is not inflation.

Demand Pull Inflation

For demand pull

inflation, aggregate

demand must keep

increasing and the

process just described

keeps repeating.

Inflation is a sustained

increase in the price

level and requires a

sustained increase in

aggregate demand.

Demand Pull Inflation

Although any of several

factors can increase

aggregate demand to

start a demand-pull

inflation, only an

ongoing increase in the

quantity of money can

sustain it.

Demand-pull inflation

occurred in the United

States during the late

1960s.

Demand Pull Inflation

11/4/2018

12

Demand Pull Inflation – 1960s

1960s: positive demand shocks

• C and I were increasing and G was increasing because of

Vietnam and Johnson’s War on Poverty.

• Unemployment very low, close to 3%

• As G increased, holding T fixed, the deficit increased and

the government sells bonds, interest rates increase.

• Also, as the demand for money increases, interest rates

increase.

Fed policy was to maintain low interest rates

• Increased the money supply

• What effect does this have on AD?

37

Cost-Push Inflation

An inflation that starts with an increase in

costs of production is called cost-push

inflation.

There are two main sources of increased

costs:

1. An increase in the money wage rate

2. An increase in the price of raw materials,

such as oil

Referred to a negative supply shocks.

Initial Effect of a

Decrease in Aggregate

Supply starting from Full

Employment

An increase in the price of

oil decreases short-run

aggregate supply and shifts

the SAS curve leftward.

Real GDP decreases and

the price level rises –

recession with inflation -

called stagflation.

Cost-Push Inflation

11/4/2018

13

Cost-Push Inflation

• The initial increase in costs creates a

one-time rise in the price level, not

inflation.

• To create inflation, aggregate demand must

increase.

• That is, the Fed must increase the quantity

of money persistently.

Suppose that the Fed

stimulates aggregate

demand to counter the

higher unemployment

rate and lower level of

real GDP.

Real GDP increases

and the price level

rises again.

Cost-Push Inflation

A Cost-Push Inflation

Process

If negative supply shocks

continue….

and the Fed responds by

increasing the quantity of

money, ...

a process of cost-push

inflation continues.

Cost-Push Inflation

11/4/2018

14

Cost-push inflation

occurred in the United

States during the 1970s

when the Fed responded

to the OPEC oil price rise

by increasing the quantity

of money.

Cost-Push Inflation

Decrease in Aggregate

Supply starting from Full

Employment

An increase in the price of

oil decreases short-run

aggregate supply and shifts

the SAS curve leftward.

Real GDP decreases and

the price level rises –

recession with inflation -

called stagflation.

Question – Negative Supply Shock

Supposed the Fed did nothing

Suppose aggregate

demand increases, but

the increase is expected

(anticipated), so its effect

on the price level is

expected.

Wages will adjust upward

at the same time

reflecting the expected

inflation.

Expected Inflation -

11/4/2018

15

The AD curve shifts

rightward and the

SAS curve shifts

leftward at the same

time…

so that the price level

rises as expected

and real GDP

remains at potential

GDP.

Expected Inflation and money wage rate

rises in line with the expected price level

Expected Inflation

Forecasting Inflation

Great quote: “we expect inflation because we have it,

we have inflation because we expect it.”

To expect inflation, people must forecast it.

The best forecast available is one that is based on

all the relevant information and is called a

rational expectation.

A rational expectation is not necessarily correct,

but it is the best available.

Deflation

An economy experiences deflation when it

has a persistently falling price level.

A one-time fall in the price level either because

the AD shifts to the left or SAS shifts to the right is

NOT deflation.

Examples of “one-timers”:

a fall in exports,

or a fall in profit expectations,

increase in the capital stock that increases potential

GDP,

an agricultural boom.

11/4/2018

16

Deflation and The Quantity Theory of Money

What Causes Deflation?

• Primarily a monetary phenomenon.

• Expressing the equation of exchange in

growth rates:

Rearranging:

∆𝑴

𝑴 +

∆𝑽

𝑽=

∆𝑷

𝑷 +

∆𝒀

𝒀

∆𝑷

𝑷 =

∆𝑴

𝑴 +

∆𝑽

𝑽 -

∆𝒀

𝒀

Deflation occurs if money growth rate is low relative

to velocity and growth in economic activity.

∆𝑷

𝑷 =

∆𝑴

𝑴 +(0.5 – 3)

Deflation What are the Consequences of Deflation?

Unanticipated deflation lowers real GDP and employment, and

diverts resources from production.

• deflation is generally not expected (“unanticipated”).

• Loan and wage contracts entered into with the expectation

some inflation.

• With unexpected deflation, workers with long-term contracts

see real wages increase, but firms see profits fall. They cut

back on employment.

• firm re-evaluate investment plans and cut back on projects that

are now viewed as unprofitable…

• as investment falls, growth in capital stock is reduced and the

growth rate in potential GDP is reduced.

Deflation in Japan 1998 - 2013

• Real GDP growth rate was 0.8 percent a year, the

money growth rate was 2.5 percent a year, and the rate

of velocity change was -3 percent a year.

• Inflation rate = 2.5 + (-3 - 0.8) percent a year.

• Deflation rate = 1.3 percent a year.

• RGDP growth fell to 0.5% in the 2000s, down from

around 5% in the 1970s and 80s.

∆𝑷

𝑷 =

∆𝑴

𝑴 +

∆𝑽

𝑽 -

∆𝒀

𝒀