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Econ 2: Announcements Problem set 4 due Wednesday March 5. 1 Winter 2008 Test 3 Test 3 histogram 120 100 120.00% 100.00% Mean: 41.25 Median: 41 Rough dist: A s: 48 and above B s: 39 47 C s: 32 38 80 Frequency y 80.00% 60.00% 60 40 20 40.00% 20.00% 0 0.00% Bin Frequency Cumulative % Econ 2: Lecture outline ADI and short-run equilibrium From the short-run to the full-employment model Using the ADI curve. The Volker deflation of 1979-1982 The oil price increases of the 1970s The 1990 and 2000 recessions 1 Equilibrium Output and the ADI Curve How and a Central Bank reacts to inflation. In response to inflation the Fed raises real interest rates to slowdown the economy. When the real interest rate rises, consumption and investment fall so aggregate expenditures fall This behavior leads to a negative relationship between inflation and aggregate demand. Slope of ADI 2 What Can Shift the ADI Curve? A shift of the ADI curve occurs when there is a change in fiscal policy or monetary policy at a given rate of inflation. An increase in government spending or a tax cut, expansionary fiscal policy, shifts the ADI curve rightward. There is a movement along the ADI curve when the Fed responds to inflation by raising interest rates which results in lower output. How does the Fed Shift the ADI Curve? The Fed shifts the ADI curve if it changes its policy rule. Suppose the Fed decides to lower the real interest rate even though inflation is constant this is a change in the Fed s policy rule. The ADI curve shifts right. Lower interest rates increase investment and consumption, increasing AE and output at the constant inflation rate. The Fed s Response to the Asian financial crisis Shifted the ADI Curve In 1998 the Fed was worried about the spread of the Asian financial crisis . It cut the real interest rate even though U.S. inflation was constant. This increased investment, consumption, and increased imports from countries in Southeast Asia that were in the throes of a financial crisis . In 2008 the Fed has been worried about the effects of the 2008, financial crisis originating in the subprime mortgage market. It cut rates even though inflation was rising. 3 Other Factors that Shift the ADI Curve A change or shock to consumption or investment will shift the ADI curve. The stock market boom of the 1990s increased consumption and shifted the ADI curve to the right for any level of inflation. An increase in perceived risks will reduce investment and shift the ADI curve to the left for any given level of inflation. Changes in fiscal policy, the tax and spending policies of the government, will shift the ADI curve. Recession Caused by a Shift in ADI (a) Recession Caused by a Shift in ADI (c) Note that the Fed could change its policy rule and lower the real interest rate before inflation starts to fall. This would shift the ADI curve back to its original position at E0, maintaining the original inflation. 4 An Expansionary Shift in the ADI Curve Expansionary government policy the ADI curve shifts right. Example of Fiscal Policy Shifting the ADI Curve the 1960s (a) Kennedy tax cut: in 1963 unemployment of 5.3% was seen as too high In 1964 taxes were cut, C increased, and demand and output increased. In 1965 unemployment was 4.4%, however by the late 1960s inflation was 5.7% and unemployment was back above 5.5%. Example of Fiscal Policy Shifting the ADI Curve the 1960s (b) 5 Changes in Energy Prices With the oil price shocks of the 1970s, the IA curve shifted up. Inflation rose and output fell below potential, Y < Yf, so unemployment rose. As inflation increased, the Fed increased real interest rates, so C and I fell, and Y fell; the economy moved into recession with higher unemployment. This was a move along the ADI curve as the IA curve shifted upward. Changes in Energy Prices (b) Volcker Dis-Inflation of the 1980s (a) In 1978 the economy was at full-employment with unemployment at 5.8%, but inflation was high, over 8%. In 1980 Fed Chair Paul Volcker changed the Fed s policy rule and aggressively increased interest rates (when inflation was nearly 10%). This caused output to fall well below potential but eventually brought inflation under control so that in 1983 inflation was just 3.2%. 6 Volcker Dis-Inflation of the 1980s (b) Volcker Dis-Inflation of the 1980s (c) Increase in Potential GDP in 1990s Due to New Information Technologies New information technology improves labor productivity. Yf may also increase due to increased labor market participation rate by women. Shifts Yf rightward as the same level of employment produces more output. Puts downward pressure on inflation The IA curve shifts downward. Moves along the ADI curve higher output and lower inflation 7 The Impact of an Increase in Potential GDP The Boom of the 1990s Pop quiz: Write your name on a sheet of paper. Write your TA s name and section on you paper. List two factors that would shift the ADI curve to the right. 8

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