CH 12 - Economic Fluctuations Model We use this model to...

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Unformatted text preview: Economic Fluctuations Model We use this model to explain fluctuations in real GDP and inflation. This model has three elements: An aggregate demand curve (AD) An inflation adjustment line (IA) An equilibrium at the intersection of the line and the curve In the economic fluctuations model, the intersection of the AD and IA gives us a prediction of real GDP and inflation The Aggregate Demand Curve Aggregate demand curve: a line showing a negative relationship between inflation and the aggregate quantity of goods and services demanded at that inflation rate. Figure 1 shows an aggregate demand curve. Note that inflation is plotted on the yaxis and real GDP is plotted on the xaxis. The Aggregate Demand Curve The Aggregate Demand Curve Why is the aggregate demand curve downward sloping? We explain this phenomenon in three stages: Stage 1: We explain the negative relationship between the real interest rate and real GDP Stage 2: We explain the positive relationship between the inflation rate and the real interest rate. Stage 3: We show how the two relationships combine to get the AD curve. Source: p.674 Interest Rates and GDP Investment is negatively related to the real interest rate because the real interest rate is the cost of borrowing. Thus higher interest rates make borrowing more costly. This relationship holds regardless of whether the investment is for capital equipment or for residential investment. Note: Investment is the component of GDP that is most sensitive to the real interest rate. Interest Rates and GDP Net exports are negatively related to real interest rate because higher real interest rates will cause the country's currency to appreciate and decrease its net exports. Lower real interest rates will cause the country's currency to depreciate and increase its net exports. Interest Rates and GDP Consumption is negatively related to interest rates because a higher real interest rate will encourage people to save more and consume less. A lower interest rate will encourage people to save less and consume more. Economists believe that the effect of the real interest rate on consumption is smaller than its effects on investment and net exports. Interest Rates and GDP Overall Effect Because investment, net exports, and consumption are all negatively related to the interest rate, aggregate spending should be negatively related to the real interest rate. Figure 2 illustrates the effect of a lower real interest rate on the spending balance and on GDP. The Interest Rate, Spending Balance, and Real GDP Interest Rates and Inflation Central Bank Interest Rate Policy: The Fed and other central banks typically follow policies in which they respond to an increase in the inflation rate by raising the nominal interest rate. The goal of controlling inflation requires that the central bank raise the nominal interest rate so that the real interest rate rises when the inflation rate rises. Interest Rates and Inflation In Table 1, the central bank responds to higher inflation by raising interest rates. For example, if inflation increases from 5.0 percent to 6.0 percent, the central bank will respond by increasing the nominal interest rate from 8.5 percent to 10 percent. Interest Rates and Inflation The increase in the interest rate must be greater than the increase in the inflation rate. This is because the real interest rate (nominal interest rate minus inflation rate) must rise for aggregate demand to fall. Interest Rates and Inflation Monetary policy rule: a description of how much the interest rate or other instruments of monetary policy respond to inflation or other measures of the state of the economy. A Monetary Policy Rule The Fed Funds Rate Federal funds rate: the interest rate on overnight loans between banks that the Federal Reserve influences by changing the supply of funds (bank reserves) in the market. The Fed Funds Rate If the Fed wants to raise the federal funds rate, it must decrease the supply of reserves. If the Fed wants to lower the federal funds rate, it must increase the supply of reserves. The Fed Funds Rate Open market operations: the buying and selling of government bonds in the open market. If the Fed wants to lower the federal funds rate, it buys government bonds. If the Fed wants to increase the federal funds rate, it sells government bonds. Interest Rates and Inflation Target inflation rate: the central bank's goal for the average rate of inflation over the long run. Some central banks, such as the Bank of England and the Reserve Bank of New Zealand, have explicit inflation targets. The Federal Reserve's inflation target is not explicitly announced. Derivation of the Aggregate Demand Curve The aggregate demand curve has a negative slope--that is, a higher inflation rate results in a lower real GDP. Why? A higher inflation rate will cause the central bank to raise the real interest rate by raising the nominal interest rate faster than the inflation rate. Derivation of the Aggregate Demand Curve The higher real interest rate decreases consumption, investment, and net exports. This causes a decline in real GDP. Figure 5 illustrates how the aggregate demand curve is derived. Figure 5: A SelfGuided Graphical Overview Figure 5: A SelfGuided Graphical Overview (enlarged) A SelfGuided Graphical Overview Graphical Overview A SelfGuided Shifts in the Aggregate Demand Curve A shift in the aggregate demand curve can be caused by changes in the following: Government purchases Inflation target rate Other changes (e.g., net exports, consumer confidence, taxes) Government Spending Higher government purchases will result in a higher level of GDP at every inflation rate. This change is graphically represented as a shift in the AD curve to the right. Lower government purchases will result in a lower GDP level at every inflation rate. This change is graphically represented as a shift in the AD curve to the left. Shifts in the Aggregate Demand Curve How Government Purchases Shift the Aggregate Demand Curve Shifts in the Aggregate Demand Curve Inflation Target Rate A higher inflation target requires a higher level of spending and a lower interest rate. This change will shift the AD curve to the right. A lower inflation target requires a lower level of spending and a higher interest rate. This change will shift the AD curve to the left. Shifts in the Aggregate Demand Curve Next graph summarizes the effects of a change in other variables on the AD curve: Lower taxes, higher consumption, and higher demand for the country's exports will shift the AD curve to the right. Higher taxes, lower consumption, and lower demand for the country's exports will shift the AD curve to the left. in the Aggregate Demand Curve A List of Possible Shifts The Inflation Adjust Line Inflation adjustment (IA) line: a flat line showing the level of inflation in the economy at a given point in time. The IA line shifts up when real GDP is greater than potential GDP; it shifts down when real GDP is lower than potential GDP. The IA line also shifts when expectations of inflation or raw material prices change. Inflation Adjustment and Changes in Inflation The Inflation Adjustment Line Is Flat A flat IA line indicates that firms and workers adjust their wages and prices in such a way that inflation remains steady in the short run as the real GDP changes. The Inflation Adjustment Line Is Flat Two reasons why inflation does not change much in the short run: 1. Expectations of continuing inflation 2. Staggered wage and price setting by different firms throughout the economy The Inflation Adjustment Line Is Flat Expectations of Continuing Inflation If inflation in the economy has been hovering at about 4 percent per year, then a firm can expect that its competitor's prices will increase by about 4 percent this year. Hence, the firm will need to raise its own prices by about 4 percent this year. The Inflation Adjustment Line Is Flat Staggered Wage and Price Setting Not all wages and prices adjust at the same time in the economy. On any given day, there will always be a wage or a price changing, but the vast majority of the wages and prices in the economy will remain constant. The IA Line Shifts When Real GDP Departs from Potential GDP When real GDP is above the potential GDP, the IA line will start to rise until the real GDP equals potential. When real GDP is below the potential GDP, the IA line will start to drop until the real GDP equals potential. When the real GDP equals potential, the IA line will not shift. Changes in Expectations or Commodity Prices An increase in the expectations of inflation will shift the IA line upward. A decrease in the expectations of inflation will shift the IA line downward. An increase in the prices of commodities (i.e. oil), that affects firm's cost of production, will shift the IA line upward. A decrease in the prices of commodities will Combining the IA Line with the AD Curve With a given AD curve, a lower IA line will result in a higher equilibrium level of GDP (relative to potential GDP) and a lower inflation rate. With a given AD curve, a higher IA line will result in a lower equilibrium level of GDP (relative to potential GDP) and a higher inflation rate. Figure 10: Determining Real GDP and Inflation Key Terms aggregate demand (AD) curve monetary policy rule federal funds rate target inflation rate inflation adjustment (IA) line ...
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