Demand-Side Stabilization: Demand-Side Stabilization: Overheating, Hard Landing and Overheating, Hard Landing and

Everything in BetweenEverything in Between

Part 2Part 2

C + I + G + (Exp – Imp) = YC + I + G + (Exp – Imp) = YAssume G increase from 125 to 175 ($50 billion Assume G increase from 125 to 175 ($50 billion

increase).increase).

Now E1 = 875 (see Table 5.1), an increase in Y of Now E1 = 875 (see Table 5.1), an increase in Y of 125. 125. Why?Why?

Multiplier effectMultiplier effect = =

change in GDP/change in components of ADchange in GDP/change in components of AD

The Multiplier EffectThe Multiplier Effect

The mechanism of the multiplier effectThe mechanism of the multiplier effectMPC = change in consumption/change in national MPC = change in consumption/change in national

income income ==ΔΔC/C/ΔΔYY = (550-475)/(750-625) = 0.6= (550-475)/(750-625) = 0.6

Multiplier = 1/(1-MPC)Multiplier = 1/(1-MPC)

Period 1Period 1:: 60% of the initial injection ($50 billion) is spent (increases Y).60% of the initial injection ($50 billion) is spent (increases Y).Period 2Period 2::60% of the $30 billion (injected in the economy in period 1) is60% of the $30 billion (injected in the economy in period 1) is spent (increases Y).spent (increases Y).And so on… (see Table 5.2).And so on… (see Table 5.2).

Changing Monetary PolicyChanging Monetary Policy An increase in the rate of growth of the money An increase in the rate of growth of the money

supply (through open market operations) leads tosupply (through open market operations) leads to

a fall in interest rates (i) which causes capital a fall in interest rates (i) which causes capital

investment to rise. investment to rise. A rise in capital investment is shown by an A rise in capital investment is shown by an

upward shift in the expenditure line in the goods upward shift in the expenditure line in the goods

market, which is reflected in the AD shifting right market, which is reflected in the AD shifting right (Fig. 5.4).(Fig. 5.4).

Tax PolicyTax Policy

CCT = = CC + bY + bYD

CCT : consumption function with tax rate t.CC : Consumer confidence.b : Marginal propensity to consume (MPC)YYD : Disposable income.YYD = Y – tY = (1 - t)YCCT = = CC + b + b(1 - t)Y

Thus, an increase in the tax rate (t) causes CCT to fall.This decrease in consumption causes a drop in the goodsmarket equilibrium and a shift to the left in AD.For a summary of the three methods of shifting AD see

Figure 5.5.

UnemploymentUnemployment

Unemployment rate = Unemployed / Civilian labor forceUnemployment rate = Unemployed / Civilian labor force Participation rate = Labor force / Population over 16Participation rate = Labor force / Population over 16

Frictional unemployment: Frictional unemployment: Unemployment associated Unemployment associated with the ‘normal’ working of an economy (wait and search with the ‘normal’ working of an economy (wait and search unemployment).unemployment).

Structural unemployment: Structural unemployment: Generally caused when Generally caused when entire sectors of the economy shut down (e.g., textiles, steel, entire sectors of the economy shut down (e.g., textiles, steel, …)…)

Cyclical unemployment: Cyclical unemployment: Unemployment that fluctuates Unemployment that fluctuates with the business cycle.with the business cycle.

Full unemployment: Full unemployment: When the economy has only When the economy has only frictional and structural unemployment.frictional and structural unemployment.

The The Natural Rate of UnemploymentNatural Rate of Unemployment is is sometimes known as the non-accelerating sometimes known as the non-accelerating inflation rate of Unemployment (NAIRU).inflation rate of Unemployment (NAIRU).When unemployment is at its natural rate there When unemployment is at its natural rate there is no tendency for inflation to increase.is no tendency for inflation to increase.

Congress enacted the Employment Act of 1946: Congress enacted the Employment Act of 1946: The Federal Government has the responsibility The Federal Government has the responsibility “to promote maximum employment, production “to promote maximum employment, production and purchasing power.”and purchasing power.”

GDP deflator and CPI were coveredGDP deflator and CPI were coveredIn chapter 2.In chapter 2.InflationInflation: A percentage increase in : A percentage increase in

the overall general price level.the overall general price level.DeflationDeflation: Average decline in the : Average decline in the

price level. price level. Examples: Great depression, Japan in Examples: Great depression, Japan in

the late 1990s.the late 1990s.DisinflationDisinflation: Declining rates of : Declining rates of

inflationinflationExamples: US in the 1980s, inflation rate Examples: US in the 1980s, inflation rate

fell from about 10% in 1980 to 3% in 1987.fell from about 10% in 1980 to 3% in 1987.

InflationInflation

In order to understand macroeconomic In order to understand macroeconomic phenomena such as soft-landing and phenomena such as soft-landing and overheating we will link changes in the price overheating we will link changes in the price level to demand-side stabilization.level to demand-side stabilization.

This process starts with a definition of different This process starts with a definition of different types of inflation: demand-pull inflation, cost-types of inflation: demand-pull inflation, cost-push inflation, and hyperinflation.push inflation, and hyperinflation.

Two macroeconomic scenarios (see Fig. 5.6).Two macroeconomic scenarios (see Fig. 5.6).

The index of Leading Economic The index of Leading Economic IndicatorsIndicators

The US leading Indicators Index has 10 components:The US leading Indicators Index has 10 components:1.1. Average weekly hours of manufacturingAverage weekly hours of manufacturing2.2. Initial claims for unemployment insuranceInitial claims for unemployment insurance3.3. New orders, consumer goods, and materialsNew orders, consumer goods, and materials4.4. Vendor performance, slower deliveriesVendor performance, slower deliveries5.5. New orders, non-defense capital goodsNew orders, non-defense capital goods6.6. Building permitsBuilding permits7.7. Stock prices, 500 common stocksStock prices, 500 common stocks8.8. Index of consumer expectationsIndex of consumer expectations9.9. Money supply, M2Money supply, M210.10. Interest rate spread, 10-year T-bonds less the Interest rate spread, 10-year T-bonds less the

Federal funds rateFederal funds rate

NAPM (ISM) IndexNAPM (ISM) Index

The monthly Institute for Supply Chain Management (ISM) index of manufacturing (formerly, the National Association of Purchasing Management, NAPM). An overall reading below 50 suggest thatthe manufacturing sector is shrinking.Note: Most recession in the US have begun with a contraction in manufacturing activity.

Articles 5.2 and 5.3 for class Articles 5.2 and 5.3 for class

discussiondiscussion