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Macroeconomics of

Business Cycles

macr o



m

Growth rates of real GDP, consumptionPercent

change

from 4quarters

earlier

Averagegrowth

rate

Real GDP growth rate

Consumptiongrowth rate



Growth rates of real GDP, consumption,

investmentPercent

change

from 4quarters

earlier

Investment growth rate

Real GDP

growth rate

Consumptiongrowth rate



Unemployment

Percent

of labor

force





Facts about the business cycle

GDP growth averages 3–3.5 percent per year

over the long run with large fluctuations in theshort run.

Consumption and investment fluctuate with

GDP, but consumption tends to be less volatileand investment more volatile than GDP.

Unemployment rises during recessions andfalls during expansions.

Okun’s Law: the negative relationshipbetween GDP and unemployment.



Index of Leading Economic

Indicators Published monthly by the Conference

Board.

Aims to forecast changes in economic

activity 6-9 months into the future.

Used in planning by businesses andgovt, despite not being a perfect

predictor.



Components of the LEI index

Average workweek in manufacturing

Initial weekly claims for unemployment insurance

New orders for consumer goods and materials

New orders, nondefense capital goods

Vendor performance

New building permits issued

Index of stock prices

M2

Yield spread (10-year minus 3-month) on Treasuries

Index of consumer expectations



Index of Leading Economic Indicators

Source:

ConferenceBoard

2004

=

100



Time horizons in macroeconomics

Long runPrices are flexible, respond tochanges in supply or demand.

Short runMany prices are “sticky” at apredetermined level.

The economy behaves much

differently when prices are sticky.



Recap of classical macro theory

Output is determined by the supply side:– supplies of capital, labor

– technology

Changes in demand for goods & services(C, I, G ) only affect prices, not quantities.

Assumes complete price flexibility.

Applies to the long run.



When prices are sticky…

…output and employment alsodepend on demand, which isaffected by:

– fiscal policy (G and T )

– monetary policy (M )

– other factors, like exogenouschanges inC or I



AD/AS Model

The paradigm most mainstream economistsand policymakers use to think about economicfluctuations and policies to stabilize the

economy Shows how the price level and aggregate

output are determined

Shows how the economy’s behavior isdifferentin the short run and long run



Aggregate demand

The aggregate demand curve shows therelationship between the price level and thequantity of output demanded.

we use a simple theory of AD based on thequantity theory of money.

Recall the quantity equationM V = P Y

For given values of M and V ,this equation implies an inverse relationshipbetween P and Y :

Y = M V / P



The downward-sloping AD curve

An increase in the

price level causes a

fall in real money

balances (M / P ),

causing a decrease in

the demand for

goods & services.

An increase in the

price level causes a

fall in real money

balances (M / P ),

causing a decrease inthe demand for

goods & services.

Y

P

AD



Shifting the AD curve

An increase in

the money

supply shiftsthe AD curve

to the right.

An increase in

the money

supply shiftsthe AD curve

to the right.

Y

P

AD1

AD

2



Aggregate supply in the long run

Recall from Chapter 3:In the long run, output is determined by

factor supplies and technology,= ( )Y F K L

is the full-employment or natural level of

output, at which the economy’s resources are

fully employed.

Y

“Full employment” means that

unemployment equals its natural rate (not zero).



The long-run aggregate supply curve

Y

P LRAS

does notdepend on P,so LRAS isvertical.

does notdepend on P,so LRAS is

vertical.

Y

( )= ,

Y

F K L



Long-run effects of an increase in M

Y

P

AD1

LRAS

Y

An increasein M shifts

AD to the

right.

P1

P2In the long run,

this raises the

price level…

…but leaves

output the same.

AD

2



Aggregate supply in the short run

Many prices are sticky in the short run.

For now we assume– all prices are stuck at a predetermined

level in the short run.– firms are willing to sell as much at that

price level as their customers are willingto buy.

Therefore, the short-run aggregatesupply (SRAS) curve is horizontal:



The short-run aggregate supply curve

Y

P

PSRAS

The SRAS curve ishorizontal:

The price level isfixed at apredeterminedlevel, and firms sellas much as buyersdemand.

The SRAS curve ishorizontal:

The price level isfixed at apredetermined

level, and firms sellas much as buyersdemand.



Short-run effects of an increase in M

Y

P

AD1

In the short run

when prices are

sticky,…

…causes output

to rise.

PSRAS

Y 2Y 1

AD

2

…an increase inaggregate demand…



From the short run to the long run

Over time, prices gradually become “unstuck.” When they do, will

they rise or fall?

Y Y >

Y Y <

Y Y =

rise

fall

remain constant

In the short-run

equilibrium, if

then over time,

P will…

The adjustment of prices is what moves

the economy to its long-run equilibrium.



The SR & LR effects of ∆ M > 0

Y

P

AD1

LRAS

Y

PSRAS

P2

Y 2

A = initialequilibrium

A

B

CB = new short-

run eq’m

after Fed

increases M

C = long-run

equilibrium

AD

2



How shocking!!!

shocks: exogenous changes in agg. supply ordemand

Shocks temporarily push the economy away fromfull employment.

Example: exogenous decrease in velocity

If the money supply is held constant, a decreasein V means people will be using their money in

fewer transactions, causing a decrease indemand for goods and services.



PSRAS

LRAS

AD2

The effects of a negative demand shock

Y

P

AD

1

Y

P2

Y 2

AD shifts left,depressing outputand employmentin the short run.

AD shifts left,depressing outputand employmentin the short run.

AB

C

Over time,

prices fall and

the economy

moves down itsdemand curve

toward full-

employment.

Over time,

prices fall and

the economy

moves down itsdemand curve

toward full-

employment.



Supply shocks

A supply shock alters production costs, affects the pricesthat firms charge. (also called price shocks)

Examples of adverse supply shocks:

– Bad weather reduces crop yields, pushing upfood prices.

– Workers unionize, negotiate wage increases.– New environmental regulations require firms to reduce

emissions. Firms charge higher prices to help cover thecosts of compliance.

Favorable supply shocks lower costs and prices.



CASE STUDY:

The 1970s oil shocks

Early 1970s: OPEC coordinates areduction in the supply of oil.

Oil prices rose

11% in 197368% in 197416% in 1975

Such sharp oil price increases aresupply shocks because theysignificantly impact production costsand prices.



1P

SRAS1

Y

P

AD

LRAS

Y Y 2

CASE STUDY:


The oil price shock shiftsSRAS up, causing outputand employment to fall.

The oil price shock shiftsSRAS up, causing outputand employment to fall.

A

B

In absence of

further price

shocks, prices will

fall over time andeconomy moves

back toward full

employment.

In absence of

further price

shocks, prices will

fall over time andeconomy moves

back toward full

employment.

2P SRAS2

A



CASE STUDY:


Predicted effectsof the oil shock:

• inflation ↑

• output ↓

• unemployment ↑

…and then agradual recovery.

0%

10%

0%

0%

40%

50%

60%

70%

197 1974 1975 1976 1

Change in oil prices (left scale)

Inflation rate-CPI (right scale)



CASE STUDY:


Late 1970s:

As economywas recovering,oil prices shot up

again, causinganother hugesupply shock!!!

0%

10%

0%

30%

40%

50%

60%

1977 1978 1979 1980 1





CASE STUDY:


1980s:

A favorablesupply shock--a significant

fall in oilprices.

As the modelpredicts,inflation andunemploymentfell:

-50%-40%

-30%

-0%

-10%0%

10%

0%

30%

40%

198 1983 1984 1985 1986 19





Stabilization policy

def: policy actions aimed atreducing the severity of short-runeconomic fluctuations.

Example: Using monetary policy tocombat the effects of adversesupply shocks…



Stabilizing output with

monetary policy

1P

SRAS1

Y

P

AD

1

B

A

Y 2

LRAS

Y

The adverse

supply shock

moves the

economy to

point B.

The adverse

supply shock

moves the

economy to

point B.

2P SRAS2



Stabilizing output with

monetary policy

1P

Y

P

AD

1

B

A

C

Y 2

LRAS

Y

But the Fed

accommodates

the shock by

raising agg.

demand.

But the Fed

accommodates

the shock by

raising agg.

demand.

results:

P is permanently

higher, but Y

remains at its full-

employment level.

results:

P is permanently

higher, but Y

remains at its full-

employment level.

2P SRAS2

AD

2



Aggregate Demand I:Aggregate Demand I:

The The IS-LMIS-LM ModelModel

The IS - LM model determinesincome and the interest rate in

the short run when P is fixed



The Big Picture

KeynesianCrossKeynesianCross

Theory of

Liquidity

Preference

Theory of

Liquidity

Preference

IS curve

IS curve

LM

curve

LM

curve

IS-LM

model

IS-LM

model

Agg.

demand

curve

Agg.

demand

curve

Agg.

supply

curve

Agg.

supply

curve

Model of

Agg.

Demandand Agg.

Supply

Model of

Agg.

Demandand Agg.

Supply

Explanation

of short-run

fluctuations

Explanation

of short-run

fluctuations



The Keynesian Cross

A simple closed economy model in which incomeis determined by expenditure.(due to J.M. Keynes)

Notation:

I = planned investmentPE = C + I + G = planned expenditure

Y = real GDP = actual expenditure

Difference between actual & planned

expenditure = unplanned inventory investment



Elements of the Keynesian Cross

( )C C Y T = −

I I=

,G G T T = =

= − + +( )PE C Y T I G

=Y PE

consumption function:

for now, planned

investment is exogenous:

planned expenditure:

equilibrium condition:

govt policy variables:

actual expenditure = planned expenditure



Graphing planned expenditure

income, output, Y

PE

planned

expenditure

PE =C +I

+G

MPC 1



Graphing the equilibrium condition

income, output, Y

PE

planned

expenditure

PE =Y

45º



The equilibrium value of income

income, output, Y

PE

planned

expenditure

PE =Y

PE =C +I

+G

Equilibrium

income



An increase in government purchases

Y

PE

P E = Y

PE =C +I

+G1

PE1 =

Y 1

PE =C +I

+G2

PE2 =

Y 2

∆ Y

At Y 1,

there is now an

unplanned drop

in inventory…

…so firms

increase output,

and income

rises toward a

new equilibrium.

∆

G



Solving for ∆ Y

Y C I G= + +Y C I G∆ = ∆ + ∆ + ∆

MPC= × ∆ + ∆Y G

C G= ∆ + ∆

( MPC)− ×∆ = ∆Y G

MPC

∆ = × ∆ −

Y G

equilibrium condition

in changes

because I exogenous

because ∆ C = MPC

∆ Y

Collect terms with ∆ Y

on the left side of theequals sign:

Solve for ∆ Y :



The government purchases multiplier

Example: If MPC = 0.8, then

Definition: the increase in incomeresulting from a $1 increase in G.

In this model, the govtpurchases multiplier equals

MPC

∆=

∆ −

Y

G

.∆ = =∆ −

Y

G

An increase in G

causes income to

increase 5 times

as much!

An increase in G

causes income to

increase 5 times

as much!



Why the multiplier is greater than 1

Initially, the increase in G causes anequal increase in Y : ∆ Y = ∆ G.

But ↑Y ⇒ ↑C

⇒further

↑Y

⇒ further ↑C

⇒ further ↑Y

So the final impact on income is muchbigger than the initial ∆ G.



An increase in taxes

Y

PE

P E

= Y PE =C2 +I

+G

PE2 = Y 2

PE =C1 +I

+G

PE1 =

Y 1

∆

Y

At Y 1, there is now

an unplanned

inventory buildup……so firms

reduce output,and income falls

toward a new

equilibrium

∆ C = −MPC∆ T

Initially, the tax

increase reduces

consumption, and

therefore PE :



Solving for ∆ Y

Y C I G∆ = ∆ + ∆ + ∆

( )MPC= × ∆ − ∆Y T

C= ∆

( MPC) MPC− × ∆ = − × ∆Y T

eq’m condition in

changes

I and G exogenous

Solving for

∆ Y :

MPC

MPC −∆ = × ∆ −

Y T Final result:



The tax multiplier

def: the change in income resulting froma $1 increase in T :

MPC

MPC

∆ −=

∆ −

Y

T

. . . .2∆ − −= = = −∆ −

Y

T

If MPC = 0.8, then the tax multiplier equals



The tax multiplier

…is negative:

A tax increase reduces C,which reduces income.

…is greater than one (in absolute value):

A change in taxes has amultiplier effect on income.

…is smaller than the govt spending multiplier : Consumers save the fraction (1 – MPC) of a tax cut,so the initial boost in spending from a tax cut issmaller than from an equal increase in G.



The IS curve

def: a graph of all combinations of r and Y that result in goods marketequilibrium

i.e. actual output = planned expenditure

The equation for the IS curve is:

( ) ( )Y C Y T I r G= − + +

J.R. Hicks





Why the IS curve is negatively sloped

A fall in the interest rate motivates firms toincrease investment spending, which drivesup total planned spending (PE ).

To restore equilibrium in the goods market,

output (a.k.a. actual expenditure, Y )must increase.



Fiscal Policy and the IS curve

We can use the IS-LM

model to seehow fiscal policy (G and T ) affectsaggregate demand and output.

Let’s start by using the Keynesiancrossto see how fiscal policy shifts the IS curve…



Y 2Y 1

Y 2Y 1

Shifting the IS curve: ∆ G

At any value of r ,

↑G ⇒ ↑PE ⇒ ↑Y

Y

PE

r

Y

PE =C +I (r 1 )

+G1

PE =C +I (r 1

)

+G2

r 1

PE

=Y

IS1

The horizontal

distance of the

IS shift equals

IS2

…so the IS curve

shifts to the right.

11 MPC

∆ = ∆−

Y G ∆

Y

NOW YOU TRY:



NOW YOU TRY:

Shifting the IS curve: ∆ T

Use the diagram of the Keynesiancross or loanable funds model toshow how an increase in taxes shifts

the IS curve.



The Theory of Liquidity Preference

Due to John Maynard Keynes. A simple theory in which the interest

rateis determined by money supply andmoney demand.



Equilibrium

The interestrate adjuststo equate thesupply anddemand for

money:

M/P real money

balances

r interest

rate

( )s

M P

M P

( )M P L r

=

L (r )

r 1



How the Fed raises the interest rate

To increase r ,

Fed reduces M

M/P real money

balances

r interest

rate

1M

P

L (r )

r 1

r 2

2M

P



The LM curve

Now let’s put Y back into the moneydemand function:

( , )M P L r Y =

The LM curve is a graph of all combinations of

r and Y that equate the supply and demand for

real money balances.

The equation for the LM curve is:

( )d

M P L r Y = ( , )



Deriving the LM curve

M/P

r

1M

P

L (r ,

Y 1 )

r 1

r 2

r

Y Y 1

r

1

L (r ,

Y 2 )

r

2

Y 2

LM

(a) The market for real money balances (b) The LM curve

Wh h LM i d l i



Why the LM curve is upward sloping

An increase in income raises moneydemand.

Since the supply of real balances isfixed, there is now excess demandin the money market at the initialinterest rate.

The interest rate must rise torestore equilibrium in the moneymarket.

H M hift th LM



How ∆ M shifts the LM curve

M/P

r

1M

P

L (r , Y 1

) r 1

r 2

r

Y Y 1

r 1

r 2

LM1

(a) The market for real money balances (b) The LM curve

2M

P

LM

2

Th h t ilib i



The short-run equilibrium

The short-run equilibrium isthe combination of r and Y

that simultaneously satisfies

the equilibrium conditions in

the goods & money markets:

( ) ( )Y C Y T I r G= − + +

Y

r

( , )M P L r Y =

IS

LM

Equilibrium

interest

rate

Equilibrium

level of

income

P li l i ith th IS LM d l



Policy analysis with the IS -LM model

We can use the IS-LM

model to analyze theeffects of

• fiscal policy: G and/orT

• monetary policy: M

( ) ( )Y C Y T I r G= − + +( , )M P L r Y =

IS

Y

r LM

r 1

Y 1

A i i t h



causing output &

income to rise.

IS1

An increase in government purchases

1. IS curve shifts right

Y

r LM

r 1

Y 1

1by

1 MPCG∆

−

IS2

Y 2

r 2

1.2. This raises money

demand, causing the

interest rate to rise…

2.

3. …which reduces investment,so the final increase in Y

1is smaller than

1 MPCG∆

−

3.

A t t



IS1

1.

A tax cut

Y

r LM

r 1

Y 1

IS2

Y 2

r

2

Consumers save (1−MPC )

of the tax cut, so the initial

boost in spending is

smaller for ∆ T than for

an equal ∆ G …

and the IS curve shifts by

MPC

1 MPCT

−∆

−1.

2.

2.…so the effects on r

and Y are smaller for ∆ T

than for an equal ∆ G .

2.

M t li A i i M



2. …causing theinterest rate to fall

IS

Monetary policy: An increase in M

1. ∆ M > 0 shiftsthe LM curve down(or to the right)

Y

r LM1

r 1

Y 1 Y 2

r 2

LM2

3. …which increases

investment, causingoutput & income to

rise.

Th F d’ t G 0



The Fed’s response to ∆ G > 0

Suppose Congress increases G.

Possible Fed responses:

1. hold M constant

2. hold r constant3. hold Y constant

In each case, the effects of the

∆ G are different…

Response 1: Hold M constant



If Congress raises G ,the IS curve shifts right.

IS1

Response 1: Hold M constant

Y

r LM

1

r 1

Y 1

IS2

Y 2

r 2If Fed holds M constant,

then LM curve doesn’tshift.

Results:

2 1

Y Y Y

∆ = −2 1

r r r ∆ = −

Response 2: Hold r constant



If Congress raises G ,the IS curve shifts right.

IS1

Response 2: Hold r constant

Y

r LM

1

r 1

Y 1

IS2

Y 2

r 2To keep r constant,

Fed increases M to shift LM curve right.

3 1Y Y Y ∆ = −0r ∆ =

LM

2

Y 3

Results:



E ti t f fi l li lti li



Estimates of fiscal policy multipliersfrom the DRI macroeconometric model

Assumption about

monetary policy

Estimated

value of

∆ Y / ∆ G

Fed holds nominalinterest rate constant

Fed holds money

supply constant

1.93

0.60

Estimated

value of

∆ Y / ∆ T

−1.19

−0.26



Shocks in the IS LM model



Shocks in the IS -LM model

LM shocks: exogenous changesin the demand for money.

Examples:

– a wave of credit card fraudincreases demand for money.

– more ATMs or the Internet reducemoney demand.

NOW YOU TRY:



NOW YOU TRY:

Analyze shocks with the IS-LM Model

Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes

consumers wealthier.

2. after a wave of credit card fraud, consumers

using cash more frequently in transactions.

For each shock,

a. use the IS-LM diagram to show the effects of theshock on Y and r .

b.determine what happens to C, I, and theunemployment rate.

CASE STUDY:



The U.S. recession of 2001 During 2001,

– 2.1 million jobs lost,unemployment rose from 3.9% to5.8%.

– GDP growth slowed to 0.8%(compared to 3.9% average annualgrowth during 1994-2000).



CASE STUDY:



The U.S. recession of 2001

Causes: 2) 9/11– increased uncertainty

– fall in consumer & business confidence

– result: lower spending, IS curve shiftedleft

Causes: 3) Corporate accounting scandals– Enron, WorldCom, etc.

– reduced stock prices, discouraged

investment

CASE STUDY:



The U.S. recession of 2001

Fiscal policy response: shifted IS

curve right– tax cuts in 2001 and 2003– spending increases

•airline industry bailout•NYC reconstruction•Afghanistan war

CASE STUDY:



The U.S. recession of 2001 Monetary policy response: shifted LM curve

right

Three-month

T-Bill Rate

Three-month

T-Bill Rate

0

1

2

3

4

5

6

7

0

1 / 0

1 / 2 0 0 0

0

4 / 0 2 / 2 0 0 0

0

7 / 0 3 / 2 0 0 0

1

0 / 0 3 / 2 0 0 0

0

1 / 0 3 / 2 0 0 1

0

4 / 0 5 / 2 0 0 1

0

7 / 0 6 / 2 0 0 1

1

0 / 0 6 / 2 0 0 1

0

1 / 0 6 / 2 0 0 2

0

4 / 0 8 / 2 0 0 2

0

7 / 0 9 / 2 0 0 2

1

0 / 0 9 / 2 0 0 2

0

1 / 0 9 / 2 0 0 3

0

4 / 1

1 / 2 0 0 3

IS-LM and aggregate demand



IS-LM and aggregate demand

So far, we’ve been using the IS-LM model to analyze the short run,when the price level is assumedfixed.

However, a change in P would shiftLM and therefore affect Y .

The aggregate demand curve (introduced in Chap. 9) captures thisrelationship between P and Y.

Deriving the AD curve



Y 1Y 2

Deriving the AD curve

Y

r

Y

P

IS

LM (P 1)

LM (P 2)

AD

P 1

P 2

Y 2 Y 1

r 2

r 1

Intuition for slope

of AD curve:

↑P ⇒ ↓(M / P )

⇒ LM shifts left

⇒ ↑r

⇒ ↓I

⇒ ↓Y

Monetary policy and the AD curve



Monetary policy and the AD curve

Y

P

IS

LM (M 2 /P 1)

LM (M 1 /P 1)

AD1

P 1

Y 1

Y 1

Y 2

Y 2

r 1

r 2

The Fed can increaseaggregate demand:

↑M ⇒ LM shifts right

AD2

Y

r

⇒ ↓r

⇒ ↑I

⇒ ↑Y at each

value of P

Fiscal policy and the AD curve



Y 2

Y 2

r 2

Y 1

Y 1

r 1

Fiscal policy and the AD curve

Y

r

Y

P

IS 1

LM

AD1

P 1

Expansionary fiscalpolicy (↑G and/or ↓T )

increases agg. demand:

↓T ⇒ ↑C

⇒ IS shifts right

⇒ ↑Y at each

value of P

AD2

IS 2

IS-LM and AD-AS



IS LM and AD AS

in the short run & long run

Recall from Chapter 9: The force that movesthe economy from the short run to the long run

is the gradual adjustment of prices.

Y Y >

Y Y <Y Y =

rise

fall

remain constant

In the short-runequilibrium, if

then over time, theprice level will

The SR and LR effects of an IS shock




A negative IS shock shifts IS and AD left,causing Y to fall.

A negative IS shock shifts IS and AD left,causing Y to fall.

Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS 1P1

LM (P 1)

IS2

AD2

AD1





Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS 1P1

LM (P 1)

IS2

AD2

AD1

In the new short-run

equilibrium,


equilibrium, Y Y <





Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS 1P1

LM (P 1)

IS2

AD2

AD1


equilibrium,


equilibrium, Y Y <

Over time, P gradually

falls, causing

• SRAS to move down

• M / P to increase,which causes LM

to move down


falls, causing



to move down




AD2


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS 1P1

LM (P 1)

IS2

AD1

SRAS 2P2

LM (P 2)


falls, causing



to move down


falls, causing



to move down




AD2

SRAS 2P2

LM (P 2)


Y

r

Y

P LRAS

Y

LRAS

Y

IS1

SRAS 1P1

LM (P 1)

IS2

AD1

This process continues

until economy reaches a

long-run equilibrium withY Y =

NOW YOU TRY:



Analyze SR & LR effects of ∆ M

a.Draw the IS-LM and AD- AS diagrams as shown

here.

b.Suppose Fed increases

M. Show the short-runeffects on your graphs.

c. Show what happens in

the transition from the

short run to the long run.

d.How do the new long-run

equilibrium values of the

endogenous variables

compare to their initial

values?

Y

r

Y

P LRAS

Y

LRAS

Y

IS

SRAS 1P1

LM (M1/P1)

AD1

The Great Depression



The Great Depression

Unemployment (right scale)

Real GNP

(left scale)

120

140

160

180

200

220

240

1929 1931 1933 1935 1937 1939

b

illion

s

of1958

dollars

0

5

10

15

20

25

30

perce

ntofla

borforce

THE SPENDING HYPOTHESIS:

Sh k t th IS



Shocks to the IS curve

asserts that the Depression was largelydue to an exogenous fall in the demandfor goods & services – a leftward shift of the IS curve.

evidence:output and interest rates both fell,which is what a leftward IS shift would

cause.



THE MONEY HYPOTHESIS:

A h k t th LM



A shock to the LM curve

asserts that the Depression was largelydue to huge fall in the money supply.

evidence:M1 fell 25% during 1929-33.

But, two problems with this hypothesis:– P fell even more, so M/P actually rose

slightly during 1929-31.

– nominal interest rates fell, which is theopposite of what a leftward LM shiftwould cause.





THE MONEY HYPOTHESIS AGAIN:

The effects of falling prices




The destabilizing effects of expecteddeflation:

↓Eπ

⇒ r ↑ for each value of i ⇒ I ↓ because I = I (r )

⇒ planned expenditure & agg. demand ↓

⇒ income & output ↓

THE MONEY HYPOTHESIS AGAIN:





The destabilizing effects of unexpected deflation:debt-deflation theory

↓P (if unexpected)

⇒ transfers purchasing power from borrowers

to lenders⇒ borrowers spend less,

lenders spend more

⇒ if borrowers’ propensity to spend is larger

than lenders’, then aggregate spending

falls,

the IS curve shifts left, and Y falls









House price change and newforeclosures 2006:Q3 – 2009Q1



foreclosures, 2006:Q3 2009Q1

New

forecl

osu

res,

%

ofal l

mo

rtgages

Cumulative change in house price index

Nevada

Georgia

Colorado

Texas

AlaskaWyoming

Arizona

California

Florida

S. Dakota

Illinois

Michigan

Rhode Island

N. Dakota

Oregon

Ohio

New Jersey

Hawaii





Consumer sentiment and growth in consumer durables and investment spending



du ab es a d est e t spe d g

Real GDP growth and Unemployment



Documents

Mankiw+5e+Chapter+1+the+Science+of+Macroeconomics[1]