978-1259285295 Chapter 22 Lecture Note Part 2

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I. Using the Aggregate Demand-Aggregate Supply Framework

A. How Do Policymakers Achieve Their Stabilization Objectives?

1. Policymakers can neutralize movements in aggregate demand but they cannot offset

supply shocks.

2. Positive supply shocks that raise output and lower inflation provide policymakers

with the opportunity to guide the economy to a new, lower inflation target without

inducing a recessionary gap.

3. Monetary Policy: monetary policy can stabilize the economy following a shift in the

dynamic aggregate demand curve.

a. A shift in the monetary policy reaction function will lead to a shift in the dynamic

aggregate demand curve.

b. If changes in consumer and/or business confidence or changes in government

expenditures result in a leftward shift in the dynamic aggregate demand curve,

policy makers can shift the monetary policy reaction function to the right, and that

will lead to a shift in the dynamic aggregate demand curve to the right as well.

c. Therefore, in the absence of a policy response, a leftward shift in the dynamic

aggregate demand curve will lead to a decrease in output; however, with the

policy response the dynamic aggregate demand curve remains at its initial

position.

4. In practice it is extremely difficult to keep inflation and output from fluctuating when

aggregate expenditure changes. There are two reasons for this:

a. It takes time to recognize what has happened; and

b. Interest rates (the policymakers’ tool) do not have an immediate effect on the

economy.

5. Therefore, while in theory central bankers can neutralize aggregate demand shocks, in

reality such shocks cause fluctuations in output and inflation.

6. Discretionary Fiscal Policy

a. There are two types of fiscal policy: (1) automatic, which operates without any

conscious actions on the part of government officials and (2) discretionary,

relying on fiscal policymakers’ decisions.

b. Automatic stabilizers (including unemployment insurance and the proportional

nature of the tax system) adjust mechanically to stimulate a slowing economy and

slow a speeding economy.

c. Sometimes, though, automatic stabilizers aren’t enough and that’s when

politicians seek to enact temporary expenditure increases and/or tax reductions.

Such changes are discretionary fiscal policy.

d. Discretionary fiscal policy shifts the dynamic aggregate demand curve, and so it

can be used just like monetary policy to offset shifts in the curve.

e. In principle it seems like fiscal policy is, therefore, an alternative to monetary

policy, but fiscal policy has two defects: (1) it works slowly and (2) it is almost

impossible to implement effectively.

f. Moreover, economics may collide with politics where fiscal policy is concerned.

Economically efficient policies may not be politically popular.

7. Under most circumstances, stabilization policy is probably best left to the central

bankers who have the ability to act quickly and who are independent from politics.

8. Positive Supply Shocks and the Opportunities They Create: the increase in short-run

aggregate supply provides policymakers with an opportunity to guide the economy to

a new, lower inflation target without creating a recession.

a. Central bankers do this by shifting their monetary policy reaction curve to the left,

which then shifts aggregate demand to the left as well.

b. This drives output below potential output, creating a recessionary gap and putting

downward pressure on inflation. Inflation falls to the new target level.

B. What Accounts for the Great Moderation?

1. The Great Moderation refers to the unprecedented economic stability across the

industrialized world in the 1990s.

2. There are three possible explanations for this phenomenal worldwide economic

performance:

a. It was luck; the 1990s were simply an exceptionally calm period;

b. Economies have become more flexible in responding to external economic

disturbances;

c. Monetary policymakers have figured out how to do their job more effectively.

3. Monetary policy is the likely explanation for the improved monetary performance.

4. While low and stable inflation is necessary for reducing economic volatility, it is not

sufficient as witnessed by the deep recession beginning in 2007.

C. What Happens When Potential Output Changes?

1. An increase in productivity that resulted in an increase in potential output would shift

the long-run aggregate supply curve to the right, but since it also reduces the costs of

production, the short-run aggregate supply curve will also shift to the right.

2. Immediately following the increase in potential output, expected inflation does not

change, so the short-run aggregate supply curve shifts the same amount as the

long-run aggregate supply curve.

3. As a result the economy moves to a new short-run equilibrium at which output is

higher and inflation is lower.

4. In the long run, output must go to the new level of potential output, but how it gets

there depends on what monetary policymakers do.

a. If policymakers are happy with the current inflation target then they will work to

move the economy to the point on the new long-run aggregate supply curve

consistent with that target.

b. That requires a policy easing, which means shifting the monetary policy reaction

function to the right, and thereby causing the dynamic aggregate demand curve to

shift to the right.

c. The new long-run equilibrium will be at the new level of potential output and the

same target inflation rate.

d. However, as we saw earlier, policymakers may take the increase in productivity as

an opportunity to lower the inflation target. This has been referred to as

“opportunistic disinflation,” where disinflation means a reduction in the rate of

inflation (NOTE: that’s not the same thing as deflation, which is a reduction in the

overall price level. Disinflation means prices are still going up but at a slower

rate.)

5. An alternative explanation for business cycle fluctuations focuses on shifts in

potential output; this is called real business cycle theory.

a. Real business cycle theory starts with the assumption that prices and wages are

flexible, so that inflation adjusts rapidly.

b. This means that the short-run aggregate supply curve shifts rapidly in response to

deviations of current output from potential output.

c. This assumption renders the short-run aggregate supply curve irrelevant, so

equilibrium output and inflation are determined by the point of intersection of the

dynamic aggregate demand curve and the long-run aggregate supply curve.

d. Thus any shift in the dynamic aggregate demand curve influences inflation but not

output.

e. Since inflation ultimately depends on the level of money growth, it is determined

by monetary policy.

f. Real business cycle theorists explain recessions and booms as the result of

fluctuations in potential output. They focus on changes in productivity and their

impact on GDP.

g. Shifts in productivity can be temporary or permanent, but any of them will shift

potential output.

C. What are the Implications of Globalization for Monetary Policy?

1. International trade can be thought of as a source of productivity-enhancing

technological progress.

2. Globalization and trade, therefore, do reduce inflation in the short run just like any

positive supply shock.

D. Can Policymakers Distinguish a Recessionary Gap from a Fall in

Potential Output?

1. Distinguishing a recessionary gap from a fall in potential output is critical.

2. When inflation rises at the same time that output falls, the appropriate policy response

depends on whether potential output has fallen.

3. If it has, policymakers need to shift their monetary policy reaction curve to the left to

ensure that inflation remains at the target rates.

4. By contract, if the simultaneous fall in output and increase in inflation is due to a shift

in the short-run aggregate supply curve, then policymakers should focus on moving

the economy back to the same point where they started.

E. Can Policymakers Stabilize Output and Inflation Simultaneously?

1. Dynamic aggregate demand shifts move inflation and output in the same direction,

which short-run aggregate supply shifts move inflation and output in opposite

directions.

2. There is no way for policymakers to neutralize supply shocks. Monetary policy can

shift the dynamic aggregate demand curve but it is powerless to move the short-run

aggregate supply curve.

3. Central bankers can choose how aggressively they react to deviations of the inflation

rate from their target rate; this means they can pick the slope of the monetary policy

reaction curve, which, in turn, affects the slope of the dynamic aggregate demand

curve.

a. The more aggressive policymakers are in keeping current inflation close to target,

the steeper their monetary policy reaction curve and the flatter the dynamic

aggregate demand curve.

b. By controlling the slope of the aggregate demand curve policymakers choose the

extent to which supply shocks translate into changes in output or changes in

inflation.

c. Therefore the choice of the slope of the monetary policy reaction curve is really a

choice about the relative volatility of inflation and output; there is a tradeoff.

4. When choosing how aggressively to respond to supply shocks, central bankers are

deciding how to conduct stabilization policy; policymakers cannot stabilize both

output and inflation, and by stabilizing one, the other becomes more volatile.

5. Monetary policymakers face an inflation-output volatility tradeoff.

Terms Introduced in Chapter 22

demand shock

disinflation

real-business-cycle theory

supply shock

Using FRED: Codes for Data in This Chapter

Data Series FRED Data Code

US consumer price index CPIAUCSL

Real GDP GDPC1

NBER recession dates (0=expansion, 1=recession) USREC

Ratio of manufacturers’ inventories to shipments AMTMIS

Total credit market debt owed by households HSTCMDODNS

Nominal GDP GDP

Real potential GDP GDPPOT

Gross domestic income GDI

Chile consumer price index CHLCPIALLMINMEI

Israel consumer price index ISRCPIALLMINMEI

U.S. federal deficit (percent of GDP) FYFSGDA188S

Spot oil price: West Texas Intermediate OILPRICE

Lessons of Chapter 22

1. Short-run fluctuations in output and inflation arise from shifts in either the dynamic

aggregate demand curve or the short-run aggregate supply curve.

A. A decrease in the central bank’s inflation target shifts the dynamic aggregate

demand to the left.

i. In the short run, this decreases both output and inflation.

ii. It creates a recessionary output gap, exerting additional downward

pressure on inflation.

iii. In the long run, inflation falls to the new target as output returns to

potential output.

B. A government expenditure increase shifts the dynamic aggregate demand

curve to the right.

i. In the short run, this increases both output and inflation.

ii. It creates an expansionary output gap, exerting additional upward

pressure on inflation.

iii. To keep inflation from rising, monetary policymakers shift their

reaction curve to the left, raising the real interest rate at every level of

inflation.

iv. Unless the central bank’s target inflation rate changes, the economy

eventually returns to its original long-run equilibrium point.

C. A negative supply shock shifts the short-run aggregate supply curve to the left.

i. In the short run, this decreases output and increases inflation.

ii. It creates a recessionary output gap that places downward pressure on

inflation.

iii. Unless the central bank’s target inflation rate changes, the economy

eventually returns to its original long-run equilibrium point.

2. Applying the dynamic aggregate demand—aggregate supply framework we see that

A. Stabilization policy is the use of monetary and fiscal policy tools to stabilize

output and inflation.

i. Monetary policy can be used to shift the dynamic aggregate demand

curve to offset changes in the quantity of aggregate output demanded.

In practice, lack of information and lags in the impact of policy

changes make this very difficult.

ii. Fiscal policy can shift the dynamic aggregate demand curve as well,

but it is difficult to do it in a timely way.

iii. A positive supply shock that lowers production costs and shifts the

short-run aggregate supply curve to the right, creates an opportunity

for policymakers to permanently lower inflation.

B. Better monetary policy is the most likely explanation for the increased

stability of the U.S. economy since the mid-1980s until 2007.

C. An increase in potential output shifts both the short- and long-run aggregate

supply curves to the right, driving output up and inflation down, as well as

creating an expansionary output gap.

D. Globalization has the same impact as an increase in potential output. In the

long run it raises output but inflation only changes if the central bank adjusts

its target.

E. It is difficult (but crucial) for monetary policymakers to distinguish a decline

in the quantity of aggregate output demanded from a fall in potential output.

F. When confronted with a shift in the short-run aggregate supply curve, central

bankers face a tradeoff between output and inflation volatility.