Transcript 33 - Long Island University

8
SHORT-RUN ECONOMIC FLUCTUATIONS
15
Aggregate Demand
and Aggregate
Supply
Short-Run Economic Fluctuations
• What causes short-run fluctuations in
economic activity?
• What, if anything, can the government do to
stop GDP from falling and unemployment from
rising?
• And if the government can’t stop the
occurrence of bad times, can it at least make
them less damaging in terms of duration and
severity?
Short-Run Economic Fluctuations
• Economic activity fluctuates from year to year.
• Real GDP increases in most years.
• On average over the past 50 years, real GDP in the
U.S. economy has grown by about 3.2 percent per
year—see chapter 10
• Real GDP per person has grown at the rate of about 2
percent per year—see chapter 12
• In some years normal growth does not occur,
causing a recession.
Short-Run Economic Fluctuations
• A recession is a period of declining real
incomes, and rising unemployment.
• A depression is a severe recession.
• An expansion is a period of increasing real
incomes, and falling unemployment.
FACTS
THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
1. Economic fluctuations are irregular and
unpredictable.
•
Fluctuations in the economy are often called the
business cycle.
2. Most macroeconomic variables fluctuate
together.
3. As output falls, unemployment rises.
Three Key Facts About Economic
Fluctuations
• Fact 1: Economic fluctuations are irregular and unpredictable
Economic fluctuations are irregular and
unpredictable
• Recessions start at the peak of a business cycle and
end at the trough.
• The length of a business cycle may be measured by
the time between one peak and the next or the time
between one trough and the next.
• The peaks and troughs of the US business cycle are officially
registered by the NBER.
• During 1945-2009, there have been 11 cycles in the US.
• The average recession lasted 11 months and the average
expansion lasted 59 months, thereby making the average
cycle roughly 70 months long.
THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
• Fact 2: Most macroeconomic variables
fluctuate together.
• When real GDP falls in a recession, so do many
other variables:
• personal income, corporate profits, consumption
spending, investment spending, industrial production,
retail sales, home sales, auto sales, etc.
• However, investment fluctuates a lot more than other
variables.
• Even though investment is about one-seventh of GDP, much of the fall
in GDP during recessions is due to the fall in investment spending.
Three Key Facts About Economic
Fluctuations
• Fact 2: Most macroeconomic variables fluctuate together -- business
investment is especially volatile
THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
• Fact 3: As output falls, unemployment rises.
• The unemployment rate never approaches zero;
instead it fluctuates around its natural rate of
about 5 percent.
Three Key Facts About Economic
Fluctuations
• Fact 3: As Output Falls, Unemployment Rises
THEORY
Aggregate Demand and Aggregate Supply
• Economists use the model of aggregate
demand and aggregate supply to explain shortrun fluctuations in economic activity around its
long-run trend.
Aggregate Demand and Aggregate
Supply
• Real GDP (Y)
• Ch. 5 Measuring a Nation’s Income
• The Price Level (P)
• GDP Deflator
• Ch. 5
• The CPI
• Ch 6 Measuring the Cost of Living
• The theory of aggregate demand and
aggregate supply is based on two theoretical
links between Y and P.
Aggregate Demand and Aggregate Supply
• The aggregate-demand curve shows the total
quantity of “Made in USA” goods and services
that everybody—households, firms, the
government, and foreigners—wants to buy at
each price level.
• The aggregate-supply curve shows the total
quantity of “Made in USA” goods and services
that US firms would like to produce and sell at
each price level.
Figure 2 Aggregate Demand and Aggregate Supply
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
AGGREGATE DEMAND
AGGREGATE DEMAND
• The aggregate demand for goods and services
has four components:
Aggregate Demand = C + I + G + NX
• Aggregate Supply = Y
• In equilibrium, supply = demand
• Therefore, in equilibrium
Y = C + I + G + NX
Figure 3 The Aggregate-Demand (AD) Curve is
downward sloping
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate Demand (AD)
C + I + G + NX
Y
Y2
2. . . . increases the quantity of
goods and services demanded.
Quantity of
Output
Bonus slide: why the demand curve for
ice cream can’t explain the AD curve
• The demand curve for an individual commodity is downward sloping
because of two effects:
• Substitution effect: when ice cream becomes cheaper people buy more
ice cream because they are switching from frozen yogurt (a substitute)
• Income effect: when price of ice cream falls and income is unchanged,
people feel richer and, therefore, buy more ice cream
• Review Chapter 4 The Market Forces of Supply and Demand
• But the AD curve can consider only changes in the overall price level.
If all prices decrease, there can be no substitution effect
• It is inconsistent to talk about changes in aggregate demand while
assuming unchanged income, because aggregate income must be
equal to aggregate demand. Therefore, the income effect can’t be
applied to the aggregate economy.
Why the Aggregate-Demand Curve Is Downward
Sloping: three reasons
• The Wealth Effect: a lower price level boosts
consumption spending by households
• The Interest-Rate Effect: a lower price level
boosts investment spending by businesses
• The Exchange-Rate Effect: a lower price level
boosts net exports
Why the Aggregate-Demand Curve Is Downward
Sloping: Wealth Effect
• P↓ causes the purchasing power of
consumers’ monetary wealth ↑
• This causes consumption ↑
• Besides, if a price decline is perceived to be
temporary it makes sense to buy what you need
now, while prices are still low
• C ↑ causes aggregate demand (C+I+G+NX) ↑
Bonus slide: Wealth Effect Controversy
• P↓ causes the real burden of the monetary debts
of debtors ↑
• This causes debtors’ consumption ↓
• Therefore, if the decrease in debtors’
consumption exceeds the increase in the
consumption of others, it is possible that C ↓
• Therefore, P↓ could cause aggregate demand
(C+I+G+NX) ↓
• For this reason, the economist Paul Krugman has
argued that the AD curve may be upward rising!
Why the Aggregate-Demand Curve Is Downward
Sloping: Interest Rate Effect
• P↓ causes nominal interest rate ↓
• See Ch. 16 for more on this.
• nominal interest rate ↓ encourages greater
investment spending by businesses (I ↑)
• I ↑ means aggregate demand (C+I+G+NX) ↑
Why the Aggregate-Demand Curve Is Downward
Sloping: Exchange-Rate Effect
• P↓ causes nominal interest rate ↓
• See Ch. 16 for more on this.
• Foreigners sell the dollars they had been holding in US
banks
• The value of the dollar ↓
• As a result, US goods become cheaper relative to
foreign goods.
• This makes U.S. net exports increase (NX ↑)
• NX↑ means aggregate demand (C+I+G+NX) ↑
Shifts in the Aggregate Demand
Curve
We have seen why the AD
curve is negatively sloped.
We know why aggregate
But what are the reasons
demand would increase
why the AD curve might
from Y1 to Y2 when the
shift? In other words, what
price level decreases from
are the reasons why
P1 to P2.
aggregate demand might
increase to Y2 even if the
price level stays put at P1?
Price
Level
P1
P2
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
Why the Aggregate-Demand Curve Might Shift
• Shifts arising from
• Consumption: consumer optimism, tax rates, prices
of assets (stocks, bonds, real estate)
• Investment: technological progress, business
confidence, tax rates, money supply
• Government Purchases
• Net Exports: foreign GDP, expectations about
exchange rates
P
Y
Table 1
The aggregate-demand curve: summary (a)
Why Does the Aggregate-Demand Curve Slope Downward?
1. The Wealth Effect: A lower price level increases real wealth, which
stimulates spending on consumption.
2. The Interest-Rate Effect: A lower price level reduces the interest rate, which
stimulates spending on investment.
3. The Exchange-Rate Effect: A lower price level causes the real exchange rate
to depreciate, which stimulates spending on net exports
Table 1
The aggregate-demand curve: summary (b)
Why Might the Aggregate-Demand Curve Shift?
1. Shifts Arising from Consumption: An event that makes consumers spend more at a
given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to
the right. An event that makes consumers spend less at a given price level (a tax hike, a
stock-market decline) shifts the aggregate-demand curve to the left.
2. Shifts Arising from Investment: An event that makes firms invest more at a given price
. level (optimism about the future, a fall in interest rates due to an increase in the money
supply) shifts the aggregate-demand curve to the right. An event that makes firms invest
less at a given price level (pessimism about the future, a rise in interest rates due to a
decrease in the money supply) shifts the aggregate-demand curve to the left.
3. Shifts Arising from Government Purchases: An increase in government purchases of
goods and services (greater spending on defense or highway construction) shifts the
aggregate-demand curve to the right. A decrease in government purchases on goods
and services (a cutback in defense or highway spending) shifts the aggregate-demand
curve to the left.
4. Shifts Arising from Net Exports: An event that raises spending on net exports at a
given price level (a boom overseas, speculation that causes an exchange-rate
depreciation) shifts the aggregate-demand curve to the right. An event that reduces
spending on net exports at a given price level (a recession overseas, speculation that
causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left
AGGREGATE SUPPLY
THE AGGREGATE-SUPPLY CURVE
• In the long run, the aggregate-supply (LRAS)
curve is vertical.
• In the short run, the aggregate-supply (SRAS)
curve is upward sloping.
THE AGGREGATE-SUPPLY CURVE: long
run
• An economy’s long-run output of goods and
services
• is also called the natural rate of output or potential
output or full-employment output
• See Chapter 7
• Long-run output depends on:
•
•
•
•
•
•
labor
physical capital
human capital
natural resources
Technology
Laws, government policies, and their enforcement
• The price level does not affect these variables in
the long run.
Figure 4 The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
Why the Long-Run Aggregate-Supply Curve
Might Shift
• Any change in the economy that alters the
natural rate of output will shift the long-run
aggregate-supply curve.
• Labor: population growth, immigration, natural
rate of unemployment
• Capital, physical or human
• Natural Resources: price of imported oil
P
• Technology
• Laws, government policies
Y
The Aggregate-Supply Curve Slopes Upward in
the Short Run
• In the short run, an increase in the overall level
of prices tends to raise the quantity of goods
and services supplied.
• A decrease in the level of prices tends to
reduce the quantity of goods and services
supplied.
• Why?
Figure 6 The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
Why the Aggregate-Supply Curve Slopes Upward
in the Short Run: three theories
• The Sticky-Wage Theory
• The Sticky-Price Theory
• The Misperceptions Theory
• But, they all reach the same conclusion:
Quantity
of output
supplied
=
Natural
rate of +
output
a✕
Actual
Expected
price − price
level
level
The Short Run Aggregate-Supply Curve
P
According to the SRAS formula, if
the overall price level is equal to
the expected price level (P = Pe),
then output supplied is equal to
the natural rate of output (Y = YN).
AS
140
Pe = 120
Also, if P > Pe, then Y > YN.
That is, the SRAS curve is upward rising.
Quantity
of output
supplied
=
Natural
rate of +
output
a✕
YN
Actual
Expected
price − price
level
level
Y = YN + a ✕ (P – Pe)
Y
The Short Run Aggregate-Supply Curve
We have just seen that if P↑ then Y↑.
AS1
P
AS2
That is, the SRAS curve is upward rising.
But the SRAS equation shows that
output supplied can increase (Y↑)
even when P is unchanged, as long
as Pe↓ or YN↑.
Pe1 = 120
Pe2 = 100
So, if either Pe↓ or YN↑, the AS
curve shifts down or to the right
Quantity
of output
supplied
=
Natural
rate of +
output
YN1
a✕
YN2
Actual
Expected
price − price
level
level
Y = YN + a ✕ (P – Pe)
Y
The Short Run Aggregate-Supply Curve
• To summarize, the SRAS
equation implies that
P
AS1
AS2
• The SRAS curve is upward
rising, and
• The SRAS curve shifts right if
• The expected price falls, or
• The natural rate of output
increases
Quantity
of output
supplied
=
Natural
rate of +
output
a✕
Y
Actual
Expected
price − price
level
level
Y = YN + a ✕ (P – Pe)
The Sticky-Wage Theory
• Suppose wages for 2010 were set in 2009
• These wage agreements were based on the
output prices that were expected to prevail in
2010
• Suppose actual prices in 2010 fall short of what
was expected
• Wages do not adjust immediately to the
unexpectedly low price level.
• An unexpectedly low price level and an unchanged
wage level makes employment and production
less profitable.
• This induces firms to reduce the quantity of goods
and services supplied.
Shape of the AS Curve: The StickyWage Theory
•
•
•
•
•
•
•
AS shows the aggregate supply curve for 2010
Back in 2009, workers and their bosses had
reached an agreement on wages for 2010
During the negotiations, they had all expected
that prices in 2010 would be Pe = 120
P
If the actual price level in 2010 (P) turns out to
be 120, the bosses’ expectations are fulfilled
and nobody gets fired.
140
So, output in 2010 is the full-employment
output, YN.
Pe = 120
Therefore, the green dot, which represents
the expected price level and the fullemployment output, must be on the AS curve
If the actual price level in 2010 (P) turns out to
be 140, production is more profitable than
was expected
•
•
•
because the prices are higher than expected and the
wages are unchanged at the previously agreed level
So, production increases beyond the fullemployment level (blue dot)
In other words, the AS curve is upward rising
AS
YN
Y
Shape of the AS Curve: The Sticky-Price Theory
• Prices of some goods and services adjust
sluggishly in response to changing economic
conditions
• An unexpected fall in the price level leaves some
firms with higher-than-desired prices.
• This depresses their sales, which induces these
firms to reduce the quantity of goods and services
they produce.
Shape of the AS Curve: The Sticky-Price
Theory
•
•
•
•
•
•
•
•
•
AS shows the aggregate supply curve for 2010
Back in 2009, businesses had expected that demand
would be strong in 2010 and prices would be Pe =
140
Menu costs make frequent price changes
impractical. E-type (O-type) firms set prices at the
beginning of even-numbered (odd-numbered)
P
months
If the actual price level in 2010 (P) turns out to be
140, the bosses’ expectations are fulfilled. Nobody Pe = 140
gets fired. So, output in 2010 is the natural rate of
output, YN.
Therefore, the green dot, which represents the
120
expected price level and the full-employment
output, must be on the AS curve
If demand falls sharply on Jan. 15, businesses must
reduce prices to keep their customers.
On Feb. 1, only E-type firms reduce their prices.
They keep their customers. They do not layoff any
employees.
But O-type firms cannot cut their prices. They lose
customers and layoff some employees
So, production decreases below the fullemployment level (blue dot)
•
•
I am assuming that firms do not produce products that are
perfectly substitutable
In other words, the AS curve is upward rising
AS
YN
Y
Shape of the AS Curve: The Misperceptions
Theory
• Changes in the overall price level temporarily
mislead suppliers about what is happening in
the markets in which they sell their output
• A lower price level causes misperceptions
about relative prices.
• These misperceptions induce suppliers to decrease
the quantity of goods and services supplied.
Shape of the AS Curve: The Misperceptions
Theory
• Suppose an overall decline in demand reduces all
prices
• A wheat farmer, however, sees only that wheat prices
have fallen and continues to believe that the prices of
the things that she buys (milk, shoes, clothes, etc.) are
unchanged at the level she had expected
• This makes work less attractive and the farmer
reduces her production of wheat.
• I am assuming that the wheat farmer knows only how to
produce wheat
• When this is repeated across the economy, both the
overall price level and total output fall
Shape of the AS Curve: The
Misperceptions Theory
•
•
•
•
•
•
•
•
AS shows the aggregate supply curve for 2010
Back in 2009, businesses had expected that
demand would be strong in 2010 and prices
would be Pe = 140
If the actual price level in 2010 (P) turns out to
P
be 140, the bosses’ expectations are fulfilled.
Nobody gets fired. So, output in 2010 is the
natural rate of output, YN.
Pe = 140
Therefore, the green dot, which represents
the expected price level and the full120
employment output, must be on the AS curve
If the prices fall unexpectedly in 2010 to 120, a
wheat farmer becomes aware of a fall in the
price of the wheat she sells, but may be
unaware that the prices of the stuff she buys
have also fallen
Disappointed, the wheat farmer chooses to
work less and produce less
So, production decreases below the fullemployment level (blue dot)
In other words, the AS curve is upward rising
AS
YN
Y
How the AS curve shifts
• AS1 shows the aggregate
supply curve for 2010
• We saw in previous slides that
the green dot, which
represents the expected price
level and the natural rate of
output, must be on the AS
curve
• If either Pe↓ or YN↑, the green
dot moves down or to the right
• When the green dot shifts, so
must the AS curve
AS1
P
AS2
Pe1 = 120
Pe2 = 100
YN1
YN2
Y
So, if either Pe↓ or YN↑, the AS
curve shifts down or to the right
The Short-Run Aggregate-Supply Curve Shifts to
the Right if:
• The natural rate of output
increases
• This happens when there is
an increase in:
Price Level
• Labor
• Physical Capital
• Human capital
• Natural Resources
• Technology.
• The Expected Price Level
decreases.
Quantity of Output
Table 2: The Short-Run AggregateSupply Curve: Summary
57
Table 2: The Short-Run AggregateSupply Curve: Summary
58
Long-run equilibrium, short-run equilibrium following a disturbance that
throws the economy off the long-run equilibrium, the readjustment to
the long-run equilibrium
RECESSIONS CAUSED BY DECREASES IN
AGGREGATE DEMAND
Figure 7 The Long-Run Equilibrium
Price
Level
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Equilibrium
price
Aggregate
demand
0
Natural rate
of output
Quantity of
Output
Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
If the shock to AD is temporary, it will
soon go back to AD1.
Y
But what if the shock to AD is
permanent?
Quantity of
Output
Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
If the shock to AD is
permanent, people will
realize that in the long run
the economy will end up at
C.
They will expect the price
level to fall to P3.
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
Quantity of
Output
Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
A
P
P2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
B
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
5. The government could also use
expansionary monetary/fiscal policies
to push AD back to AD1.
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
ECONOMIC FLUCTUATIONS: AD
• Contraction (leftward shift) in Aggregate
Demand
• In the short run,
• output decreases,
• the overall price level decreases, and
• the unemployment rate increases
• In the long run,
• the overall price level decreases,
• but output and the unemployment rate remain
unchanged at their long-run levels
Policy response to a fall in aggregate
demand
• If production and employment take too long to
return to their long-run levels, the government
could step in to hasten the process
• The government could push the aggregate
demand curve back where it was by:
• increasing the money supply (expansionary
monetary policy)
• Cutting taxes or increasing government spending
(expansionary fiscal policy)
Great Depression, recession of 2001, Great Recession of 2008
HISTORY
Two big shifts in aggregate demand:
Great Depression and World War II
• Early 1930s: large drop in real GDP
• The Great Depression
• Largest economic downturn in U.S. history
• From 1929 to 1933
• Real GDP fell by 27%
• Unemployment rose from 3 to 25%
• Price level fell by 22%
• Cause: decrease in aggregate demand
• Decline in money supply (by 28%)
• Decreasing: consumer spending, investment spending
68
Two big shifts in aggregate demand:
Great Depression and World War II
• Early 1940s: large increase in real GDP
• Economic boom
• World War II
• More resources to the military
• Government purchases increased
• Aggregate demand – increased 1939 - 1944
• Doubled the economy’s production of goods and
services
• 20% increase in the price level
• Unemployment fell from 17 to 1%
69
Figure 9
U.S. real GDP growth since 1900
Over the course of U.S. economic history, two fluctuations stand out as especially large. During
the early 1930s, the economy went through the Great Depression, when the production of
goods and services plummeted. During the early 1940s, the United States entered World War II,
and the economy experienced rapidly rising production. Both of these events are usually
explained by large shifts in aggregate demand.
70
The Recession of 2001
• 2001: Recession
• Unemployment rate
• December 2000: 3.9%
• August 2001: 4.9%
• June 2003: 6.3%
• January 2005: 5.2%
• Three events – decrease in aggregate demand
1.The end of dot-com bubble in stock market
• Stock prices fell (25%)
• Reduced consumer & investment spending
• Aggregate-demand curve - shifted to left
71
The recession of 2001
• Three events – decrease in aggregate demand
2. Terrorist attacks on September 11, 2001
• Stock market fell (12%) in one week
• Increased uncertainty about the future
• Aggregate-demand curve – shifted further to left
3. Series of corporate accounting scandals
• Enron and WorldCom
• Stock market fell
• Aggregate-demand curve – shifted further to left
72
The recession of 2001
• 2001: Recession
• Policymakers - quick to respond
• The Fed - expansionary monetary policy
• Interest rates fell; Federal funds rate fell
• Stimulated spending
• Congress
• Tax cut in 2001; Immediate tax rebate; Tax cut in 2003
• To stimulate consumer & investment spending
• Aggregate-demand curve – shifted to right
• Offset the three contractionary shocks
73
CRISIS OF 2008
Roots of the Crisis of 2008
• The crisis of 2008 may have been caused by the Fed’s
overreaction to the recession of 2001
• The Fed cut interest rates sharply kept them low for
too long
Roots of the Crisis of 2008
• Those low interest rates may have fueled a
‘bubble’ in home prices
The Recession of 2008–2009
• Developments in the mortgage market
• Easier for subprime borrowers to get loans
• Borrowers with a higher risk of default (income and
credit history)
• Securitization
• Process by which a financial institution (mortgage
originator) makes loan
• Then (investment bank) bundles them together
mortgage-backed securities
77
The Recession of 2008–2009
• Developments in the mortgage market
• Mortgage-backed securities
• Sold to other institutions, which may not have fully
appreciated the risks in these securities
• Other issues
• Inadequate regulation for these high-risk loans
• Misguided government policy
• Encouraged this high-risk lending
78
The Recession of 2008–2009
• 1995-2006
• Increase in housing demand
• Increase in housing prices
• More than doubled
• 2006-2009, housing prices fell 30%
• Substantial rise in mortgage defaults and home
foreclosures
• Financial institutions that owned mortgage-backed
securities
• Huge losses, stopped making loans
79
The Recession of 2008–2009
• Large contractionary shift in AD
• Real GDP fell sharply
• By 4% between the forth quarter of 2007 and the second
quarter of 2009
• Employment fell sharply
• Unemployment rate rose from 4.4% in May 2007 to
10.1% in October 2009
80
The Recession of 2008–2009
• Three policy actions - aimed in part at returning
AD to its previous level
• The Fed
• Cut its target for the federal funds rate
• From 5.25% in September 2007 to about zero in December 2008
• Started buying mortgage-backed securities and other
private loans
• In open-market operations
• Provided banks with additional funds
81
The Recession of 2008–2009
• Three policy actions
• October 2008, Wall Street bailout $700 billion
• For the Treasury to use to rescue the financial system
• To stem the financial crisis on Wall Street
• To make loans easier to obtain
• Equity injections into banks
• U.S. government – temporarily became a part owner of
these banks
82
The Recession of 2008–2009
• Three policy actions
• January 2009, President Barack Obama
• $787 billion stimulus bill, February 17, 2009
• To be spent over two years
• Economy
• Starting to recover from the economic downturn
• Real GDP - growing again
• Unemployment – 9.5% in June 2010
83
Crisis of 2008: housing bubble pops!
• This is where it all began
Crisis of 2008: the stock market tanked
• This reduced people’s wealth … which reduced
consumption … which reduced aggregate
demand
Crisis of 2008: consumption spending
tanked
• This was a major blow to aggregate demand
Crisis of 2008: consumption spending
began tanking early
• We got hit by the collapse of the housing prices
bubble … and by the collapse in share prices
Crisis of 2008: business investment
tanked
• This was a major blow to aggregate demand
• Businesses got scared way back in 2006!
Crisis of 2008: Real GDP fell sharply
• This was the worst recession since the Great
Depression
Crisis of 2008: Real GDP fell sharply
• Growth of real GDP turned negative
Crisis of 2008: unemployment spiked
• Demand had collapsed … so jobs disappeared
Crisis of 2008: prices actually fell
• … for a while
Crisis of 2008: no inflation
• We had deflation, for a while
Crisis of 2008: our net exports
improved
• This was a consequence of our falling incomes
• But this did not help aggregate demand all that
much
Crisis of 2008: government spending
rose
• This helped aggregate demand
Crisis of 2008: government spending
rose sharply as a percentage of GDP
• But it wasn’t enough
Crisis of 2008: government receipts
tanked
• Incomes fell … so tax payments fell too …
automatic stabilizers in action!
Crisis of 2008: fiscal policy stimulus
• The government went on a borrowing binge to
stimulate the economy
Crisis of 2008: fiscal policy stimulus
• The government went on a borrowing binge to
stimulate the economy
Crisis of 2008: monetary stimulus
• Real money supply kept rising at a slightly
faster than usual pace
Crisis of 2008: monetary stimulus
• The Federal Reserve did all it could
• But the Federal Funds Rate could not be
reduced below zero!
RECESSIONS CAUSED BY
DECREASES IN AGGREGATE SUPPLY
ECONOMIC FLUCTUATIONS: AS
• A leftward shift in Short-Run Aggregate Supply
• Output falls below the natural rate of employment
• Unemployment rises
Stagflation!
• The price level rises
• If the government does nothing, the SRAS will
shift back to where it was.
• The price level, total production and
unemployment will be unaffected in the long run.
Figure 10 An Adverse Shift in Aggregate Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
Y2
2. . . . causes output to fall . . .
Y
Quantity of
Output
Stagflation
• Adverse shifts in aggregate supply cause
stagflation—a period of recession and
inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand
cannot offset both of these adverse effects
simultaneously.
The Effects of a Shift in Aggregate Supply
• Policy Responses to Recession
• Policymakers may respond to a recession in one of
the following ways:
• Do nothing and wait for prices and wages to adjust.
• Take action to increase aggregate demand by using
(expansionary) monetary and fiscal policy.
Figure 11 Accommodating an Adverse Shift in
Aggregate Supply
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
aggregate
supply
P3
C
P2
3. . . . which P
causes the
price level
to rise
further . . .
0
A
4. . . . but keeps output
at its natural rate.
Natural rate
of output
Short-run
aggregate
supply, AS
AS2
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand,
AD
Quantity of
Output
Oil and the economy
• Economic fluctuations in the U.S. economy
• Since 1970
• Some: originated in the oil fields of the Middle East
• Some event - reduces the supply of crude oil
flowing from Middle East
• Price of oil - rises around the world
• Aggregate-supply curve – shifts left
• Stagflation
• Mid-1970s
• Late-1970s
Oil and the economy
• Some event – increases the supply of crude oil
from Middle East
• Price of oil decreases
• Aggregate-supply curve – shifts right
• Output – rapid growth
• Unemployment – falls
• Inflation rate – falls
Oil and the economy
• Recent years: World market for oil – not an
important source of economic fluctuations
• Conservation efforts
• Changes in technology
• 2008 - world oil prices – rising significantly
• Increased demand from a rapidly growing China
John Maynard Keynes (1883-1946)
• Our understanding of the
short-run behavior of the
economy grew out of
economists’ attempts to
understand why the Great
Depression happened
• Published in 1936,
Keynes’s The General
Theory of Employment,
Interest and Money laid
the foundations
TIME Cover, December 31, 1965
John Maynard Keynes (1883-1946)
• “The long run is a
misleading guide to
current affairs. In the long
run we are all dead.
Economists set themselves
too easy, too useless a
task if in tempestuous
seasons they can only tell
us when the storm is long
past, the ocean will be
flat.”
• A Tract on Monetary Reform
(1923)
Summary
• All societies experience short-run economic
fluctuations around long-run trends.
• These fluctuations are irregular and largely
unpredictable.
• When recessions occur, real GDP and other
measures of income, spending, and production
fall, and unemployment rises.
Summary
• Economists analyze short-run economic
fluctuations using the aggregate demand and
aggregate supply model.
• According to the model of aggregate demand
and aggregate supply, the output of goods and
services and the overall level of prices adjust to
balance aggregate demand and aggregate
supply.
Summary
• The aggregate-demand curve slopes downward
for three reasons: a wealth effect, an interest
rate effect, and an exchange rate effect.
• Any event or policy that changes consumption,
investment, government purchases, or net
exports at a given price level will shift the
aggregate-demand curve.
Summary
• In the long run, the aggregate supply curve is
vertical.
• The short-run, the aggregate supply curve is
upward sloping.
• The are three theories explaining the upward
slope of short-run aggregate supply: the
misperceptions theory, the sticky-wage theory,
and the sticky-price theory.
Summary
• Events that alter the economy’s ability to
produce output will shift the short-run
aggregate-supply curve.
• Also, the position of the short-run aggregatesupply curve depends on the expected price
level.
• One possible cause of economic fluctuations is
a shift in aggregate demand.
Summary
• A second possible cause of economic
fluctuations is a shift in aggregate supply.
• Stagflation is a period of falling output and
rising prices.