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Macroeconomics 33040 - Spring 2015Topic 2: Basic Macro Model: Where We Are Headed

Loukas Karabarbounis

University of Chicago, Booth School of Business

1 Preview: Aggregate Demand and Aggregate Supply

2 Interpreting Business Cycles

3 Summary and Readings

Disclaimer

The purpose of Topic 2 is to give a broad overview of where we areeventually headed. As macroeconomic knowledge in this course is atruly cumulative process, a prior perspective of what is our ultimategoal can be very motivating.

A key goal of this course is to understand the causes andconsequences of business cycles. At least half of the course isabout business cycles.

The main tool we will use to analyze business cycles is calledaggregate demand and aggregate supply (AD/AS) analysis.

You are not required to understand now where the AD and the AScome from. We will spend the next 8 weeks understanding whatdeeper macro forces lead to the AD and the AS.

I do expect you, however, to understand what is an AD shock andwhat is an AS shock and what these imply for GDP and inflation.

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Aggregate Demand (AD)

Definition

Aggregate Demand (AD): is a negative relationship between theinflation rate of goods and services pi and the goods and servicesC + I + G + NX demanded by households, firms, government, andforeigners.

Here, the standard micro intuition that as prices go up, people canafford to buy less goods and services is not correct.

The reason is that pi refers to the general price index and not tothe price of apples relative to oranges (substitution effect).

The intuition behind the AD is that lower inflation causes the Fedto lower real interest rates which stimulates aggregate demand.

More on all these later...

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Aggregate Supply (AS)

Definition

Aggregate Supply (AS): is the relationship between the inflation rateof goods and services pi and the goods and services Y produced by firms.

1 LRAS (Long-Run AS): vertical at potential output Y

Y determined by technology, capital, labor supply factors, and pricesof inputs outside the model (e.g. oil prices)

2 SRAS (Short-Run AS): horizontal/upward sloping at a given pointof time and shifts gradually over time

Short-run: there are frictions (e.g. costs) to changing output pricesor nominal wages

Shifts over time (gradually) in the SRAS:

SRAS shifts up when people expect inflation to increase in the future

SRAS shifts down when people expect inflation to decrease in thefuture

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Equilibrium in the AD/AS Framework

YSupply

= C + I + G + (X M) Demand

1 Short-Run (SR) Equilibrium: AD = SRAS

what is produced equals what is purchased (supply equals demand)

2 Long-Run (LR) Equilibrium: AD = SRAS = LRAS

what is produced equals what is purchased (supply equals demand)

what is produced equals what is feasible in the long-run (i.e. afterprices and wages have adjusted fully)

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Short Run (SR) Equilibrium

SRAS

AD

Y

0

0Y

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Aggregate Demand (AD) Shocks

Start from initial equilibrium where AD0 intersects SRAS0.

Consider a permanent negative demand shock (e.g. consumersbecome pessimistic about the future and decrease their spending).

This shock shifts the AD curve from AD0 to AD1.

The SRAS does not shift (under some conditions ... more later).

The new short run equilibrium is given by the intersection of AD1with SRAS0.

As we move along the SRAS curve, the economy experienceslower output Y and lower inflation pi.

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Aggregate Demand Shocks: Initial SR Equilibrium

SRAS0

AD0

Y

0

0Y

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Aggregate Demand Shocks: New SR Equilibrium

SRAS0

AD0

Y

0

0Y

1

1Y

AD1

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Aggregate Supply (AS) Shocks

Start from initial equilibrium where AD0 intersects SRAS0.

Consider a permanent negative supply shock (e.g. OPEC decidesto increase the price of oil).

This shock shifts the SRAS curve from SRAS0 to SRAS1.

The AD does not shift (under some conditions ... more later).

The new short run equilibrium is given by the intersection of AD0with SRAS1.

As we move along the AD curve, the economy experiences loweroutput Y and higher inflation pi.

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Aggregate Supply Shocks: Initial SR Equilibrium

SRAS0

AD0

Y

0

0Y

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Aggregate Supply Shocks: New SR Equilibrium

SRAS0

AD0

Y

0

0Y

1

1Y

SRAS1

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Aggregate Demand vs. Aggregate Supply Shocks

1 Aggregate Demand shocks

we observe a positive relationship between Y and pi

that is, either Y and pi are both low (when AD shocks are negative)or Y and pi are both high (when AD shocks are positive)

2 Aggregate Supply shocks

we observe a negative relationship between Y and pi

that is, either Y is low and pi is high (when AS shocks are negative)or Y is high and pi is low (when AS shocks are positive)

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Recent US Business Cycles: GDP and Inflation

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

1970 1980 1990 2000 2010

ShadedareasindicateUSrecessions-2015research.stlouisfed.org

RealGrossDomesticProduct,3DecimalGrossDomesticProduct:ImplicitPriceDeflator

(Perc

entC

hang

efrom

YearAgo

)

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Recent Recessions in the US

Recession Dates Recession Length Inflation

12/1969 11/1970 11 months Moderate Increasing

11/1973 03/1975 16 months High Increasing

01/1980 07/1980 6 months High Increasing

07/1981 11/1982 16 months High Decreasing

07/1990 03/1991 8 months Low Decreasing



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Interpretation of US Business Cycles

Business Cycles Inflation Story

Great Depression

1929-1933

Decreasing inflation

Demand shock

Consumption shock (stock

market)

Feds deflationary policies

1970s recessions Fast increasing inflation

Supply Shock

Increasing oil prices

1981-1982 recession Fast decreasing inflation

Demand shock

Feds new inflation policy

(Volckers disinflation)

1990-1991 recession Stable/decreasing inflation

Demand shock

Consumers confidence

(uncertainty of Iraq war)

1990s growth Stable/decreasing inflation

Supply shock

IT revolution and productivity

growth

2001 recession Stable/decreasing inflation

Demand shock

Investment (stock market and

inventories)

Great recession

2007-2009

(Online Readings 2.1-2.4)

Decreasing inflation

Demand shock

Low interest rates + unregulated

financial innovation

Housing bubble burst

Credit crunch

Consumers confidence

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What Have We Learned?

How to use the AD/AS framework to interpret business cycles.

That both aggregate demand and aggregate supply shocks areimportant in explaining US business cycles.

Plausible demand shocks that led to the Great Recession of2007-2009.

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Readings

1 ABC: Chapter 8.4.

2 Online Readings Topic 2.

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Preview: Aggregate Demand and Aggregate SupplyInterpreting Business CyclesSummary and Readings

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