Economics

THIRD EDITION

By John B. Taylor

Stanford University

Copyright © 2001 by H

1

Chapter 24 (Macro 11)

The Economic

Fluctuations Model

Copyright © 2001 by H

2

Overview

• The main purpose of this chapter is to

provide an explanation of the dynamics of

economic fluctuations, particularly inflation

and real GDP. The economic fluctuations

model is constructed by first deriving the

aggregate demand/inflation curve and then

the price adjustment line. The model can be

used to study the determination of real GDP

and the price level.

Copyright © 2001 by H

3

Teaching Objectives

1. Explain that a basic set of factors causes

real GDP to depart and return to potential

over the business cycle.

2. Introduce interest rates and inflation into

the dynamics of the business cycle.

3. Describe the important role that policy

can play in altering the course of business

cycles. This is done through a policy rule

that relates interest rates to aggregate

expenditure.

Copyright © 2001 by H

4

Teaching Objectives

4. Explain the primary factors that determine

location of the ADI curve. This occurs through the

components of aggregate spending that are

sensitive to interest rates (spending balance) and

the policy rule.

5. Explain the factors that shift the ADI curve:

Changes of the policy rule and changes in

government spending, along with autonomous

shocks to aggregate spending, determine the

location of the ADI curve.

Copyright © 2001 by H

5

Teaching Objectives

• 6. Introduce the microeconomic basis of price

adjustment.

7. Explain the PA line and the factors that cause it

to shift.

8. Explain how the intersection of the ADI curve

and the PA line determines the level of equilibrium

real GDP and the inflation rate at some point in

time in the economy.

Copyright © 2001 by H

6

Key Terms

•

•

•

•

•

aggregate demand/inflation ( ADI ) curve

target inflation rate

monetary policy rule

price adjustment ( PA ) line

federal funds rate

Copyright © 2001 by H

7

1. The Aggregate Demand/Inflation Curve

• The ADI curve shows that there is an

inverse (negative) relationship between

inflation changes and the corresponding

changes in real GDP.

• When inflation increases, real GDP

declines.

• When inflation slows down, real GDP goes

up.

• Real GDP = C + I + G + X = AE

Copyright © 2001 by H

8

Figure 24.1

(Macro 11)

The Aggregate

Demand Curve

Copyright © 2001 by H

9

Between Inflation Interest Rate and Real GDP

Copyright © 2001 by H

10

Showing Relation of

Interest Rate to

Investment

Copyright © 2001 by H

11

STAGE I: Interest rate and Investment

• As real (inflation-adjusted) interest rate

goes up, cost of borrowing goes up, so that

business investment (buying a new machine

or extending business) and housing

investment declines.

• As real interest rate declines, investment

goes up, because the cost of investment

declines

Copyright © 2001 by H

12

Showing Relation of

Interest Rate to Net

Exports

Copyright © 2001 by H

13

Interest Rate and Net Exports

• If US interest rates increase, it becomes

more attractive to invest in the US,

compared to other countries such as Canada

or Mexico, our top trading partners.

• This raises the demand for US dollars and

appreciates the US dollar against other

currencies like Canadian $s or Mexican

pesos.

• This hurts our exports but raises our

imports.

Copyright © 2001 by H

14

Interest Rate and Consumption Expenditures

• Evidence indicates that consumption is less

sensitive to interest rate changes than

investment and net exports

• In general, higher interest rates encourage

people to save more (consume less),

indicating an inverse relationship between

interest rates and consumption

• Figure 24.2 shows the net impact.

Copyright © 2001 by H

15

Figure 24.2

(Macro 11)

The Interest Rate, Spending Balance, and Real GDP

Copyright © 2001 by H

16

STAGE II: Interest Rates and Inflation

• So far we have seen how real interest rates

affect real GDP.

• Now we want to study how inflation affects

interest rates.

• Real interest rate = nominal interest rates

minus expected inflation rate

• Note that it is the real interest rate that we

use to decide about our spending plans

Copyright © 2001 by H

17

Central Banks and Inflation

• When inflation increases (declines), the Fed

raises (lowers) the nominal interest rates.

This is called the “policy rule”

• Higher inflation signals a rise in aggregate

expenditures. Central banks raise nominal

interest rates more than the inflation rate, so

that the real interest rate increases.

• Higher real interest rates lower AE and

slows down inflation

Copyright © 2001 by H

18

Figure 24.3

(Macro 11)

A Monetary Policy Rule

Copyright © 2001 by H

19

Monetary Policy Rule

• The monetary policy rule in Figure 24.3

shows that central banks raise the interest

rate when inflation rises and lower it when

inflation declines.

• The dashed line has a slope of 1. Monetary

policy rule has a bigger slope: Nominal

interest rate is increased by more than

inflation, so that the real interest changes.

• Note that AE decisions depend on “real”

rate.

Copyright © 2001 by H

20

STAGE 3: Deriving AD curve

• When inflation increases, two things happen:

(1) Central banks raise the nominal interest rate

more than inflation, raising the real interest rate

(2) The higher real interest rate will decrease

real GDP because of lower AE

• Just the opposite happens when inflation

decreases

• Thus, AD curve shows a negative link between

real interest rates and real GDP

Copyright © 2001 by H

21

Figure 24.4

(Macro 11)

A Self-Guided

Graphical Overview

Copyright © 2001 by H

22

Movements along the AD curve

• A change in inflation causes a movement

along the demand curve

• When inflation rises and the Fed raises the

interest rate and real GDP declines. This

causes a movement up and to the left along

the AD curve.

• When inflation decreases, there is a

movement down and to the right.

Copyright © 2001 by H

23

Shifts of the AD curve

• Besides inflation, other things affects

aggregate demand.

• When such non-inflation determinants of

AD curve changes, we say that there is a

“shift” in the AD curve.

• Changes in government purchases, shifts in

monetary policy, changes in taxes, shifts in

demand for next exports, changes consumer

confidence, among others, affect AD.

Copyright © 2001 by H

24

Figure 24.5

(Macro 11) How

Government

Purchases Shift the

Aggregate Demand

Curve

Copyright © 2001 by H

25

THIRD EDITION

By John B. Taylor

Stanford University

Copyright © 2001 by H

1

Chapter 24 (Macro 11)

The Economic

Fluctuations Model

Copyright © 2001 by H

2

Overview

• The main purpose of this chapter is to

provide an explanation of the dynamics of

economic fluctuations, particularly inflation

and real GDP. The economic fluctuations

model is constructed by first deriving the

aggregate demand/inflation curve and then

the price adjustment line. The model can be

used to study the determination of real GDP

and the price level.

Copyright © 2001 by H

3

Teaching Objectives

1. Explain that a basic set of factors causes

real GDP to depart and return to potential

over the business cycle.

2. Introduce interest rates and inflation into

the dynamics of the business cycle.

3. Describe the important role that policy

can play in altering the course of business

cycles. This is done through a policy rule

that relates interest rates to aggregate

expenditure.

Copyright © 2001 by H

4

Teaching Objectives

4. Explain the primary factors that determine

location of the ADI curve. This occurs through the

components of aggregate spending that are

sensitive to interest rates (spending balance) and

the policy rule.

5. Explain the factors that shift the ADI curve:

Changes of the policy rule and changes in

government spending, along with autonomous

shocks to aggregate spending, determine the

location of the ADI curve.

Copyright © 2001 by H

5

Teaching Objectives

• 6. Introduce the microeconomic basis of price

adjustment.

7. Explain the PA line and the factors that cause it

to shift.

8. Explain how the intersection of the ADI curve

and the PA line determines the level of equilibrium

real GDP and the inflation rate at some point in

time in the economy.

Copyright © 2001 by H

6

Key Terms

•

•

•

•

•

aggregate demand/inflation ( ADI ) curve

target inflation rate

monetary policy rule

price adjustment ( PA ) line

federal funds rate

Copyright © 2001 by H

7

1. The Aggregate Demand/Inflation Curve

• The ADI curve shows that there is an

inverse (negative) relationship between

inflation changes and the corresponding

changes in real GDP.

• When inflation increases, real GDP

declines.

• When inflation slows down, real GDP goes

up.

• Real GDP = C + I + G + X = AE

Copyright © 2001 by H

8

Figure 24.1

(Macro 11)

The Aggregate

Demand Curve

Copyright © 2001 by H

9

Between Inflation Interest Rate and Real GDP

Copyright © 2001 by H

10

Showing Relation of

Interest Rate to

Investment

Copyright © 2001 by H

11

STAGE I: Interest rate and Investment

• As real (inflation-adjusted) interest rate

goes up, cost of borrowing goes up, so that

business investment (buying a new machine

or extending business) and housing

investment declines.

• As real interest rate declines, investment

goes up, because the cost of investment

declines

Copyright © 2001 by H

12

Showing Relation of

Interest Rate to Net

Exports

Copyright © 2001 by H

13

Interest Rate and Net Exports

• If US interest rates increase, it becomes

more attractive to invest in the US,

compared to other countries such as Canada

or Mexico, our top trading partners.

• This raises the demand for US dollars and

appreciates the US dollar against other

currencies like Canadian $s or Mexican

pesos.

• This hurts our exports but raises our

imports.

Copyright © 2001 by H

14

Interest Rate and Consumption Expenditures

• Evidence indicates that consumption is less

sensitive to interest rate changes than

investment and net exports

• In general, higher interest rates encourage

people to save more (consume less),

indicating an inverse relationship between

interest rates and consumption

• Figure 24.2 shows the net impact.

Copyright © 2001 by H

15

Figure 24.2

(Macro 11)

The Interest Rate, Spending Balance, and Real GDP

Copyright © 2001 by H

16

STAGE II: Interest Rates and Inflation

• So far we have seen how real interest rates

affect real GDP.

• Now we want to study how inflation affects

interest rates.

• Real interest rate = nominal interest rates

minus expected inflation rate

• Note that it is the real interest rate that we

use to decide about our spending plans

Copyright © 2001 by H

17

Central Banks and Inflation

• When inflation increases (declines), the Fed

raises (lowers) the nominal interest rates.

This is called the “policy rule”

• Higher inflation signals a rise in aggregate

expenditures. Central banks raise nominal

interest rates more than the inflation rate, so

that the real interest rate increases.

• Higher real interest rates lower AE and

slows down inflation

Copyright © 2001 by H

18

Figure 24.3

(Macro 11)

A Monetary Policy Rule

Copyright © 2001 by H

19

Monetary Policy Rule

• The monetary policy rule in Figure 24.3

shows that central banks raise the interest

rate when inflation rises and lower it when

inflation declines.

• The dashed line has a slope of 1. Monetary

policy rule has a bigger slope: Nominal

interest rate is increased by more than

inflation, so that the real interest changes.

• Note that AE decisions depend on “real”

rate.

Copyright © 2001 by H

20

STAGE 3: Deriving AD curve

• When inflation increases, two things happen:

(1) Central banks raise the nominal interest rate

more than inflation, raising the real interest rate

(2) The higher real interest rate will decrease

real GDP because of lower AE

• Just the opposite happens when inflation

decreases

• Thus, AD curve shows a negative link between

real interest rates and real GDP

Copyright © 2001 by H

21

Figure 24.4

(Macro 11)

A Self-Guided

Graphical Overview

Copyright © 2001 by H

22

Movements along the AD curve

• A change in inflation causes a movement

along the demand curve

• When inflation rises and the Fed raises the

interest rate and real GDP declines. This

causes a movement up and to the left along

the AD curve.

• When inflation decreases, there is a

movement down and to the right.

Copyright © 2001 by H

23

Shifts of the AD curve

• Besides inflation, other things affects

aggregate demand.

• When such non-inflation determinants of

AD curve changes, we say that there is a

“shift” in the AD curve.

• Changes in government purchases, shifts in

monetary policy, changes in taxes, shifts in

demand for next exports, changes consumer

confidence, among others, affect AD.

Copyright © 2001 by H

24

Figure 24.5

(Macro 11) How

Government

Purchases Shift the

Aggregate Demand

Curve

Copyright © 2001 by H

25

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