Lecture 10 - AD-AS Model

Final Exam Prep

Final starts from the "Money and Inflation" lecture.

The final will be predominantly multiple choice, less analysis.

Boom Cycle

See AD-AS Diagram on page 12 of packet.

How does a stock/housing boom cycle work?

Initially, we're at equilibrium (point 1). When a boom occurs, C and I go up, leading to a rightward/upward shift in AD. In the short run, you end up at point 2 and you have an inflationary gap. We have close to full employment (or at least the lower theoretical unemployment, considering that some ppl are always out of work).

At point 2, Y is greater than Ybar (expected output). There may even be unemployment less than the "natural" minimum, U^N. The labor market tightens and labor demand goes up, leading to upward pressures on wages (which are 70% of cost of production), leading to increased cost of production.

Over time, more and more firms raise their prices and the SRAS curve shifts upward. And we end up at equilibrium point 3: output is lower and prices are higher. But there still may be an inflationary gap. The SRAS curve should continue moving upward until it eliminates the gap at point 5 (where did point 4 go?).

At this point you're at full employment level. No extra workers. In the absent of any monetary of fiscal policy intervention, you just end up with higher prices and no other changes. :( This is the wage and price spiral. Policy tries to push the AD curve down buy other mechanisms.

This is illustrated in the diagram on page 14 of the packet.

Recession Cycle

Take the case of Japan: 1992-

They had full level of employment in the 1990s. Before 1990, there was an asset price bubble. At the height of the bubble, a commonly-quoted claim was that the land beneath the Imperial Palace in Tokyo was worth more than the entire state of California.Between 1990 and 1992, there was a massive asset price collapse. The Nikkei 225 (like S&P 500) dropped from almost 40,000 to 20,000.

(i) Balance-sheet channel. This led to bankruptcies of households and firms. There was no longer appetite for consumption or investment. C down, I down.
(ii) Bank-lending channel. Led to loan losses, banks went bankrupt and were acquired by the government. They were nationalized. Credit to households and firms were severely reduced. It became very difficult to borrow from banks. Consumption and investment (C and I) both went down.
(iii) Deflationary effects. If prices are going down, people will postpone purchases, thereby pushing down consumption and investment. (C and I down).

Due to all these channels, the AD went down, creating a recessionary gap. Deflation doesn't necessary result in lower prices, but it could be that prices are growing less quickly.

This results in U greater than U^N and then downward pressure on wages, lower cost of production. SRAS curve shifts downward and over time, lower prices. A new equilibrium at point 3, yet still Y is less than Ybar until over time, firms cut prices and SRAS meets LRAS and AD. Eventually, the economy returns to potential GDP, yet prices are now permanently lower.

The Japenese tried to push the AD back up through policy, but it didn't work. Bernanke is trying to do that now in the US also.

Supply shocks

A supply shock to aggregate supply is a shock to the economy that alters the cost of production and as a result the prices that firms charge.

(1) Positive supply shock (would shift SRAS to the right)
Ex: Productivity gains from new technology such as IT revolution.

(2) Negative supply shock (would shift SRAS to the left)
Examples:
Drought that destroy crops
New environmental protection law
Labor strike, increased wages
Oil price shocks

Consider adverse supply shocks (ex: oil price shock) - SRAS curve shifts upward. The result is higher prices and lower output (P up, Y down). This is called stagflation.

Fed options:
(i) Do nothing. Go through the recession until prices return to P1 and Y returns to Ybar.
(ii) Push the AD outward with monetary expansion. But this comes at the cost of higher prices. But this restores the output back to Ybar more quickly.

Which is worse - unemployment (recession) or inflation?

Fiscal Policy

2008 Tax Rebate and Oil Price Effects on the US in the Near Term

2008 Tax Rebate = $110 bln (compared to $38 blin on 2001 tax rebates)

1975 and 2001 tax rebates: 12-25% and 22% were spent in the first quarter (Poterba 1988 AER; Shapiro-Slemrod 2003 AER)

Thus, 20% of rebates are spent. C rises by $22 bln = 0.8% quarterly = 3.2% annually
C is 70% of GDP, so Y rises by 2.2%

Rising oil price acts as a tax on consumers (trnasfer income to oil producers). US import of oil per year = 4.5 bln barrels.
Oil prices rose by 40% in 2008. Oil "tax" = $180 blin a year (greater than tax rebates!)

Income effects of tax rebates will be larger in shorter period, but high oil prices (if this oil tax remains) will reduce income and consumption in near term, dragging the economic recovery in the near term.