Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Understanding Business Cycle Fluctuations Copyright ©...

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Understanding Business Cycle Fluctuations

Chapter Twenty-Two

Introduction

• While the economy can and does move away from long-run equilibrium, it has a natural self-correcting mechanism.• It returns it to the point where resources are being

used at their normal rates and

• Gaps between current and potential output disappear.

Introduction

• Why is it that output and inflation vary from quarter to quarter and year to year?

• What determines the extent of the fluctuations?• Figure 22.1 illustrates the long-run trends in

the U.S. inflation rate over the past 50 years.• It also displays a series of shaded bars

representing recessions.

Introduction

• While there is no apparent relationship between the level of inflation and these recessions, it does appear that the inflation rate:• Falls when the economy is contracting.

• Rises when it is expanding.

• At least that is what happens most of the time.• But in general there appears to be a connection

between growth and changes in inflation.

Introduction

• In recent years, the frequency of recessions has fallen.• Recessions used to occur once every five years.

• Now they occur on average about every eight years.

• This reduction in the volatility of real growth has been called the “Great Moderation.”

Introduction

• In this chapter we will:• Catalogue the various reasons that the dynamic

aggregate demand curve and the aggregate supply curve shift.

• Examine what happens during the transition as the economy moves to long-run equilibrium.

• Use the model to understand how central bankers work to achieve their stabilization objectives.

Introduction

• We will also examine: • How policymakers work to achieve their

stabilization goals;

• The appropriate actions to take when potential output changes; and

• The difficulty central bankers have figuring out why output has fallen.

Sources of Fluctuations in Output and Inflation

• Remember that long-run equilibrium means:1. Y = YP output = potential output.

2. = T inflation = target inflation.

3. = e inflation = expected inflation.

• Short-run equilibrium means:• The dynamic aggregate demand curve (AD) and

the short-run aggregate supply (SRAS) curve cross.

• Immediately after either the SRAS curve or AD curve shift, the economy will move away from its long-run equilibrium.

• Understanding short-run fluctuations in output and inflation requires that we study shifts in AD and SRAS.

• In this chapter we will be looking at shocks.• Economists define shocks as something

unexpected, for example, an increase in oil prices or change in consumer confidence.

• A shock shifts the AD or SRAS curve.• Because it affects costs of production, the oil price

increase is a supply shock.

• A change in consumer confidence affects consumption expenditure so it is a demand shock.

Shifts in the Dynamic Aggregate Demand Curve• Recall that a shift in the AD curve can be cause

by either:• A shift in the monetary policy reaction curve or

• A change in components that are not sensitive to the interest rate that shifts aggregate expenditure, for example, government spending.

A Decline in the Central Bank’s Inflation Target

• Over the past several decades, numerous countries have succeeded in reducing their inflation rates from fairly high levels to the modest ones we see today.

• All of these changes involved permanent declines in inflation that must have been a result of a decrease in the central bank’s inflation target.

• To analyze this, we begin with the monetary policy reaction curve.

• A fall in T shifts the monetary policy reaction curve to the left.• The decrease in the inflation target raises the real

interest rate policymakers set at each level of inflation.

• This reduces aggregate expenditure shifting the AD curve to the left as well.

• The economy moves to a new short-run equilibrium.

• The new short-run equilibrium at 2 has inflation and current output lower than they were prior to the monetary policy tightening.

• This creates a recessionary gap: Y < YP.• There is now downward pressure on

production costs.• This shifts SRAS to the right.

• The new long-run equilibrium at 3 is where inflation equals the central bank’s new target and output equals potential output.

An Increase in Government Purchases

• What are the macroeconomic implications of a large expansionary move in fiscal policy?

• An increase in G shifts the AD curve to the right.

• The economy moves from the original short-run equilibrium point 1 to a new short-run equilibrium point 2.• The immediate impact is to raise both current

output and inflation.

• Because potential output has not changed, this is not the long-run effect.

• The higher level of current output means that there is an expansionary gap: Y > YP.• Firms increase both their product prices and wages

more than they would at normal output.

• This shifts the SRAS curve to the left, driving inflation even higher.

• As inflation increases, monetary policymakers raise the real interest rate, moving the economy along the AD curve.• Output begins to fall back toward its long-run

equilibrium level, potential output.

• The economy settles at point 3.• Note, however, that inflation is higher at 3 than

it was at 1.• This is above the policymakers’ original

inflation target, T.

• So long as monetary policymakers remain committed to their original inflation target, they need to do something to get the economy back to the point where it began.

• In this case, tighter monetary policy shifts the AD curve to the left.• This brings the economy back to the long-run

equilibrium where output equals potential output and inflation equals the central bank’s target.

• Without a change in target inflation, an increase in government purchases causes a temporary increase in both output and inflation.

A Decline in Aggregate Expenditure

• A decline in aggregate expenditure has the opposite effect of an increase in government spending.

• The AD curve shifts to the left, driving output down.

• A decline in aggregate expenditure causes a temporary decline in both output and inflation.

• In the absence of any monetary policy response, the recessionary output gap causes the SRAS curve to shift to the right.

A Decline in Aggregate Expenditure

• The shift in the SRAS curve drives inflation down future and current output begins to rise toward potential.

• If policymakers do not react, inflation and output will return to their original long-run levels.

Shifts in the Dynamic Aggregate Demand Curve -

Examples• In response to increases in government

spending during the escalation of the Vietnam War in the late 1960s,• The Fed simply allowed inflation to rise.

• What could have been a temporary increase in inflation became a permanent one.

Shifts in the Dynamic Aggregate Demand Curve• Large tax cuts in 2001 and rise in defense

spending associated with the war in Iraq did not have the same impact at in the 1960s.• The fiscal stimulus came at a time when the

economy was weakening for other reasons.

• The Fed had learned the important lesson that it may need to raise interest rates to counter the risk of inflation from expansionary fiscal policy.

Summary of Impact of Increase in Dynamic Aggregate Demand

Shifts in Short-Run Aggregate Supply

• Changes in production costs shift the SRAS curve.

• What are the effects of an increase in the costs of production - a negative supply shock?• Ex: Increase in price of oil.

• Immediately the SRAS curve shifts left.• These are bad consequences: higher inflation and

lower growth

• The short-run equilibrium moves to point 2 where the new SRAS curve meets AD.

• This creates a condition referred to as stagflation.• Economic stagnation coupled with increased

inflation.

• The recessionary gap puts downward pressure on production costs and inflation.

• As a result of the recessionary gap, the SRAS curve begins to shift right.

• This drives inflation down and output up.• This continues until the economy returns to

potential output and the central bank’s target inflation level.

• As with an increase in government purchases, a supply shock has no effect on the economy’s long-run equilibrium point.

• A supply shock causes inflation to rise temporarily and then fall.• This happens at the same time that current output

falls temporarily and then rises.

• In the long run, the economy returns to the point where output equals potential output and inflation equals the central bank’s target.

1. A recession is a decline in activity, not just a dip in growth rate.

2. Exact length is ambiguous.

3. Dating the peaks and troughs involves judgment.

• Table 22.3 displays the results of the NBER’s analyses of the business cycle since the end of WWII.

• Recessions differ along several dimensions: depth, duration, and diffusion.

Using the Aggregate Demand-Aggregate Supply

FrameworkWe examine the following:

1. How do policymakers achieve their stabilization objectives?

2. What accounts for the “Great Moderation”?

3. What happens when potential output changes?

4. What are the implications of globalization for monetary policy?

5. Can policymakers distinguish a recessionary gap from a fall in potential output?

6. Can policymakers stabilize output and inflation simultaneously?

How Do Policymakers Achieve Their Stabilization

Objectives?• The aggregate demand-aggregate supply

framework is useful in understanding how monetary and fiscal policymakers seek to stabilize output and inflation using stabilization policy.

• When shifting their reaction curve, central bankers shift AD.• They cannot shift the SRAS curve.

• This means monetary policymakers can neutralize demand shocks, but cannot offset supply shocks.

Objectives?• Nevertheless, positive supply shocks that raise

output and lower inflation provide policymakers with an opportunity.• Following a positive supply shock, central bankers

can guide the economy to a new, lower inflation target without inducing a recessionary output gap.

Objectives?• As for fiscal policy, our macroeconomic

framework allows us to study the impact of changes in government taxes and expenditures as well.

• The active use of fiscal policy faces great challenges.

• The conclusion is that stabilization policy is usually best left to central bankers.

Monetary Policy

• What happens if consumers and businesses suddenly become more pessimistic about the future?

• This shifts the AD curve to the left.• Output falls below potential causing a recessionary

Monetary Policy

• Drop in consumer or business confidence:

• AD0 AD1

• Economy 12

• Stabilization requires shifting AD back towhere it started.

Monetary Policy

• Policymakers will conclude that the long-run real interest rate has fallen.

• If the inflation target stays the same, the drop in aggregate expenditure prompts them to shift the monetary policy reaction curve to the right.• This reduces the level of the real interest rate.

• The AD curve now shifts right, back to its original level.

• The policy response means the economy will be back at long run equilibrium.

Monetary Policy

• In practice, it is extremely difficult to keep inflation and output from fluctuating when aggregate expenditure changes.

• There are two reasons:• It takes time to recognize what has happened.

• Changes in interest rates do not have an immediate impact on the economy.

• While in theory we can neutralize aggregate demand shocks, in reality they create short-run fluctuations in output and inflation.

• Stability improves welfare.• Individuals strive to stabilize consumption, but

it can be difficult.• When income falls temporarily you can:

• Draw on savings (emergency funds) or

• Borrow using credit.

• But credit is only a stop-gap measure.• The financial crisis of 2007-2009 demonstrates

how risky credit can be.

Discretionary Fiscal Policy

• There are two types of fiscal policy:• Automatic stabilizers.

• Automatic stabilizers operate without any further actions on the part of the government.

• Ex: unemployment insurance and the proportional nature of the tax system.

• Discretionary policy.

• Discretionary policy relies on fiscal policymakers’ decisions.

• Discretionary policy changes aggregate expenditures shifting the dynamic aggregate demand curve.

• Fiscal policy can act just like monetary policy to offset shifts in the dynamic aggregate demand curve and stabilize inflation and output.

• On closer examination, however, it has at least two shortcomings:

1. Discretionary fiscal policy works slowly, and

2. It is almost impossible to implement effectively.

• Because economic data only become available several months after they are collected, the economy is often halfway through a recession before there is a consensus that a downturn has actually started.

• This means that discretionary fiscal policy is likely to have its biggest impact when it is no longer needed.

• Also, remember that economists don’t write stimulus packages; politicians do.

• Economics clearly collides with politics where fiscal stimulus is concerned.• For economists, the best policies are the ones that

influence a few key people to change their behavior, avoiding rewarding people who do what they would have done anyway.

• For politicians, the best policies are programs that reward the largest number of people possible.

• Therefore discretionary fiscal policy is a poor stabilization tool.

• Under most circumstances, stabilization policy is probably best left to the central bankers.• They have both the ability to act quickly and the

independence to put the economy before politics.

• During the 2007-2009 financial crisis, many industrial countries undertook large-scale discretionary fiscal stimulus.

Positive Supply Shocks and the Opportunity They

Create• What happens when production costs fall - a

positive supply shock?• The SRAS curve shifts to the right.

• This drives up inflation and output immediately.

• We have an expansionary gap.

• This leads to increasing costs which shift the SRAS curve to the left.• This continues until the economy returns to the

original long-run equilibrium.

Positive Supply Shock

• Fall in production costsshifts SRAS Right.• Economy 12

• Costs rise and SRAS moves back to original level.• Economy 21

Create• However, a positive supply shock creates an

opportunity for policymakers to guide the economy to a new, lower inflation target without inducing a recession.• Central bankers will shift the monetary policy

reaction curve to the left.

• The AD therefore shifts left as well.

• This continues until it reaches the point where the new SRAS curve intersects the LRAS curve.

Create

What Accounts for the Great Moderation

• The 1990s brought unprecedented economic stability - the “Great Moderation” in the volatility of real growth.• From 1991 to 2001 there were 10 years of solid

growth and inflation fell steadily.

• The volatility of inflation and growth dropped by more than half.

• This prosperity and stability was shared across the industrialized world.

• There are three possible explanations for this worldwide economic performance:

1. Everyone was extremely lucky.

2. Economies have become more flexible in absorbing external economic disturbances.

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

• The 1990s was not a calm period for the financial markets, so it is difficult to argue that the stability was just good fortune.

• So what is it?• Advances in information technology have

increased manufactures’ flexibility in responding to changes in demand.• This resulted in dramatic declines in inventories at

every stage of the production process.

• Innovations in mortgages and other forms of personal credit made it easier for households and businesses to borrow.• They were then better able to smooth their spending

during periods of temporary income fluctuations.

• However, rising levels of risky debt eventually led to record defaults during the financial crisis.

• That leaves monetary policy as the only remaining explanation.

• Economists now have a much better understanding of how to implement monetary policy.

• To succeed in keeping inflation low and stable while keeping real growth high and stable, central bankers must focus on raising real interest rates when inflation goes up and lowering them when inflation goes down.

• While keeping inflation low and stable is necessary for reducing economic volatility, the deep recession that began in December 2007 shows that it is not sufficient.

• If households and businesses are no longer able or willing to use credit to smooth their spending over time it may not be possible for Fed policymakers to sustain the low economic volatility of the 1985-2007 period, even if they remain effective in keeping inflation low.

What Happens When Potential Output Changes?

• We have assumed up to this point that potential output has not change.

• But potential output can change.• The consequences for both short-run

movements in output and inflation and for long-run equilibrium are important.

• What happens when YP increases due to an increase in productivity?• The long-run aggregate supply curve will shift to

the right as YP increases.

• An increase in productivity reduces costs of production, so it is a positive supply shock as well.

• The SRAS curve will shift right.

• Remember that the SRAS curve intersects the LRAS curve at the point where current inflation equals expected inflation.

• An increase in YP shifts SRAS right and shifts LRAS right.

• But SRAS still crosses LRAS where = e.

• SRAS shifts the same distance as LRAS.

• In the short-run, output and inflation are determined by the intersection of SRAS and AD.

• Since AD is unchanged, the economy is at point 2 in the short-run.

• We can see this is the following graph.

• In the long run, output must go to the new level of potential output, YP

• How it gets there depends on what monetary policymakers do.

• If policymakers are happy with their inflation target, they will work to move the economy to the point on the LRAS curve consistent with their target.

• But the higher level of potential output comes along with a lower long-run real interest rate.• Returning inflation to its higher level means

shifting the monetary policy reaction curve to the right.

• This shifts AD to the right.

• The policy adjustment will drive output and inflation up until they reach their new LR equilibrium level at the original inflation target and YP

What Happens When Potential Output Changes?• With T unchanged,

policymakers shift AD right.

• The economy moves to the new level of potential output and the original T at point 3.

• Remember, however, that a positive supply shock creates an opportunity for monetary policymakers to reduce their inflation target.

• If policymakers do nothing, at point 2, there is a recessionary gap.• This lowers production costs shifting the SRAS

curve to the right.

• This continues until output equals potential output.

• Long run in this case is at a new lower inflation target at the new potential output.

• With a new, lower T: policymakers allow the economy to move to point 4.

• They do this by leaving the monetary policy reaction curve alone.

• In the 1990s the LRAS curve shifted to the right, and when it did the Fed took the opportunity to reduce their implicit inflation target.

• At the time, this was referred to as opportunistic disinflation.• This describes declines in inflation.

What Are the Implications of Globalization for Monetary Policy?*

• The simplest way to understand the macroeconomic impact of international trade is to think of it as a source of productivity enhancing technological progress.

• Shifting the factors of production from domestic to foreign factories is the same as U.S. producers finding a new, cheaper technology to produce domestically.• Improvements in technology increase potential

output.

What Are the Implications of Globalization for Monetary Policy?*

• Our conclusion is that globalization and trade do reduce inflation in the short run.• And just like any positive supply shock they

provide an opportunity to reduce inflation permanently.

• Is globalization likely to have a sizeable impact on inflation even in the short run?• It is likely a modest impact.

• We can’t get away from the fact that changes in domestic inflation are tied to domestic monetary policy.

Can Policymakers Distinguish a Recessionary Gap from a Fall in

Potential Output?*

• In the early 1970s U.S. GDP growth began to fall.

• In 1974 there was a severe recession but inflation rose dramatically.

• When inflation is rising while output is falling, the appropriate policy response depends on whether potential output has fallen.

Potential Output?*

• Being able to distinguish a recessionary gap from a fall in potential output is critical.

• The proximate cause of the 1970s episode was a tripling of the price of oil.• That increase in production costs translates into a

negative supply shock.

• But the right response depends on what happened to potential output at the time.

Potential Output?*

• In retrospect we know that as oil prices rose:• The productive capacity of the economy fell, and

• Potential output went down with it.

• At the time, policymakers didn't realize that.• Instead, they thought lower output reflected a

recessionary gap.• This led to an inappropriate response that drove

inflation up, where it stayed longer than it should have.

Recessionary Output Gap

Recessionary output gap caused by a negative supply shock.

Policymakers focus on returning inflation to target.

They raise the interest rate along an unchanged monetary policy reaction curve.

Potential Output?*

• If a negative supply shock is associated with a decline in potential output, things are quite different.

• The economy moves to point 1 as SRAS shifts left.• Inflation is higher and output is lower.

• There is an expansionary gap.

• Even though output has fallen, potential output has fallen by more and output remains above the new, lower, YP.

Fall in Potential Output

• Without any change in the monetary policy reaction curve, the economy will move to point 2.

Potential Output?*

• The challenge for policymakers is to figure out that potential output has fallen and that this has increased the long-run real interest rate.

• Keeping inflation at its target requires a leftward shift in the monetary policy reaction curve.

• Policymakers need to raise the real interest rate by even more than they would in the case of a recessionary gap.

Potential Output?*

• In order to set their policy-controlled interest rate as accurately as possible, central bankers need to know the size of the output gap.

• This requires measuring the level and growth rate of both current and potential GDP accurately.

• The practical implication of the statistical discrepancy is that it makes us unsure about the current level of real output.

Can Policymakers Stabilize Output and Inflation

Simultaneously?*• Short run fluctuations in output and inflation

are caused by either demand shifts or supply shifts.

• By shifting their monetary policy reaction curve, policymakers offset demand shocks.

• Unfortunately, supply shocks are a different story.• There is no way to neutralize them.

Simultaneously?*• Monetary policymakers can shift the dynamic

aggregate demand curve, but they are powerless to move the SRAS curve.

• But, central bankers can choose how aggressively they react to deviations of inflation from their target caused by supply shocks.

• They do this by picking the slope of their monetary policy reaction curve, which determines the slope of the AD curve.

Simultaneously?*

Simultaneously?*• The more aggressively policymakers are

keeping current inflation close to target, the steeper their monetary policy reaction curve,• The flatter the AD curve.

• By controlling the slope of AD, policymakers choose the extent to which supply shocks translate into changes in output or changes in inflation.

• The more central bankers stabilize inflation, the more volatile output will be, and vice versa.• There is a trade-off.

Simultaneously?*• A relatively flat AD curve implied by the steep

monetary policy reaction curve means:• A supply shock creates large changes in current

output.

• A negative supply shock drives output down sharply, opening up a large recessionary gap.

• This should force inflation down faster than a small recessionary gap.

• Policymakers are counting on that mechanism when they choose this path.

Simultaneously?*• By reacting aggressively to supply shocks,

policymakers force current inflation back to target quickly.

• The cost of following this path, however, is that it causes output to fall substantially.

• Stable inflation means volatile output.

Simultaneously?*• Panel B of Figure 22.14 shows what happens

when policy makers are less concerned about keeping inflation close to target in the short run.

• When policymakers worry about more short-run fluctuations in output than about temporary movements in inflation, they will choose a relatively flat monetary policy reaction curve.

• The result is a steep AD curve.

Simultaneously?*• In this case, inflation rises, creating a

recessionary output gap.• But the output gap is small, so the downward

pressure on inflation is relatively weak.• Inflation therefore adjusts slowly, remaining

high for a longer period than it would have if policymakers had reacted more aggressively.

• Stable output means volatile inflation.• Monetary policymakers face an inflation-

output volatility trade-off.

Simultaneously?*

• In mid-2008, the increase in oil prices to record highs had put the Fed in a difficult spot.• Inflation was rising while the economy was

declining.

• Should the Fed raise interest rates to cap inflation or lower rates to avoid a deeper crisis and recession?

• Uncertainty was very high.

• The ECB hiked its policy rate, but the Fed stood pat, having cut the target federal funds rate in several steps earlier in the year to 2 percent.

• But the September 2008 collapse of Lehman Brothers intervened to drive both the global economy and inflation sharply lower.

• By mid-December, the Fed had brought its target rate near zero.

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Understanding Business Cycle Fluctuations

End ofChapter Twenty-Two

Stephen G. CECCHETTI Kermit L. SCHOENHOLTZ Understanding Business Cycle Fluctuations Copyright ©...

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