Managing Economic Fluctuations. Managing Macroeconomic Fluctuations 1

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1 Managing Economic Fluctuations -Keynesian macro: - -term nominal interest rates. - - P. - - P. Managing Macroeconomic Fluctuations 1

2 Review: New Keynesian Model -run macroeconomics: - π = γ (Y Y P ) + π e + ρ γ > 0 π e ρ. Y = Y d (r,...) = Y d r r = r + λ π λ > 0. -run macroeconomics: - Y = Y P π e = π ρ = 0 - r = r * real rate Y d (r,...) = Y P - r = r * λ π * π * - Y P. Managing Macroeconomic Fluctuations 2

3 Part 1: Disturbances and their effects: Aggregate Demand Shock & No Response - π. - Longer- P π π e P - logic Managing Macroeconomic Fluctuations 3

4 Temporary Aggregate Supply Shock & No response P Managing Macroeconomic Fluctuations 4

5 Permanent Aggregate Supply Shock & No Response P. normal economic - P. Managing Macroeconomic Fluctuations 5

6 Part 2: Disturbances and policy responses with focus on monetary policy: Aggregate Demand Shock with Monetary Response i MP- How does the Fed know P Managing Macroeconomic Fluctuations 6

7 Temporary Supply Shock: Policy Options 1. Stabilize inflation 2. Stabilize output - must - P. Managing Macroeconomic Fluctuations 7

8 Permanent Supply Shock: Policy Options 1. Stabilize inflation 2. Stabilize output P P Accelerating inflation? P n: Demand-Pull Inflation versus Cost-Push inflation Managing Macroeconomic Fluctuations 8

9 Demand-Pull Inflation P. P Managing Macroeconomic Fluctuations 9

10 Cost-Push Inflation P P Managing Macroeconomic Fluctuations 10

11 Why shifts in LRAS create complications: Information: How much do we know about shocks? : only interest rates - is ½- - - π - π V r π. π to monetary to - not - From i P P. - From u Disagreement about LRAS is a source of legitimate policy disputes. Managing Macroeconomic Fluctuations 11

12 Output and Unemployment: Okun s Law u - U. U >U Y < Y P - Y P - : U U 1 2 ( Y Y P ) = 1 (Y Y P ) Y P 2Y P ó : => Information about potential output is quite imperfect. - U Y P as constants Managing Macroeconomic Fluctuations 12

13 Application: U.S. Inflation Question: What do we know about the natural rate of unemployment? Managing Macroeconomic Fluctuations 13

14 Actual and Natural Unemployment: Managing Macroeconomic Fluctuations 14

15 Lessons about Stabilization Policy. - can - - lags - Pre- cannot P Inflation is always and everywhere a monetary phenomenon. - P P mostly When expectations matter, speculation about policy shifts can become a separate source of shocks uncertainty uncertainty Managing Macroeconomic Fluctuations 15

16 Guide to Problem Solving Systematic Approach - - π 2. Longer run analysis: P. P. Managing Macroeconomic Fluctuations 16

17 Limitations of Graphical Analysis Dynamic Stochastic General Equilibrium Analysis - - shocks - dynamic adjustment processes - - aggregate - Managing Macroeconomic Fluctuations 17

18 Examples from U.S. History: Negative Supply Shocks: , Oil Shocks Managing Macroeconomic Fluctuations 18

19 Examples from U.S. History: Paul Volcker s Disinflation: Managing Macroeconomic Fluctuations 19

20 Examples from U.S. History #3: Positive Supply Shocks: Managing Macroeconomic Fluctuations 20

21 Examples from U.S. History : Negative Demand Shocks in Managing Macroeconomic Fluctuations 21

22 Examples from U.S. History: Negative Shocks and the Financial Crisis Managing Macroeconomic Fluctuations 22

23 China in : Demand Shock Only Managing Macroeconomic Fluctuations 23

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