In-Depth Notes on Macroeconomic Concepts

Real Shocks

• LRAS and Economic Shocks:
  • Negative Shocks -> LRAS Curve Moves Left:
  • Bad weather (impactful in agricultural economy)
  • Higher prices for oil/inputs
  • Productivity slump/technological downturn
  • Increased taxes or regulations
  • Production disruption (e.g. war, earthquake, or pandemic)
  • Positive Shocks -> LRAS Curve Moves Right:
  • Good weather
  • Lower prices for oil/inputs
  • Productivity boom/technological advancements
  • Decreased taxes or regulations
  • Smooth production processes without disruptions

Self-Check: Impact of Higher Business Taxes

• Higher business taxes will shift the long-run aggregate supply curve:
  • Answer: a – to the left (decreases LRAS).

Real Business Cycle vs. New Keynesian Model

• Real Business Cycle (RBC) Model:
  • Output fluctuations caused by real (supply) shocks only.
• New Keynesian Model:
  • Business cycles arise from both demand and supply shocks.
  • Analysis includes events like the Great Depression.

Business Cycles and Public Policy

• RBC Models view business cycles/recessions as primarily due to shifts in the Solow Growth Curve.
• Prices adjust quickly to economic shocks.
• Examples of productivity shocks: war, natural disasters.

New Keynesian Theories

• Business cycles are driven by both supply shocks and demand shocks affecting the Solow Growth Curve.
• Prices adjust slowly, which influences short-term outcomes.

Aggregate Demand and Supply Interactions

• Real GDP Growth Rate vs. Inflation Rate:
  • Positive Shock:
  • Real growth rate: 7 ext{%}
  • Inflation rate: 3 ext{%}
  • Negative Shock:
  • Real growth rate: -1 ext{%}
  • Inflation rate: 11 ext{%}

Shocks to Aggregate Demand (RBC Model)

• Effects of Demand Shocks:
  • Positive demand shock: higher inflation.
  • Negative demand shock: lower inflation.

Keynes on Price Flexibility and Aggregate Demand

• Price inflexibility can lead to recessions when aggregate demand falls (Keynes).

New Keynesian Model Overview

• Key assumption: Prices and wages do not adjust immediately to economic shocks.
• Money supply increases leading to potential growth effects.

Why Money is Not Neutral in the Short Run

• Example with a baker in Zimbabwe due to monetary policy changes causing temporary output increases.
• Price adjustments occur as perceivable inflation creates demand changes across goods.

Short-Run Aggregate Supply (SRAS)

• Definition: SRAS indicates a positive relationship between the inflation rate and real growth when prices/wages are sticky.
• Characteristics:
  • Short run impacts of demand shifts on inflation and real growth.

Key Points on SRAS Dynamics

• SRAS upward sloping.
• Increase in aggregate demand leads to increases in inflation and growth in the short run.
• Each SRAS associated with specific expected inflation.

Aggregate Demand Shocks

• Positive shock: inflation rises or real growth increases.
• Long term contrasts with SRAS adjustments and inflation impacts.

Effects of Unexpected Money Supply Increases

• Both inflation and growth rates increase in the short run post unexpected money supply increases leading to inflation adjustments long-term.

The Great Depression Analysis

• Root causes: Major falls in aggregate demand due to stock market crash, bank failures, and reduced spending.
• Additional pressures from lack of monetary expansion during the downturn.

Real Shocks during the Great Depression

• Bank failures impacted money supply and efficiency of financial systems.
• Policy responses, such as tariffs, resulted in international retaliation affecting trade further.