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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.