SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY

<< EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION

Money & Banking MGT411

Lesson 45

SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY

Changes in potential output shift the long-run aggregate supply curve

At first the shift has no impact on the short-run aggregate supply curve, so inflation and output

remain stable

But with time, the increase in potential output will mean that current output is now below

potential output, creating a recessionary output gap, which puts downward pressure on inflation,

shifting the short-run aggregate supply curve downward

Figure: The Effects of an increase in potential Output on Inflation and Output

An increase in potential output shifts the LRAS curve to the right. In the short run, current

output remains unchanged. But since current output is now below potential output, the resulting

recessionary gap places downward pressure on inflation and output eventually begin to rise.

Inflation (�)

Old LRAS

New LRAS

Target

SRAS

Inflation (�T)

Short run

equilibrium is

unchanged

Old

New

Output (Y)

Potential

Output

What happens next depends on what policymakers do; they can:

Take advantage of the downward pressure on inflation to reduce their inflation target

Initiate actions that ensure that inflation does not fall.

In either case, notice that the higher level of potential output means a lower long-term real

interest rate.

Business cycle fluctuations can therefore be explained in terms of shifts in aggregate demand

that change its point of intersection with a flat short-run aggregate supply curve

An alternative explanation for business cycle fluctuations focuses on shifts in potential output, a

view called real business cycle theory.

Real business cycle theory

Real business cycle theory starts with the assumption that prices and wages are flexible, so that

inflation adjusts rapidly (the short-run aggregate supply curve shifts quickly in response to

deviations of current output from potential output).

This assumption implies that the short-run aggregate supply curve is irrelevant: equilibrium

output and inflation are determined by the point on the aggregate demand curve where current

output equals potential output

Any shift in the aggregate demand curve, regardless of its source, will change inflation but not

output

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Money & Banking MGT411

Real business cycle theorists explain recessions and booms by looking at fluctuations in

potential output, focusing on changes in productivity and their impact on GDP

The Impact of a Shift in Aggregate Demand and Aggregate Supply on Output and Inflation

Increase in Aggregate

Positive Inflation

Increase in Potential

Demand

Shock

Output

Consumer Confidence up Labor Costs up

Capital in Production up

Source

Business Optimism up Raw Material Prices up Labor in Production up

Expected Inflation up Productivity up

Govt. Purchases up

Taxes Down

Exchange Rate

Depreciates

Short-Run Y Increases

Y falls

Y unchanged

� Is unchanged

� rises

� Unchanged

Effects

1. Recessionary output gap

1. Recessionary output

1. Expansionary

Path of

puts downward pressure

gap puts downward

output gap puts

Adjustment

on inflation

pressure on inflation

upward pressure on

2. As Inflation begins to

2. As Inflation begins

inflation

fall, output begins to

to fall, output begins

2. As Inflation begins

rise

to rise

to rise, output

begins to fall

Y = original potential

Y = original potential Y = new potential output

Long-Run

� = target (may change)

output

Effects

� = target (may change)

� = target (may

change)

Inflation will rise

Inflation will fall

Effects of

temporarily unless the

temporarily unless the temporarily unless the

Monetary

central bank changes its central bank changes its central bank changes its

Policy

inflation target.

Stabilization Policy

Monetary Policy

Policymakers can shift the aggregate demand curve by shifting their monetary policy reaction

curve, but they cannot shift the short-run aggregate supply curve

They can neutralize movements in aggregate demand, but they cannot eliminate the effects of

an inflation shock

Shifts in Aggregate Demand

If households and businesses become more pessimistic, driving down aggregate demand, the

economy moves into a recession as the new short-run equilibrium point is at a current output

less than potential output.

Policymakers will conclude that the long-run real interest rate has gone down and will shift their

monetary policy reaction curve to the right, reducing the level of the real interest rate at every

level of inflation

This shifts the aggregate demand curve back to its initial position

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Money & Banking MGT411

Figure: Stabilizing a shift in Aggregate Demand

Following a drop in consumer or business confidence, ADC shifts to the left. to stabilize the economy,

the central bank can ease the policy, shifting the monetary policy reaction curve to the right. This

reduces the real interest rate at every level of inflation and shifts the aggregate demand curve back to

where it started. Their action leaves current output and inflation unchanged.

In the absence of a policy response, output would fall; instead, output remains steady along with

inflation.

Policymakers have neutralized the shift in aggregate demand, keeping current output equal to

potential output and current inflation equal to target inflation.

Inflation Shocks and the Policy Tradeoff

For policymakers, an inflation shock is an entirely different story.

A positive inflation shock drives down output and drives up inflation.

Policymakers can shift the monetary policy reaction curve and so shift the aggregate demand

curve, relying on the economy's natural response to an output gap to bring inflation back to

target

New short run

Inflation (�)

Equilibrium

New SRAS

Target

Old SRAS

Inflation

(�T)

Flat ADC

Current

Potential

Output (Y)

Output

The central bank can respond aggressively to keep Current Inflation near Target

But this tool cannot be used to bring the economy back to its original long-run equilibrium

point, because monetary policy can shift the aggregate demand curve but not the short-run

aggregate supply curve

However, monetary policymakers can choose the slope of their monetary policy reaction curve

and so affect the slope of the aggregate demand curve, and in this way monetary policymakers

can choose the extent to which inflation shocks translate into changes in output or changes in

inflation

By reacting aggressively to inflation shocks, policymakers force current inflation back to target

quickly, but at a cost of substantial decreases in output

LRAS

Inflation (�)

New short run

equilibrium

New SRAS

Target Inflation

Old SRAS

(�T)

Steep AD

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Money & Banking MGT411

Output (Y)

Current

Potential

Output

The central bank can respond cautiously to Minimize Deviations of Current Output from

Potential Output

When choosing how aggressively to respond to inflation shocks, central bankers decide how to

conduct stabilization policy; they can stabilize output or inflation, but not both

Opportunities Created by Increased Productivity

When productivity rises, potential output increases. This shifts the long-run aggregate supply

curve to the right, eventually creating a recessionary gap, which exerts downward pressure on

inflation.

This gives policymakers the opportunity to guide the economy to a new, lower inflation target

without inducing a recession

Since the increase in potential output lowers the long-run real interest rate, rather than reducing

their inflation target, policymakers can shift their monetary policy reaction curve to the right,

shifting aggregate demand to the right.

This will increase current output quickly, leaving inflation unchanged at the target level

Fiscal Policy

The people who control the government's tax and expenditure policies can stabilize output and

inflation too.

Fiscal policy can be used just like monetary policy to neutralize shocks to aggregate demand

and stabilize output and inflation.

Fiscal policy has two defects: it works slowly and it is almost impossible to implement

effectively

Most recessions are short, data is available only with a lag, and it takes time for Congress to

pass legislation.

Economics collides with politics where fiscal stimulus is concerned as politicians design

stimulus packages based more on political calculation than economic logic.

Under most circumstances, then, stabilization policy should be left to the central bankers; fiscal

policy does have a role but only after monetary policy has run its course

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