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Money & Banking ­ MGT411
VU
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
AD
unchanged
Old
New
Output (Y)
Potential
Potential
Output
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
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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
output
Effects
= target (may change)
= target (may
change)
Inflation will rise
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.
inflation target.
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
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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
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
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Output (Y)
Current
Potential
Output
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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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY