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Economics 3rd ch09


By John B. Taylor
Stanford University

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Chapter 24 (Macro 11)
The Economic
Fluctuations Model
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• The main purpose of this chapter is to

provide an explanation of the dynamics of
economic fluctuations, particularly inflation
and real GDP. The economic fluctuations
model is constructed by first deriving the
aggregate demand/inflation curve and then
the price adjustment line. The model can be
used to study the determination of real GDP
and the price level.

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Teaching Objectives
1. Explain that a basic set of factors causes
real GDP to depart and return to potential
over the business cycle.
2. Introduce interest rates and inflation into
the dynamics of the business cycle.
3. Describe the important role that policy
can play in altering the course of business
cycles. This is done through a policy rule
that relates interest rates to aggregate
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Teaching Objectives
4. Explain the primary factors that determine
location of the ADI curve. This occurs through the
components of aggregate spending that are
sensitive to interest rates (spending balance) and
the policy rule.
5. Explain the factors that shift the ADI curve:
Changes of the policy rule and changes in
government spending, along with autonomous
shocks to aggregate spending, determine the

location of the ADI curve.
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Teaching Objectives
• 6. Introduce the microeconomic basis of price
7. Explain the PA line and the factors that cause it
to shift.
8. Explain how the intersection of the ADI curve
and the PA line determines the level of equilibrium
real GDP and the inflation rate at some point in
time in the economy.

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Key Terms

aggregate demand/inflation ( ADI ) curve
target inflation rate
monetary policy rule
price adjustment ( PA ) line
federal funds rate

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1. The Aggregate Demand/Inflation Curve

• The ADI curve shows that there is an
inverse (negative) relationship between
inflation changes and the corresponding
changes in real GDP.
• When inflation increases, real GDP
• When inflation slows down, real GDP goes
• Real GDP = C + I + G + X = AE
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Figure 24.1
(Macro 11)
The Aggregate
Demand Curve

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Between Inflation Interest Rate and Real GDP

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Showing Relation of
Interest Rate to

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STAGE I: Interest rate and Investment

• As real (inflation-adjusted) interest rate
goes up, cost of borrowing goes up, so that
business investment (buying a new machine
or extending business) and housing
investment declines.
• As real interest rate declines, investment
goes up, because the cost of investment

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Showing Relation of
Interest Rate to Net

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Interest Rate and Net Exports
• If US interest rates increase, it becomes
more attractive to invest in the US,
compared to other countries such as Canada
or Mexico, our top trading partners.
• This raises the demand for US dollars and
appreciates the US dollar against other
currencies like Canadian $s or Mexican
• This hurts our exports but raises our
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Interest Rate and Consumption Expenditures

• Evidence indicates that consumption is less
sensitive to interest rate changes than
investment and net exports
• In general, higher interest rates encourage
people to save more (consume less),
indicating an inverse relationship between
interest rates and consumption
• Figure 24.2 shows the net impact.
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Figure 24.2
(Macro 11)
The Interest Rate, Spending Balance, and Real GDP

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STAGE II: Interest Rates and Inflation
• So far we have seen how real interest rates
affect real GDP.
• Now we want to study how inflation affects
interest rates.
• Real interest rate = nominal interest rates
minus expected inflation rate
• Note that it is the real interest rate that we
use to decide about our spending plans
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Central Banks and Inflation
• When inflation increases (declines), the Fed
raises (lowers) the nominal interest rates.
This is called the “policy rule”
• Higher inflation signals a rise in aggregate
expenditures. Central banks raise nominal
interest rates more than the inflation rate, so
that the real interest rate increases.
• Higher real interest rates lower AE and
slows down inflation
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Figure 24.3
(Macro 11)
A Monetary Policy Rule

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Monetary Policy Rule
• The monetary policy rule in Figure 24.3
shows that central banks raise the interest
rate when inflation rises and lower it when
inflation declines.
• The dashed line has a slope of 1. Monetary
policy rule has a bigger slope: Nominal
interest rate is increased by more than
inflation, so that the real interest changes.
• Note that AE decisions depend on “real”
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STAGE 3: Deriving AD curve
• When inflation increases, two things happen:
(1) Central banks raise the nominal interest rate
more than inflation, raising the real interest rate
(2) The higher real interest rate will decrease
real GDP because of lower AE
• Just the opposite happens when inflation
• Thus, AD curve shows a negative link between
real interest rates and real GDP

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Figure 24.4
(Macro 11)
A Self-Guided
Graphical Overview

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Movements along the AD curve
• A change in inflation causes a movement
along the demand curve
• When inflation rises and the Fed raises the
interest rate and real GDP declines. This
causes a movement up and to the left along
the AD curve.
• When inflation decreases, there is a
movement down and to the right.
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Shifts of the AD curve
• Besides inflation, other things affects
aggregate demand.
• When such non-inflation determinants of
AD curve changes, we say that there is a
“shift” in the AD curve.
• Changes in government purchases, shifts in
monetary policy, changes in taxes, shifts in
demand for next exports, changes consumer
confidence, among others, affect AD.
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Figure 24.5
(Macro 11) How
Purchases Shift the
Aggregate Demand

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