ECON1102 Lecture Notes - Lecture 7: Austrian Business Cycle Theory, Nominal Rigidity, Malinvestment
TOPIC 7B: THE AS-AD MODEL CONTINUED
WHAT CAUSES BUSINESS CYCLES?
- Real Business Cycle (Neo-classical) Theory
o Variations in TFP; business cycles are fluctuations driven by real forces in the economy
o Fluctuations essentially due to fluctuations in potential output
- (New) Keynesian Business Cycle Theory
o Fluctuations the result of AS and AD shocks
o Busiess le possil drie aial spirits
o “hoks ofte ade orse propagated due to rigidities in the economy (sticky prices/inflation,
sticky wages, imperfect information, etc.)
- Austrian Business Cycle Theory
o Flutuatios largel result of redit les; al-iestet
- Heterodo Post-Keesia Theories
o Fluctuations largely result of credit cycles
o Solutions tend to business cycles tend to advocate government intervention whereas Austrians
believe in free markets
- Marxian Theories
o Fluctuations largely consequence of distributive struggle between capitalists and workers
EVENT 1: AN INFLATION SHOCK
- The monetary policy rule dictates that
increase in inflation be fought by an increase
in the real interest rate, reducing short-run
output
- Stagflation is the stagnation of economy
activity accompanied by inflation
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- People need to observe inflation slowing falling then they will expect to fall
*Rational expectations are associated with neoclassical economics. Assumes people know everything.
Much shorter.
Adapted expectations takes time. Nothing sticks.
Adapted and rational are opposites.
- Movement of the AS curve follows the principle of transition dynamics – movement back to the steady
state is fastest when the economy is furthest from its steady state.
- In summary, the impact of a price shock is that:
o It raises inflation directly.
o Even if the shock lasts for a single period, the shock raises expected inflation and inflation remains
higher for a longer period of time.
o It takes a prolonged slump to get these expectations back to normal and the economy suffers
stagflation.
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EVENT 2: A POSITIVE AD SHOCK
Arrows keep moving because inflationary expectations are increasing. Slow adjustment because
expectations are lagging behind reality.
Have to assume some adaptive policy or some other stikiess h stailisers dot alas ork.
EMPIRICAL EVIDENCE: INFLATION-OUTPUT LOOPS
- When plotting inflation on the vertical axis and output on the horizontal axis, the economy will follow
counter clockwise loops to shocks in the economy.
- Positive short-run output leads to rising inflation.
- A rise in inflation leads policymakers to reduce output.
- Is this borne out in the data?
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Document Summary
Heterodo(cid:454) (cid:894)(cid:862)post-ke(cid:455)(cid:374)esia(cid:374)(cid:863)(cid:895) theories: fluctuations largely result of credit cycles, solutions tend to business cycles tend to advocate government intervention whereas austrians believe in free markets. Marxian theories: fluctuations largely consequence of distributive struggle between capitalists and workers. The monetary policy rule dictates that increase in inflation be fought by an increase in the real interest rate, reducing short-run output. Stagflation is the stagnation of economy activity accompanied by inflation. People need to observe inflation slowing falling then they will expect to fall. Movement of the as curve follows the principle of transition dynamics movement back to the steady state is fastest when the economy is furthest from its steady state. In summary, the impact of a price shock is that: It raises inflation directly: even if the shock lasts for a single period, the shock raises expected inflation and inflation remains higher for a longer period of time.
