What Caused the Great Recession?
Assessing Two Explanations
In this assignment you will take our model to the data to understand what might have been the cause of the Great Recession.

A. Was it Caused by a Real Shock?

 

Derive the aggregate demand curve and the long-run aggregate supply curve Solve for the initial equilibrium.

a. What is the real GDP growth? What is the rate of inflation?

b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves, equilibrium inflation and GDP growth, and vertical intercepts.

Here is a list of possible changes in the economy. Of the real shocks in this list, which of these changes is most likely to have caused the Great Recession? Explain why your answer is right, and why each of the other three answers is not.

i. The growth rate of the capital stock increases to 3 percent per year

ii. The growth rate of the money supply falls to -4 percent per year

iii. The growth rate of productivity falls to -5 percent per year

iv. The growth rate of real consumption spending increases to 2 percent per year

Suppose the answer you chose in Question 3 actually happened. Solve for the new equilibrium.

a. What is real GDP growth? What is the rate of inflation?

b. Add the new equilibrium to your aggregate supply-demand diagram from A.2.b, making sure to shift any curves as necessary.

B. Was it Caused by a Demand Shock?

Suppose that the AD and LRAS curves are exactly as you derived in Part A.1.

What is the short-run aggregate supply curve?

Solve for the initial equilibrium.

a. What is real GDP growth? What is the rate of inflation?

b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves, equilibrium inflation and GDP growth, and vertical intercepts. (Unlike your diagram for A.2.b, this one will have the short-run aggregate supply curve.)

Now suppose that the growth rate of the money supply falls to -4 percent per year.

a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium (that is, before expectations have shifted). What is real GDP growth? What is the rate of inflation?

c. Add the new short-run equilibrium to your aggregate supply-demand diagram from B.2.b, making sure to shift any curves as necessary.

Assume the change in the growth rate of money is permanent. Also assume that neither Congress nor the Federal Reserve take any action to address this shock.

a. In words, explain why, in the long run, the short-run aggregate supply curve will shift. Why does this return to long-run equilibrium?

b. Solve for the new long-run equilibrium. What is real GDP growth? What is the rate of inflation?

c. Write down the new short-run aggregate supply curve.

d. Add the new long-run equilibrium to your aggregate supply-demand diagram from B.2.b/B.3.b, making sure to shift any curves as necessary.

Suppose instead that our setup is exactly as it was in B.2 (before the money supply fell). Now suppose that the velocity of money is

 

a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium. What is real GDP growth? What is the rate of inflation?

C. Which Explanation Does Better?

Now let's take the predictions of these two theories and assess which one is more accurate. This will help us decide which of the two perspectives is more useful.

Look back at your answers to Part A. How does the model predict a real shock will affect inflation in a recession? (That is, when GDP falls?)

Look back at your answers to Part B. How does the model predict a demand shock will affect inflation in a recession? (That is, when GDP falls?)

The figure below shows what actually happened to inflation and real GDP growth during the Great Recession. Which of the two predictions best matches the data? What does that imply is the most likely cause of the Great Recession?

Suppose that the long run aggregate supply curve is given by =+} Ky=34A HAK Initially, A = 2A-2, K = OK>=0. Suppose the money supply is growing at a rate of 5 percent per year, and the velocity of money does not change.