Chapter 4 Part 2 of World Economy .pptx

World Economy Chapter 4 Part 2

1. Unit 4 (Part 2) – Expectations, Supply Shocks, and Economic Cycles Topics: Expectations, Supply Shocks, Business Cycles Case Study: Oil Shocks 1973 vs 2022 Energy Crisis Learning Objectives: • Understand how expectations influence inflation and unemployment. • Examine how supply shocks disrupt traditional models. • Analyze business cycle fluctuations and their causes. • Compare 1973 oil shock with 2022 energy crisis for policy lessons.

2. Role of Expectations in Macroeconomics • Inflation expectations shape wage and price setting. • Adaptive expectations: people use past inflation to form future expectations. • Rational expectations: people use all available information. • Expectations can shift Phillips curve upwards. • Anchored expectations crucial for monetary stability. • Modern central banks focus heavily on managing expectations. [Figure Placeholder: Insert Fig. 4.18 – Adaptive vs Rational Expectations Illustration].

3. Adaptive Expectations • Workers and firms extrapolate from past inflation. • Leads to systematic forecast errors if inflation changes unexpectedly. • Causes lag in adjustment, contributing to inflation persistence. • Important in explaining 1970s inflation dynamics. • Adaptive model assumes slow adjustment of expectations over time.

4. Rational Expectations • Introduced by John Muth (1961), popularized by Robert Lucas. • Assumes agents use all available information. • Policy anticipated by public loses effectiveness. • Implies only unexpected policy can affect unemployment. • Rational expectations revolution reshaped macro theory in 1970s/80s.

5. Expectations-Augmented Phillips Curve • Friedman/Phelps model integrated expectations. • Curve shifts when inflation expectations rise. • Long-run Phillips curve vertical at natural unemployment. • Short-run trade-off exists only if expectations not fully adjusted. • Anchoring expectations stabilizes inflation. [Figure Placeholder: Insert Fig. 4.20 – Expectations-Augmented Phillips Curve].

6. Supply Shocks – Introduction • Supply shocks = sudden changes in production costs. • Can be adverse (oil price hikes) or favorable (tech innovations). • Adverse shocks shift short-run aggregate supply curve left. • Cause inflation and lower output simultaneously. • 1970s oil shocks classic example. • 2022 energy crisis another case.

7. Types of Supply Shocks • Energy shocks: oil, gas, electricity price hikes. • Food shocks: droughts, crop failures. • Global supply chain disruptions. • Productivity changes due to technology. • Geopolitical conflicts disrupting trade.

8. Oil Shock of 1973 – Background • Triggered by Yom Kippur War. • OPEC imposed embargo on US and allies. • Oil prices quadrupled. • Inflation surged across oil-importing nations. • Growth slowed, unemployment rose. • Stagflation entrenched in global economy. [Figure Placeholder: Insert Fig. 4.23 – Oil Price Spike 1973].

9. Oil Shock of 1979 – Background • Triggered by Iranian Revolution. • Oil production disrupted. • Prices doubled again. • Reinforced wage-price spirals. • Inflation expectations unanchored. • Led to harsh monetary tightening in US and Europe.

10. Impact of Oil Shocks – 1970s • Inflation exceeded 10% in many OECD countries. • Unemployment rose simultaneously. • Trade deficits widened. • Monetary policy responses inconsistent. • Stagflation discredited Keynesianism. • Shift toward monetarist policies globally. [Figure Placeholder: Insert Fig. 4.26 – OECD Inflation & Unemployment 1970s].

11. 2022 Energy Crisis – Background • Triggered by Russia-Ukraine war. • Natural gas supply to Europe disrupted. • Global oil and gas prices surged. • Europe especially vulnerable. • Inflation highest since 1970s. • Renewed fears of stagflation. [Figure Placeholder: Insert IMF Energy Price Index 2022].

12. Comparing 1973 vs 2022 • Both caused by geopolitical conflict. • 1973: oil embargo, 2022: gas disruption. • 1970s economies more oil-dependent. • 2022: better diversification, renewable energy. • Central banks more credible today. • Inflation still surged globally.

13. Policy Responses to 1970s Shocks • Governments initially pursued demand stimulus. • Policies worsened inflation. • Wage/price controls largely ineffective. • Eventually harsh monetary tightening. • Painful recessions followed. • Set stage for neoliberal reforms of 1980s.

14. Policy Responses to 2022 Crisis • Central banks raised interest rates rapidly. • Fiscal policies cushioned households (subsidies, transfers). • Energy rationing measures in Europe. • Greater coordination across advanced economies. • Less severe unemployment increase than 1970s. • Inflation still persistent.

15. Expectations in 1970s vs 2020s • 1970s: expectations unanchored, inflation spiraled. • Today: central banks anchor expectations via credibility. • Inflation expectations surveys show smaller increases. • Stronger institutional frameworks matter. • But risk of de-anchoring remains if shocks persist.

16. Business Cycles – Introduction • Fluctuations in GDP, unemployment, and inflation. • Phases: expansion, peak, recession, trough. • Driven by demand and supply shocks. • Policy aims to smooth cycles. • Oil shocks triggered recessions in 1970s/80s. [Figure Placeholder: Insert Fig. 4.30 – Stylized Business Cycle].

17. Causes of Business Cycles • Demand shocks: changes in consumption, investment, exports. • Supply shocks: oil prices, productivity shifts. • Financial shocks: credit booms and busts. • Policy shocks: fiscal/monetary errors. • External shocks: wars, pandemics, natural disasters.

18. 1970s Recessions • Two major recessions: 1974–75 and 1980–82. • Both triggered by oil shocks. • Characterized by stagflation. • Global trade contracted. • High inflation persisted despite recessions. [Figure Placeholder: Insert Fig. 4.33 – Global GDP Growth 1970s].

19. 2020s Recession Risks • COVID-19 recession followed by energy shock. • Inflation surged, growth slowed. • Central banks prioritized inflation control. • Risk of prolonged stagflation debated. • IMF forecast downgraded global growth. • Comparisons made with 1970s.

20. Policy Lessons from Oil Shocks • Demand stimulus ineffective against supply shocks. • Importance of diversified energy sources. • Central bank credibility essential. • Need for international coordination. • Fiscal cushions protect vulnerable groups. • Lessons informed 2022 response.

21. Criticisms of Expectations Theory • Adaptive model too simplistic. • Rational model assumes unrealistic information use. • Both may fail during extreme shocks. • Behavioral economics adds new insights. • Anchoring expectations complex in practice.

22. Criticisms of Policy Responses • 1970s: delayed tightening worsened inflation. • 1980s: harsh tightening caused unnecessary unemployment. • 2022: fiscal subsidies risk prolonging inflation. • Balancing equity vs stability remains challenge. • No perfect response to large shocks.

23. Case Study – Oil Shocks 1973 vs 2022 • Both crises illustrate vulnerability of modern economies to energy shocks. • 1970s shocks produced stagflation and discredited Keynesianism. • 2022 crisis revived stagflation fears but with milder outcomes. • Differences highlight improved policy credibility and diversification. • Still, both underscore ongoing energy dependence.

24. Summary of Key Points • Expectations shape inflation-unemployment dynamics. • Supply shocks shift curves, causing stagflation. • Business cycles driven by multiple shocks. • Oil shocks 1973 vs 2022 provide key comparisons. • Policy lessons emphasize credibility, diversification, coordination.

25. Next Steps – Unit 5 • Focus shifts to long-run growth models. • Role of productivity, capital accumulation, and institutions in sustaining growth.