Mankiw 5e Chapter 9: Intro to Economic Fluctuations

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• Chapter 7

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Time horizons

• Long run Prices are flexible, respond to
  changes in supply or demand
• Short runmany prices are sticky at some
  predetermined level

The economy behaves much differently when prices
are sticky.
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In Classical Macroeconomic Theory,

• (what we studied in chapters 3-6)
• Output is determined by the supply side
• supplies of capital, labor
• technology
• Changes in demand for goods services (C, I, G
  ) only affect prices, not quantities.
• Complete price flexibility is a crucial
  assumption,
• so classical theory applies in the long run.

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When prices are sticky

• output and employment also depend on demand for
  goods services,
• which is affected by
• fiscal policy (G and T )
• monetary policy (M )
• other factors, like exogenous changes in C or
  I.

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Short run fluctuations

• The questions
• What forces push the economy away from its
  potential?
• Why does it take so long for the economy to
  return to its potential?
• Develop the economic fluctuations model

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1. Forces that push the economy away of its
growth path

• Assumptions
• Fixed prices so DEMAND DETREMINES OUTPUT
• Firms supply whatever customers want at existing
  prices customers determine the level of output
  and employment
• Demand becomes the ruling force! If demand is
  strong, real GDP exceeds potential (boom) , if
  demand is week, real GDP drops below potential
  (recession)
• Firms then adjust their prices back to
  equilibrium eventually back to the long run path

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1. Forces that push the economy away of its
growth path
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a) Shift of aggregate demand
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b) A price shock
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2. Aggregate demand and the spending decision

• Spending decisions influenced by
• Cut in income taxes
• Increase in interest rates
• Cut in defense spending
• By adding up the spending demand aggregate
  spending or aggregate demand
• Question Is it consistent with the income that
  the public receives? Does the economy have enough
  resources?

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2. Aggregate demand and the spending decision

• Aggregate demand determines output?
• - most business firm operates with some excess
  capacity increase in demand produce more
  goods (US manufacturing capacity is 80)
• Possibility of additional hiring
• There is short run flexibility for firms to meet
  an increase in demand (same for a decrease
  firms produce less output)

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Price level unresponsive?

• Firms can adjust output but also prices.
• Increase in demand (increase in price) and
  decrease in demand (decrease in price)
• Problem sticky prices in the short run compared
  with production
• The adjustment of prices occurs gradually (in
  long run prices are flexible) but production
  adjust almost instantaneously

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3. The Point of Balance of Income and Spending

• Next study spending behavior
• How take in account the effects of income on
  spending
• Long Run supply demand, spending income

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3. The Point of Balance of Income and Spending

• Income identity
• Y C I G X

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3. The Point of Balance of Income and Spending

• Spending
• Consumption
• total demand fro consumption of all economy
• - depends on disposable income, also on wealth,
  expected future income and the price of goods
  today compared with tomorrow (discuss more later)

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Consumption

• A simple consumption fc. (Keynes)
• C a bYd
• b marginal propensity to consume how much an
  additional dollar of disposable income is spent
  on consumption
• a intercept
• Yddisposable income
• Ex C 220 0.9Yd

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Consumption

• Yd Y T
• t tax rate, total tax tY
• C a b(1-t)Y
• Consumption depends positively on income
• C and Y endogenous variables (determined inside
  the model)
• I, G, X- exogenous variables (determined outside
  the model)
• The model
• Y C I G X
• C a b(1-t)Y

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Spending balance algebraic solution
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Maintaining Spending Balance

• Balance the income consumers receive is the
  same as the income generated by their spending.
• If spending not in balance?
• suppose consumers spend too much relative to
  income consumers contract their consumption,
  firms produce less, workers income fall until
  balance
• How do we know we reach the balance and not
  collapse?

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Maintaining Spending Balance

• Usually contract in consumption less than fall in
  income. Why?
• Some of the fall in income reduced taxes so
  disposable income does not fall as much as income
  smaller reduction in consumption generates a
  smaller drop in income in second round
• The process of consumption and income
  contraction converges to a new lower point
  balance.

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The multiplier
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The Multiplier

• The change in GDP is greater than the change in
  investment
• The larger marginal propensity to consume, the
  larger the multiplier

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The Multiplier

• Fluctuations in investment associated with
  cyclical fluctuations in GDP (Keynes)
  essential source of business fluctuations
• Relatively small fluctuations in investment
  large fluctuations in GDP
• The mechanism multiplier
• Changes in other exogenous variables government
  spending and net exports also result in changes
  in income

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Net Exports - endogenous

• Open economy macroeconomics
• When income increases consumption increases,
  but also imports increases (X decreases)

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Net Exports - endogenous

• X g mY
• g constant
• m marginal propensity to import
• For each dollar that GDP rises , net exports fall
  by the same amount

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Net Exports - endogenous

• Open economy multiplier

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Net Exports - endogenous

• Forces that raise GDP cause a trade deficit
• Ex. Increase in G raise the trade deficit (but
  also fiscal deficit)