Introduction to Economic Fluctuations

1
Introduction to Economic Fluctuations

• Chapter Nine

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Introduction

• The primary objective of this chapter and the
  ones that follow is to study the causes and
  consequences of short-run economic fluctuations
  in output and employment business cycle
• Short-run fluctuations are a recurring phenomenon
  is the U.S. economy (see graph on next slide)
• Economy experiences on average 3.5 real GDP
  growth per year
• This growth is not steady there are recessions
  (periods of falling income and rising
  unemployment) and there are expansions (periods
  of rising income and falling unemployment)
• Recession of 1990 real GDP fell by 2.2 from
  peak to trough and unemployment rose to 7.7
• Expansion of 1997 real GDP growth rose to a high
  of 6.1
• Notice that business cycles are very common but
  also very irregular/unpredictable
• In this chapter we will begin to develop a
  different model that is able to explain the
  short-run economic fluctuations depicted in the
  graph.

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Real GDP Growth in the United States
4
Time Horizons in MacroeconomicsHow the Short
Run and Long Run Differ

• Why do we need a different model to study the
  economy in the short-run? Because the classical
  model applies to what time horizon?
• The key differences between the short and long
  run is the behavior of prices
• In the long-run prices are flexible and can
  respond to changes in supply and demand
• In the short-run many prices are sticky at some
  predetermined level and thus cannot fully respond
  to changes in supply and demand
• Consider the effects of a 5 money supply
  reduction in the long run
• How does this affect Y, C, I, S, NX? Why?
• How does this affect P?
• What is this separation in the classical model
  called?
• In the long-run, changes in the money supply do
  not cause fluctuations in output or employment

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Time Horizons in Macroeconomics

• In order to explain the short-run economic
  fluctuations that are so obvious from the graph,
  we need to develop a model in which changes in
  nominal variables can affect output and
  employment in other words, we need a model
  where the classical dichotomy fails.
• Consider the effects of a 5 money supply
  reduction in the short run
• The reduction in the money supply does not
  immediately cause all firms to lower their prices
  and wages price stickiness
• Thus, the short-run impact of a money supply
  reduction will not be the same as the impact in
  the long-run where prices absorb all of the
  change in the money supply
• We will see that the failure of prices to fully
  and quickly adjust implies that output and
  employment must do some of the adjusting instead

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The Model of Aggregate Supply and Aggregate Demand

• To see how the presence of sticky prices causes
  short-run fluctuations we need to look at a model
  of supply and demand (for output)
• In the classical model, does the amount of output
  depend on the demand or the economys ability to
  supply goods and services?
• Y F(K,L)
• Prices adjust in order to ensure that demand
  supply if demand gt supply, P rises causing
  demand to fall if demand lt supply, P falls
  causing demand to rise
• When prices are sticky, output will depend in
  part on the demand for goods/services which in
  turn depends on monetary and fiscal policy
• The model of aggregate demand and aggregate
  supply show how the price level and the quantity
  of aggregate output are jointly determined in the
  short run so output is no longer uniquely
  supply determined

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Aggregate Demand

• The aggregate demand curve shows the relationship
  between the price level and the quantity of
  output demanded. It tells us the quantity of
  goods/services people want to buy at any given
  level of prices.
• For this chapters intro to the AD/AS model, we
  use a simple theory of aggregate demand based on
  the Quantity Theory of Money.
• Chapters 10-12 develop the theory of aggregate
  demand in more detail.

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The Quantity Equation as Aggregate Demand

• Recall from chapter 4 that the quantity theory
  says that M?VP?Y
• Whats V? If velocity is constant then this
  equation states that the money supply determines
  nominal GDP
• Recall that the quantity equation can be
  transformed into a supply/demand equation for
  real money balances
• (M/P )d k Y where V 1/k velocity
• This equation states that the demand for real
  money balances (and thus supply) is proportional
  to output
• For given values of M and V, these equations
  imply an inverse relationship between P and Y
• Holding M and V constant, if P increases, Y must
  decrease to retain equality between (M/P ) and k
  Y

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Why the Aggregate Demand Curve Slopes Downward

• As a strictly mathematical matter, if you hold M
  and V constant
• M/P (1/V)?Y ?if P? ? Y?
• Intuitively, if the price level rises, each
  transaction that takes place requires more
  dollars, so the number of transactions falls and
  the quantity of goods/services falls provided
  that we do not change the money supply or the
  income velocity of money.

10
Shifts in the Aggregate Demand Curve

• The AD curve is drawn for fixed values of M and V
• If we change M or V, the entire AD curve shifts
• Consider a reduction in M
• MV PY tells us that a fall in M (holding V
  constant) results in a proportionate fall in PY
• For any given P, Y must be lower for any given
  Y, P must be lower ? AD shifts left
• Consider an increase in M
• If M rises ? PY rises proportionately
• For any given P, Y must rise For any given Y, P
  must rise ? AD shifts right

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Aggregate Supply

• Acting alone, the AD curve will not tell us what
  the actual price level or output will be in our
  economy
• To pin down P and Y, we need a second
  relationship between these two variables, namely
  an aggregate supply relationship
• Aggregate supply (AS) the relationship between
  quantity of goods/services supplied and the price
  level
• Firms that supply goods have flexible prices in
  the long-run but sticky prices in the short-run
  thus behavior of AS will depend critically on the
  assumed time horizon

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The Long Run The Vertical Aggregate Supply Curve

• Recall from chapter 3 in the long run, output is
  determined by factor supplies and technology

• is the full-employment or natural level of
  output, the level of output at which the
  economys resources are fully employed.

• Full employment means that unemployment equals
  its natural rate.

• Full-employment output does not depend on the
  price level,
• so the long run aggregate supply (LRAS) curve
  is vertical

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The long-run aggregate supply curve
The LRAS curve is vertical at the full-employment
level of output.
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Long-run effects of an increase in M
Does the vertical AS curve satisfy the classical
dichotomy?
An increase in M shifts the AD curve to the
right.
P1
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The Short Run The Horizontal Aggregate Supply
Curve

• The classical model and the vertical AS curve
  apply only in the long-run firms have time to
  adjust prices fully to demand shocks
• In the short-run, some prices are sticky and
  therefore do not adjust to changes in demand
  this means that the short-run AS curve is not
  vertical
• Consider an extreme case
• All prices are stuck at some predetermined level
  in the short-run because of menu costs perhaps
• Firms are willing to sell as much as households
  are willing to buy at the prevailing price level
• Because the price level is fixed, the short-run
  aggregate supply (SRAS) curve is horizontal

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The short run aggregate supply curve
The SRAS curve is horizontal The price level is
fixed at a predetermined level, and firms sell as
much as buyers demand.
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Short-run effects of an increase in M
an increase in aggregate demand
Does the horizontal AS curve satisfy the
classical dichotomy?
Y1
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From the short run to the long run

• Over time, prices gradually become unstuck.
  When they do, will they rise or fall?

• This adjustment of prices is what moves the
  economy to its long-run equilibrium.

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The SR LR effects of ?M gt 0
A initial equilibrium
B new short-run eqm after Fed increases M
C
B
A
C long-run equilibrium
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Stabilization Policy

• Short-run fluctuations in output, employment, and
  prices come from changes in aggregate supply or
  aggregate demand
• Economists call these exogenous shifts in AS or
  AD economic shocks
• Demand shock a shock that shifts the AD curve
• Supply shock a shock that shifts the AS curve
• These shocks disrupt the economy by pushing
  output away from its long-run natural rate
• 2 goals of the model of aggregate demand and
  aggregate supply
• Show how shocks cause short-run economic
  fluctuations
• Evaluate how macroeconomic policy can best
  respond to these adverse supply and demand shocks
  stabilization policy
• Stabilization policy refers to policy actions
  aimed at reducing the severity of short-run
  economic fluctuations
• Because output fluctuates around its long-run
  natural rate, stabilization policy dampens the
  business cycle by keeping output as close to its
  natural rate as possible

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Shocks to Aggregate Demand

• Assume there is an exogenous increase in the
  velocity of money, what happens to AD? Why?
• What happens to output and prices in the
  short-run?
• Explain what happens in the long-run.
• During the transition, where is output relative
  to the LR natural rate?
• What can the Fed do to dampen this fluctuation
  and keep output closer to its natural rate?

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Shocks to Aggregate Supply

• A supply shock alters production costs, affects
  the prices that firms charge. (also called price
  shocks)
• Examples of adverse supply shocks
• Bad weather reduces crop yields, pushing up food
  prices.
• Workers unionize, negotiate wage increases.
• New environmental regulations require firms to
  reduce emissions. Firms charge higher prices to
  help cover the costs of compliance.
• All of these events are adverse supply shocks,
  which means they push costs and prices upward. A
  favorable supply shock reduces costs and prices
  (technological innovation)

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Shocks to Aggregate Supply

• Assume that there is an adverse supply shock
  (OPEC) what happens to the SRAS curve? Why?
• If the government does nothing to alter AD, what
  happens to the price level and the amount of
  output produced? - stagflation
• What happens in the LR if the FED does nothing in
  response to the supply shock? Why might this be
  a bad idea?
• What could the FED do to the money supply to
  bring output back to its natural rate more
  quickly?
• What is the one drawback of accommodating the
  supply shock?
• Under which shock does the FED face a tough
  tradeoff between stabilizing output and
  stabilizing the price level?

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CASE STUDY The 1970s oil shocks

• Early 1970s OPEC coordinates a reduction in
  the supply of oil.
• Oil prices rose 11 in 1973 68 in 1974
  16 in 1975
• Such sharp oil price increases are supply shocks
  because they significantly impact production
  costs and prices.

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CASE STUDY The 1970s oil shocks
The oil price shock shifts SRAS up, causing
output and employment to fall.
B
In absence of further price shocks, prices will
fall over time and economy moves back toward full
employment.
A
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CASE STUDY The 1970s oil shocks

• Predicted effects of the oil price shock
• inflation ?
• output ?
• unemployment ?
• and then a gradual recovery.

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CASE STUDY The 1970s oil shocks
Late 1970s As economy was recovering, oil
prices shot up again, causing another huge supply
shock!!!
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CASE STUDY The 1980s oil shocks
1980s A favorable supply shock--a significant
fall in oil prices. As the model would predict,
inflation and unemployment fell
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Chapter Summary

• 1. Long run prices are flexible, output and
  employment are always at their natural rates, and
  the classical theory applies.
• Short run prices are sticky, shocks can push
  output and employment away from their natural
  rates.
• Aggregate demand and supply a framework to
  analyze economic fluctuations
• The aggregate demand curve slopes downward.
• The long-run aggregate supply curve is vertical,
  because output depends on technology and factor
  supplies, but not prices.
• The short-run aggregate supply curve is
  horizontal, because prices are sticky at
  predetermined levels.
• Shocks to aggregate demand and supply cause
  fluctuations in GDP and employment in the short
  run.
• The Fed can attempt to stabilize the economy with
  monetary policy.