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9 Introduction to Economic Fluctuations University of Wisconsin Charles Engel In this chapter, you will learn… facts about the business cycle how the short run differs from the long run an introduction to aggregate demand an introduction to aggregate supply in the short run and long run

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in this chapter you will learn
In this chapter, you will learn…
  • facts about the business cycle
  • how the short run differs from the long run
  • an introduction to aggregate demand
  • an introduction to aggregate supply in the short run and long run
  • how the model of aggregate demand and aggregate supply can be used to analyze the short-run and long-run effects of “shocks.”

CHAPTER 9.01

facts about the business cycle
Facts about the business cycle
  • GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.
  • Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP.
  • Unemployment rises during recessions and falls during expansions.
  • Okun’s Law: the negative relationship between GDP and unemployment.

CHAPTER 9.01

growth rates of real gdp consumption

Real GDP growth rate

Consumption growth rate

Average growth rate

Growth rates of real GDP, consumption

10

Percent change from 4 quarters earlier

8

6

4

2

0

-2

-4

1970

1975

1980

1985

1990

1995

2000

2005

growth rates of real gdp consumption investment

Real GDP growth rate

Investment growth rate

Consumption growth rate

Growth rates of real GDP, consumption, investment

Percent change from 4 quarters earlier

40

30

20

10

0

-10

-20

-30

1970

1975

1980

1985

1990

1995

2000

2005

unemployment

1970

1975

1980

1985

1990

1995

2000

2005

Unemployment

Percent of labor force

12

10

8

6

4

2

0

okun s law

1966

1951

1984

2003

1987

1975

2001

1982

1991

-3

-2

-1

0

1

2

3

4

Okun’s Law

10

Percentage change in real GDP

8

6

4

2

0

-2

-4

Change in unemployment rate

increased stability of gdp reading by trehan
Increased stability of GDP – reading by Trehan
  • Why have fluctuations in GDP been smaller in the past 20 years?
    • Fewer shocks?
    • Better policy? We will move now into the examination of macro policy.
  • While some argue that structural features of the economy have changed, so real shocks (oil price increase) have a smaller effect, that may in fact be a result of better policy.

CHAPTER 9.01

time horizons in macroeconomics
Time horizons in macroeconomics
  • Long run: Prices are flexible, respond to changes in supply or demand.
  • Short run:Many prices are “sticky” at some predetermined level.

The economy behaves much differently when prices are sticky.

CHAPTER 9.01

recap of classical macro theory chaps 3 8
Recap of classical macro theory (Chaps. 3-8)
  • 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.
  • Assumes complete price flexibility.
  • Applies to the long run.

CHAPTER 9.01

when prices are sticky
When prices are sticky…

…output and employment also depend on demand, which is affected by

  • fiscal policy (G and T )
  • monetary policy (M )
  • other factors, like exogenous changes in C or I.

CHAPTER 9.01

the model of aggregate demand and supply
The model of aggregate demand and supply
  • the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy
  • shows how the price level and aggregate output are determined
  • shows how the economy’s behavior is different in the short run and long run

CHAPTER 9.01

aggregate demand
Aggregate demand
  • The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.
  • For this chapter’s 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.

CHAPTER 9.01

the quantity equation as aggregate demand
The Quantity Equation as Aggregate Demand
  • From Chapter 4, recall the quantity equation

M V = P Y

  • For given values of M and V, this equation implies an inverse relationship between P and Y:

CHAPTER 9.01

the downward sloping ad curve

P

AD

Y

The downward-sloping AD curve

An increase in the price level causes a fall in real money balances (M/P),

causing a decrease in the demand for goods & services.

CHAPTER 9.01

shifting the ad curve

P

AD2

AD1

Y

Shifting the AD curve

An increase in the money supply shifts the AD curve to the right.

CHAPTER 9.01

aggregate supply in the long run
Aggregate supply in the long run
  • 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 economy’s resources are fully employed.

“Full employment” means that unemployment equals its natural rate (not zero).

CHAPTER 9.01

the long run aggregate supply curve

LRAS

P

Y

The long-run aggregate supply curve

does not depend on P, so LRAS is vertical.

CHAPTER 9.01

long run effects of an increase in m

LRAS

P

P2

In the long run, this raises the price level…

AD2

AD1

Y

…but leaves output the same.

Long-run effects of an increase in M

An increase in M shifts AD to the right.

P1

CHAPTER 9.01

aggregate supply in the short run
Aggregate supply in the short run
  • Many prices are sticky in the short run.
  • For now (and through Chap. 12), we assume
    • all prices are stuck at a predetermined level in the short run.
    • firms are willing to sell as much at that price level as their customers are willing to buy.
  • Therefore, the short-run aggregate supply (SRAS) curve is horizontal:

CHAPTER 9.01

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.

P

SRAS

Y

The short-run aggregate supply curve

CHAPTER 9.01

short run effects of an increase in m

In the short run when prices are sticky,…

P

SRAS

AD2

AD1

Y

…causes output to rise.

Y2

Short-run effects of an increase in M

…an increase in aggregate demand…

Y1

CHAPTER 9.01

from the short run to the long run
From the short run to the long run

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

In the short-run equilibrium, if

then over time, P will…

rise

fall

remain constant

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

CHAPTER 9.01

the sr lr effects of m 0

LRAS

P

P2

SRAS

AD2

AD1

Y

Y2

The SR & LR effects of M>0

A = initial equilibrium

B = new short-run eq’m after Fed increases M

C

B

A

C = long-run equilibrium

CHAPTER 9.01

shock
Shock!!!
  • shocks: exogenous changes in agg. supply or demand
  • Shocks temporarily push the economy away from full employment.
  • Example: exogenous decrease in velocity

If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.

CHAPTER 9.01

the effects of a negative demand shock
AD shifts left, depressing output and employment in the short run.

LRAS

P

P2

SRAS

AD2

AD1

Y

Y2

The effects of a negative demand shock

A

B

Over time, prices fall and the economy moves down its demand curve toward full-employment.

C

CHAPTER 9.01

supply shocks
Supply shocks
  • 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.
  • Favorable supply shocks lower costs and prices.

CHAPTER 9.01

case study the 1970s oil shocks
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.

CHAPTER 9.01

case study the 1970s oil shocks29
The oil price shock shifts SRAS up, causing output and employment to fall.

LRAS

P

SRAS2

SRAS1

AD

Y

Y2

CASE STUDY: The 1970s oil shocks

B

In absence of further price shocks, prices will fall over time and economy moves back toward full employment.

A

A

CHAPTER 9.01

case study the 1970s oil shocks30
Predicted effects of the oil shock:

inflation 

output 

unemployment 

…and then a gradual recovery.

CASE STUDY: The 1970s oil shocks

CHAPTER 9.01

case study the 1970s oil shocks31
Late 1970s:

As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

CASE STUDY: The 1970s oil shocks

CHAPTER 9.01

case study the 1980s oil shocks
1980s:

A favorable supply shock--a significant fall in oil prices.

As the model predicts, inflation and unemployment fell:

CASE STUDY: The 1980s oil shocks

CHAPTER 9.01

stabilization policy
Stabilization policy
  • def: policy actions aimed at reducing the severity of short-run economic fluctuations.
  • Example: Using monetary policy to combat the effects of adverse supply shocks:

CHAPTER 9.01

stabilizing output with monetary policy

LRAS

P

SRAS2

SRAS1

AD1

Y

Y2

Stabilizing output with monetary policy

The adverse supply shock moves the economy to point B.

B

A

CHAPTER 9.01

stabilizing output with monetary policy35

LRAS

P

SRAS2

AD2

AD1

Y

Y2

Stabilizing output with monetary policy

But the Fed accommodates the shock by raising agg. demand.

B

C

A

results: P is permanently higher, but Y remains at its full-employment level.

CHAPTER 9.01

chapter summary
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.

2. Aggregate demand and supply: a framework to analyze economic fluctuations

CHAPTER 9 Introduction to Economic Fluctuations

slide 35

chapter summary37
Chapter Summary

3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

CHAPTER 9 Introduction to Economic Fluctuations

slide 36

chapter summary38
Chapter Summary

6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.

7. The Fed can attempt to stabilize the economy with monetary policy.

CHAPTER 9 Introduction to Economic Fluctuations

slide 37