Introduction to Economic Fluctuations

1. Introduction to Economic Fluctuations Chapter Nine

2. 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.

3. Real GDP Growth in the United States

4. Time Horizons in Macroeconomics:How 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

5. � 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

6. 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 economy�s ability to supply goods and services? Y = F(K,L) Prices adjust in order to ensure that demand = supply; if demand > supply, P rises causing demand to fall; if demand < 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

7. 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 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.

8. The Quantity Equation as Aggregate Demand Recall from chapter 4 that the quantity theory says that M?V=P?Y What�s 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

9. 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

11. 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

12. The Long Run: The Vertical Aggregate Supply Curve Recall from chapter 3: in the long run, output is determined by factor supplies and technology

13. The long-run aggregate supply curve

14. Long-run effects of an increase in M

15. The Short Run: The Horizontal Aggregate Supply Curve The classical model and the vertical AS curve apply only in the long-run; firm�s 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

16. The short run aggregate supply curve

17. Short-run effects of an increase in M

18. From the short run to the long run

19. The SR & LR effects of ?M > 0

20. 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

21. 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?

22. 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)

23. 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?

24. 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.

25. CASE STUDY: The 1970s oil shocks

26. CASE STUDY:  The 1970s oil shocks

27. CASE STUDY:  The 1970s oil shocks

28. CASE STUDY:  The 1980s oil shocks

29. 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.