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Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10) Li Gan Department of Economics Texas A&M University We have just come out of a severe recession – but risk to have another one. Historically, GDP fluctuates. Shaded areas are recessions GDP components

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Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10)


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lecture 7 short run economic fluctuations and business cycles part i chapter 9 and 10

Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10)

Li Gan

Department of Economics

Texas A&M University

historically gdp fluctuates
Historically, GDP fluctuates.

Shaded areas are recessions

gdp components
GDP components
  • GDP = consumption

+ investment

+ government purchase

+ net exports

  • Which components fluctuates the most during the business cycles?
investment10
Investment
  • Since investment varies the most during the business cycles, it will be a key variable in our analysis.
unemployment rate
Unemployment rate
  • Unemployment rate also fluctuates substantially.
  • http://www.google.com/publicdata?ds=usunemployment&met=unemployment_rate&tdim=true&dl=en&hl=en&q=unemployment+rate
  • Looks like we have emerged from the worst.
okun s law
Okun’s law
  • Percentage change in Real GDP =

3.5% - 2 x change in the unemployment rate

  • Quite intuitive: a higher unemployment rate indicates a lower number of people working

 Lower output.

leading economic indicators
Leading economic indicators
  • Average workweek of production workers in manufacturing
    • Businesses often adjust their work hours before they adjust number of workers – because of transaction costs.
  • Average initial weekly claims for unemployment insurance
    • Quick indicators of labor market situations.
  • New orders for consumer goods and materials, adjusted for inflation
    • New consumer goods
  • New orders, nondefense capital goods
    • New investment
  • Vendor performance
    • A measure of number of companies receiving slower deliveries from suppliers. A lower performance indicates a future increase in activity.
leading economic indicators15
Leading economic indicators

6. New building permits issued

7. Index of stock prices

  • Expectations about the future.

8. Money supply (M2), adjusted for inflation

  • More money supply predicts increase in spending
leading economic indicators16
Leading economic indicators

9.Interest rate spread: the yield spread between 10-year treasury notes and 3-month treasury notes.

  • Typically, interest rate for long-term bond is higher than interest rate for short-term bond.
interest rate spread
Interest rate spread
  • Interest rates usually decline during a recession.
  • If investors anticipate a recession in the near future, they will sell their short-term bonds and buy longer-term bonds to carry them through the recession.
interest rate spread18
Interest rate spread
  • Price of short-term bonds will be lower yields (interest rates) will be higher.
  • Price of long-term bonds will be higher  yields (interest rates) will be lower.
  • If these two effects are sufficiently strong, the interest rate spread can invert, or become negative.
short run and long run
Short run and long run
  • The key difference between the short run and the long run is if prices are “sticky”.
    • Suppose that Fed suddenly reduces the money supply by 5%. In the long run, the prices would be down by 5% while output, employment, and other real variables remain the same.
    • In the short run, however, many prices do not respond to changes in monetary policy.
price stickiness in the short run
Price stickiness in the short run
  • Why prices do not change in the short run:
  • Mankiw’s Menu Cost theory
    • Suppose it is optimal for firms to increase price by 1%.
    • Mankiw argues that the gains of increasing prices is proportional to the square of 1% (very very small), smaller than even printing a new set of “menus”.
    • Therefore, firms do not change prices in the short run.
price stickiness in the short run22
Price stickiness in the short run
  • However, everybody agrees that firms would change prices in the long run.
  • Therefore, the difference between a long-run and a short-run is whether prices may change or not.
aggregate demand
Aggregate demand
  • Quantity theory of money:

MV = PY

  • Rewrite this: M/P = kY, where k = 1/V
  • At any given M, one must have:
aggregate supply curve
Aggregate supply curve
  • Two major schools of thoughts:
    • Neoclassical:
      • Chicago, Stanford, Minnesota, etc.
    • Keynesian
      • Harvard, Berkeley, MIT, Princeton, etc.
  • They differ by how they view the aggregate supply curve.
neoclassical macroeconomics prices are flexible
Neoclassical macroeconomics: prices are flexible

aggregate supply

Price P

Neoclassical

World

output

Income Y

a shift in aggregate demand price changes but output remains the same
A shift in aggregate demand: price changes but output remains the same

aggregate supply

Price P

Neoclassical

World

New price

Old price

Aggregate Demand

output

Income Y

key points of neoclassical economics
Key points of neoclassical economics
  • Prices are flexible to adjust.
  • Aggregate demand shocks would only affect prices not the real output.
  • Economic fluctuations are mostly due to shocks on aggregate supply
    • Shocks such as technology innovation, etc. would affect aggregate supply and hence aggregate output.
key implications
Key implications
  • Government plays very little role during the business cycles.
  • Very close to Republicans’ point of view.
key economists in this camp
Key economists in this camp

Robert Lucas, Jr

1995 Nobel

Edward Prescott

2004 Nobel

Finn Kydland

2004 Nobel

a shift in aggregate demand price remains the same output increases
A shift in aggregate demand price remains the same, output increases

Price P

Keynesian

World

Short run AS

Aggregate Demand

Old output

Income Y

New output

key points of keynesian economics
Key points of Keynesian economics
  • Prices are sticky in the short run but flexible in the long run.
  • Shifts in aggregate demand curve would affect short run output.
  • Economic fluctuations and business cycles are mostly due to shocks to aggregate demand.
    • Shocks such as a drop in stock prices reduces future expectations.
key implications34
Key implications:
  • Government is very important in “managing economy.”
    • When economy is doing poorly, government may try to shift aggregate demand curve to the right.
  • Very close to Democrats’ point of view.
key economists
Key economists

Ben Bernanke

Current Fed Chairman

John Maynard Keynes

1983-1946

keynesian long run and short run
Keynesian: Long run and short run

Price P

Long run AS

Short run AS

Aggregate Demand

Income Y

a money supply increase short run moves along the short run as
A money supply increase: short run, moves along the short run AS

Price P

Same price, higher output

Aggregate Demand

Short run AS

Long run AS

New output

Income Y

A money supply increase

a money supply increase long run prices adjusted and total output backs to the original value
A money supply increase: long run, prices adjusted and total output backs to the original value

Price P

Move along the AD curve

Aggregate Demand

Short run AS

Long run AS

Income Y

Higher price, same output

A money supply increase

examples of government intervention
Examples of government intervention
  • A negative supply by Hurricane Katrina, or by 911 Terrorist Attack, destroy a large amount of capital stock.
  • A demand shock caused by subprime mortgage crisis, a large drop in stock market.
a negative shock in supply examples 911 terrorist attack hurricane katrina
A negative shock in supply examples: 911 terrorist attack, Hurricane Katrina

A sudden and large increase in oil price

Price P

AD

Income Y

new output

old output

keynesian stablization policy fed raises money supply
Keynesian stablization policy: Fed raises money supply

Price P

New equilibrium

New AD

AD

Income Y

Fed raises money supply

AD shifts right

A higher short run output

stablization policy raises too little money supply and or government spending
Stablization policy: raises (too little) money supply and/or government spending

Price P

New equilibrium

New AD

AD

Raises money supply or government spending AD shifts right

Income Y

A higher short run output

stablization policy raises too much money supply and government spending
Stablization policy: Raises (too much) money supply and government spending

Price P

New equilibrium

New AD

AD

Income Y

Fed raises money supply

AD shifts right

A higher short run output

stablization policy
Stablization policy
  • An negative aggregate shock:
    • Short run aggregate supply curves shifts up.
    • A lower short run output
  • Fed raises money supply
    • Aggregate demand shifts right.
    • Short run output is higher.
  • Higher long run prices.
slide46
A negative shock in demand shifts AD curve left examples: subprime mortgage crisis, crash of stock market

Price P

AD

Income Y

new output

old output

stablization policy raise too little the money supply and or government spending to shift ad right
Stablization policy: raise (too little) the money supply and/or government spending to shift AD right

Price P

AD

Income Y

stablization policy raise too much the money supply and or government spending to shift ad right
Stablization policy: raise (too much) the money supply and/or government spending to shift AD right

Price P

AD

Income Y

why aggregate demand curve shifts
Why aggregate demand curve shifts
  • The key public policy is to shift the aggregate demand curve.
  • We want to understand why changes in government spending or money supply may shift aggregate demand curve.
the keynesian cross
The Keynesian cross
  • The GDP equality:

E = C + I + G

= C(Y-T) + I + G

= a + b(Y-T) + I + G

  • Expenditure = Income
multiplier effect government spending
Multiplier effect: government spending
  • An increase in G, ΔG, would raise income by ΔG.
  • An increase in income by ΔG would then raise the consumption by MPC x ΔG
  • Such an increase in income would then raise the income by MPC x ΔG
  • ….
multiplier effect
Multiplier effect
  • Total increase in income:
  • If MPC is 0.6, then:

ΔY = ΔG /(1-MPC) = ΔG /(1-0.6) = 2.5ΔG

The multiplier effect is 2.5.

multiplier effect tax
Multiplier effect: tax
  • A decrease in taxes of ΔT immediately raises disposable income by ΔT.

 anincrease in consumption by MPC x ΔT.

  • Total increase in consumption is:

MPC x ΔT / (1-MPC).

summary
Summary
  • Economies fluctuate over time, and investment varies the most among all GDP components.
  • The key difference between the Keynesian economics and neo-classical economies is the treatment of prices.
summary57
Summary
  • Neoclassical economics:
    • Prices are flexible and the aggregate supply curve is vertical.
    • Aggregate demand shifts have no effect on real output but only change prices.
    • Very little role for government in the economy.
summary58
Summary
  • Keynesian economics:
    • Prices are sticky in the short run, and aggregate supply curve is horizontal.
    • Shifting in aggregate demand can change real output in the short run.
    • Government can play an important role in stablizing economy.
    • Long run behavior is the same as what neoclassical economics suggests.
    • Fiscal policies (G and tax T) may have multiplier effects.