Chapter 9 Introduction to Economic Fluctuations

Transcription

1 art IV Business Cycle Theory: Short Run Chapter 9 Introduction to Economic Fluctuations Zhengyu Cai h.d. Institute of Development Southwestern University of Finance and Economics All rights reserved

2 What are we going to learn? Reality: short run facts Method: a simplified AD AS model Implication Monetary policy Shocks and stabilization policy Zhengyu Cai Spring Macroeconomics Chapter 9 2/27

3 Recap: time horizons in macroeconomics Long run and very long run rices are flexible, respond to changes in supply or demand. Output is determined by the supply side: capital, labor, technology. Changes in demand for goods & services (CC, II, GG) only affect prices, not quantities. (Output = income = expenditure) Short run Many prices are sticky at a predetermined level. Output and employment also depend on demand. Demand is affected by fiscal, monetary policies, etc. Zhengyu Cai Spring Macroeconomics Chapter 9 3/27

4 Reality: facts about the business cycle GD growth averages percent per year over the long run with large fluctuations in the short run. Zhengyu Cai Spring Macroeconomics Chapter 9 4/27

5 Reality: facts about the business cycle Consumption and investment fluctuate with GD, but consumption tends to be less volatile and investment more volatile than GD. Zhengyu Cai Spring Macroeconomics Chapter 9 5/27

6 Reality: facts about the business cycle Unemployment rises during recessions and falls during expansions. Zhengyu Cai Spring Macroeconomics Chapter 9 6/27

7 Reality: facts about the business cycle Okun s law: the negative relationship between GD and unemployment. (Not a real law.) Zhengyu Cai Spring Macroeconomics Chapter 9 7/27

8 In microeconomics, we use demand and supply model to show how the price and quantity are determined. In macroeconomics, we use AD-AS model to show how the price level and aggregate output are determined. Aggregate demand (AD) and aggregate supply (AS) model Zhengyu Cai Spring Macroeconomics Chapter 9 8/27

9 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 develop the theory of aggregate demand in more detail. From Chapter 4, recall the quantity equation M V = For given values of M and V, this equation implies an inverse relationship between and Zhengyu Cai Spring Macroeconomics Chapter 9 9/27

10 Aggregate demand An increase in the price level causes an increase in demand of money. But money supply is given, it will cause a decrease in the demand for goods & services. AD Zhengyu Cai Spring Macroeconomics Chapter 9 10/27

11 Aggregate demand An increase in the money supply shifts the AD curve to the right. AD 1 AD 2 Zhengyu Cai Spring Macroeconomics Chapter 9 11/27

12 Aggregate supply (long run) Recall from Chap. 3: In the long run, output is determined by factor supplies and technology n = F ( K, L) n is the full-employment or natural level of output, at which the economy s resources are fully employed. Full employment means that unemployment equals its natural rate (not zero). Zhengyu Cai Spring Macroeconomics Chapter 9 12/27

13 Aggregate supply (long run) nn does not depend on, so LRAS is vertical. LRAS = F ( K, L) n Zhengyu Cai Spring Macroeconomics Chapter 9 13/27

14 Long-run equilibrium and monetary policy LRAS An increase in M shifts AD to the right. In the long run, this raises the price level 2 1 AD 2 AD 1 but leaves output the same. n Zhengyu Cai Spring Macroeconomics Chapter 9 14/27

15 Aggregate supply (short run) Many prices are sticky in the short run. For now (and through Chap. 11), 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: Zhengyu Cai Spring Macroeconomics Chapter 9 15/27

16 Aggregate supply (short run) The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. SRAS Zhengyu Cai Spring Macroeconomics Chapter 9 16/27

17 Aggregate supply (short run) In the short run when prices are sticky, an increase in aggregate demand SRAS AD 1 AD 2 causes output to rise. 1 2 Zhengyu Cai Spring Macroeconomics Chapter 9 17/27

18 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 > n < n = n then over time, will rise fall remain constant The adjustment of prices is what moves the economy to its long-run equilibrium. Zhengyu Cai Spring Macroeconomics Chapter 9 18/27

19 Implication: monetary policy (ΔM > 0) A = initial equilibrium B = new short-run eq m after Fed increases M 2 LRAS A C MONE IS NEUTRAL IN THE LONG RUN! B SRAS AD 2 C = long-run equilibrium n 2 AD 1 Zhengyu Cai Spring Macroeconomics Chapter 9 19/27

20 Implication: shocks and stabilization policy Move along the curve or shift the curve? Random Shocks: exogenous changes in agg. supply or demand Stabilization policy: policy actions aimed at reducing the severity of short-run economic fluctuations. Aggregate demand shock: 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. Zhengyu Cai Spring Macroeconomics Chapter 9 20/27

21 Implication: a negative demand shock AD shifts left, depressing output and employment in the short run. LRAS Over time, prices fall and the economy moves down its demand curve toward full employment. 2 B 2 n A C SRAS AD 1 AD 2 Zhengyu Cai Spring Macroeconomics Chapter 9 21/27

22 Implication: a negative demand shock Facing the negative demand shock, what action the government can take? Zhengyu Cai Spring Macroeconomics Chapter 9 22/27

23 Implication: aggregate supply shock 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. Zhengyu Cai Spring Macroeconomics Chapter 9 23/27

24 Implication: an adverse supply shock Early 1970s: OEC coordinates a reduction in the supply of oil. Oil prices rose 11% in % in % in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. Zhengyu Cai Spring Macroeconomics Chapter 9 24/27

25 Implication: an adverse supply shock The oil price shock shifts SRAS up, causing output and employment to fall. LRAS Stagflation: takes long time to recover In absence of further price shocks, prices will fall over time and economy moves back toward full employment. 2 B 1 2 n A SRAS 2 SRAS 1 AD Zhengyu Cai Spring Macroeconomics Chapter 9 25/27

26 Implication: an adverse supply shock But the Fed accommodates the shock by raising agg. demand. 2 B LRAS C SRAS 2 Results: is permanently higher, but remains at its fullemployment level. 1 2 A AD 1 AD 2 Zhengyu Cai Spring Macroeconomics Chapter 9 26/27

27 Summary Long run: prices flexible output determined by factors of production & technology unemployment equals its natural rate Short run: prices fixed output determined by aggregate demand unemployment negatively related to output Zhengyu Cai Spring Macroeconomics Chapter 9 27/27