Chapter 9. Introduction to Economic Fluctuations (Continued) CHAPTER 9 Introduction to Economic Fluctuations. slide 0

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1 Chapter 9 Introduction to Economic Fluctuations (Continued) slide 0

2 Stabilization Policies Economic fluctuations (or business cycles) refer to deviations of real GDP growth from its long run average growth rate. These deviations are caused by changes in AD or change in AS in the short run. Shifts in AD: Demand Shock Shifts in AS: Supply Shock Stabilization policies are the policies that aim to decrease short run fluctuations. Monetary policy Fiscal policy slide 1

3 Shocks to Aggregate Demand What causes shifts in AD? M or V Example: If the money supply is held constant, an increase in V means people will be using their money in more transactions, causing a increase in demand for goods and services. M V P nominal spending : AD slide 2

4 P LRAS P 2 C P A B SRAS AD 2 AD 1 2 slide 3

5 If the Fed knows the impact of financial innovations on the economy ( 2 >bar ) and the long-term inflation, it may try to counter-act by implementing a contractionary MP at the same time that AD shifts to right. AD 1 AD 2 (due to V) and AD 2 AD 1 (due to contraction in M) This is an example of a stabilization policy which aims to prevent the fluctuations in output in the short run and prices in the long run slide 4

6 The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. P LRAS Over time, prices fall and the economy moves down its demand curve toward fullemployment. P P 2 B 2 A C SRAS AD 1 AD 2 slide 5

7 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. Oil price shocks (say due to a cartel or war) Favorable supply shocks lower costs and prices. slide 6

8 Example P LRAS The adverse supply shock moves the economy to point B. P 2 P 1 B A SRAS 2 SRAS 1 AD 1 2 slide 7

9 P LRAS SRAS1 SRAS2: P1 P2 (New short run equilibrium at B) P 2 P 1 B 2 A AD SRAS 2 SRAS 1 At point B, B <bar : Because the economy is producing below its full capacity, in the long run prices fall: movement form point B A along AD. slide 8

10 What can the policy maker do to reduce the fluctuation? Do nothing: The natural forces will bring the economy from B to A eventually. Cost: ou need to suffer the recession. If you want to minimize the recession period the Fed can offset the contractionary influence of the supply shock by implementing an expansiony MP. Or, government can implement expansionary FP slide 9

11 Stabilizing output with monetary policy But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but remains at its fullemployment level. P 2 P 1 P B 2 LRAS C A SRAS 2 AD 2 AD 1 slide 10

12 Quiz #3 this Thursday (November 29, 2012) from Chapter 9 slide 11

13 End of chapter problem 1 Economy initially in LR equilibrium Banks start paying interest on checking accounts How does this affect the demand for money,velocity If there is no MP action, what happens to prices and output in SR and LR How can the Fed stabilize prices How can the Fed stabilize output slide 12

14 Interest payment on checking accounts Demand for checking accounts (up) Demand for M=C+D (up) M (up) V=P/M (down) Less velocity means less transactions AD (down) declines and P constant in SR. constant and P declines in LR. Expansionary MP to stabilize output and prices slide 13

15 End of chapter problem 2 Fed reduces the money supply by five percent What happens to AD, output and prices in SR and LR? According to Okun s law, what happens to unemployment in SR and LR? What happens to r in SR and LR? slide 14

16 AD shifts left. Output declines, P constant in SR. Output returns back to potential, prices decline in LR. Using quantity theory, prices decline by 5 percent in LR. declines in SR Unemp. increases in SR is constant in LR Unemp. constant (i.e. back to natural rate) In SR (down) S (down) r (up) In LR (constant) S(constant) r(constant) slide 15

17 End of chapter problem 3 Fed A only cares about keeping prices stable Fed B only cares about keeping output and employment at their natural levels Explain how each Fed would respond to a) Exogenous decrease in velocity b) An exogenous increase in the price of oil slide 16

18 Hint: Decline in velocity shifts AD to the left a) Expansionary MP by Fed A and Fed B b) Fed A: Do nothing Fed B: Expansionary MP slide 17