Chapter 9 Introduction to Economic Fluctuations slide 0
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. slide 1
Overview (1) So far we ve focused in the LR: We assumed that the level of output was fixed We ve assumed that the classical dichotomy holds Real and nominal sides of the economy are separate. Fiscal or monetary policies do not affect long run. Prices are flexible slide 2
Overview (2) In this chapter we will focus on the SR. In the short run: Real GDP is not constant. It is subject to fluctuations Business cycles. Business Cycles refer to fluctuations in real GDP from its long run average Fiscal and Monetary policies are effective and they aim to minimize fluctuations. Classical Dichotomy does not hold. Prices are fixed. slide 3
Facts about the business cycle GDP growth is not steady 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. slide 4
Percent change from 4 quarters earlier Growth rates of real GDP, consumption 10 8 6 Real GDP growth rate Consumption growth rate Average growth rate 4 2 0-2 -4 1970 1975 1980 1985 1990 1995 2000 2005
Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier 40 30 20 10 Investment growth rate Real GDP growth rate 0-10 Consumption growth rate -20-30 1970 1975 1980 1985 1990 1995 2000 2005
Unemployment Percent of labor force 12 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005
Okun s Law Percentage change in real GDP 10 8 1951 1966 3.5 2 u 6 1984 2003 4 2 1987 0 1975-2 2001 1991 1982-4 -3-2 -1 0 1 2 3 4 Change in unemployment rate
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. slide 9
How the Short Run and the Long Run differ Suppose there is a contractionary MP: M decreases by 5%. According to the quantity theory, we know that this policy P by 5% in the LR with no impact on. But what happens in SR? Not all prices will decline as soon as the Fed decreases the money supply. There is a mechanism which forces these firms to prices (the model of AD and AS) which takes time to transmit to economy. While prices are sticky, output and employment respond to the M (i.e. when there is less money to spend, demand, output, and employment ) slide 10
In the LR: The Model of Aggregate Supply and Aggregate Demand Output is determined by the supply side: supplies of capital, labor technology. Prices adjust to make sure d =. In the SR: the level of output depends on not only on supply side but also on demand (prices do not adjust). slide 11
The model of AD and AS resembles the supply and demand for a single good (Econ 200). However, this time the good is GDP and the price is the overall price level (e.g. GDP deflator). slide 12
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. slide 13
The Quantity Equation as Aggregate Demand From Chapter 4, recall the quantity equation M V = P For given values of M and V, this equation implies an inverse relationship between P and slide 14
Example Let M = 100, V = 0.5 P = 1 = MV/P = 50 P = 2 = MV/P = 25 P = 3 = MV/P = 16 Keeping the M and V fixed, as P,. This downward sloping curve is called AD curve. slide 15
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. P AD slide 16
Shifts in AD curve The AD curve is drawn for given M and V. Any change in M or V causes shifts in AD M changes due to MP V changes due to financial innovation Fiscal Policy (e.g. G, V = (P/M) ) slide 17
Example Continuing with the previous example, suppose money supply doubles. M = 200, V = 0.5: P = 1 = MV/P = 100 P = 2 = 50 P = 3 = 32 slide 18
Shifting the AD curve An increase in the money supply shifts the AD curve to the right. P AD 1 AD 2 slide 19
Notes Expansionary MP or FP shifts AD to the right Contractionary MP or FP shifts AD to the left slide 20
Aggregate supply in the long run Recall from Chapter 3: In the long run, output is determined by factor supplies and technology F ( K, L) 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). slide 21
The long-run aggregate supply curve does not depend on P, so LRAS is vertical. P LRAS F ( K, L) slide 22
How is the price level determined in LR? P LRAS P 1 AD 1 slide 23
Long-run effects of an increase in M In the long run, this raises the price level P 2 P 1 P LRAS An increase in M shifts AD to the right. AD 2 AD 1 but leaves output the same. slide 24
Aggregate supply in the short run Many prices are sticky in the short run. 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: slide 25
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 P SRAS slide 26
P P SRAS AD 1 1 slide 27
Short-run effects of an increase in M In the short run when prices are sticky, P an increase in aggregate demand P SRAS AD 1 AD 2 causes output to rise. 1 2 slide 28
Expansionary MP AD as AD increases (for a given price), firms are left with prices too low (relative to demand) and high demand produce more and sell more economic expansion Note, if the prices could adjust, AD P when demand for a product, P. slide 29
We said: In LR, SR, P P MP only affects prices MP only affects output What is the transition from SR to LR? slide 30
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. slide 31
Intuition (1) Suppose aggregate demand is higher than the fullemployment level of output in the economy s initial shortrun equilibrium. Then, there is upward pressure on prices: In order for firms to produce this above-average level of output, they must pay their workers overtime and make their capital work at a high intensity, which causes more maintenance, repairs, and depreciation. For all these reasons, firms would like to raise their prices. In the short run, they cannot. But over time, prices gradually become unstuck, and firms can increase prices in response to these cost pressures. slide 32
Intuition (2) Instead, suppose that output is below its natural rate. Then, there is downward pressure on prices: Firms can t sell as much output as they d like at their current prices, so they would like to reduce prices. With lower than normal output, firms won t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the natural rate of unemployment. The high unemployment rate puts downward pressure on wages. Wages and prices are stuck in the short run, but over time, they fall in response to these pressures. slide 33
The SR & LR effects of M > 0 A = initial equilibrium P LRAS B = new shortrun eq m after Fed increases M P 2 P A C B SRAS AD 2 C = long-run equilibrium 2 AD 1 slide 34