ECON 3010 Intermediate Macroeconomics Chapter 10 Introduction to Economic Fluctuations
Facts about the business cycle GDP growth averages 3 3.5 percent per year C (consumption) and I (Investment) fluctuate with GDP C tends to be less volatile and I more volatile than GDP. Unemployment rises during recessions and falls during expansions (also known as Okun s law).
Growth rates of real GDP, consumption Percent change from 4 quarters earlier 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 2010
Growth rates of real GDP, consump., 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 2010
Unemployment Percent of labor force 12 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010
Okun s Law Percentage change in real GDP 10 8 1951 1966 = 3 2 u 6 1984 2003 4 1971 2 1987 0 2001 1975-2 2008 1991 1982 2009-4 -3-2 -1 0 1 2 3 4 Change in unemployment rate
Index of Leading Economic Indicators Published monthly by the Conference Board. Forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and government, despite not being a perfect predictor.
Components of the LEI index Average workweek in manufacturing Initial weekly claims for unemployment insurance New orders for consumer goods and materials New orders, nondefense capital goods Vendor performance New building permits issued Index of stock prices M2 ield spread (10-year minus 3-month) on Treasuries Index of consumer expectations
Index of Leading Economic Indicators, 1970-2012 120 110 100 2004 = 100 90 80 70 60 50 40 30 20 10 Source: Conference Board 0 1970 1975 1980 1985 1990 1995 2000 2005 2010
Time horizons in macroeconomics Long run Prices are flexible, respond to changes in supply or demand. Short run Many prices are sticky at a predetermined level. The economy behaves much differently when prices are sticky.
Recap of classical macro theory (Chaps. 3-8) Output is determined by the supply side: supplies of capital, labor technology Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Assumes complete price flexibility. Applies to the long run.
When prices are sticky output and employment also depend on demand, which is affected by: fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I
The model of aggregate demand and supply Used by mainstream economists and policymakers use to think about economic fluctuations and policies Shows how the price level and aggregate output are determined Shows how the economy s behavior is different in the short run and long run
Aggregate Demand The aggregate demand (AD) curve shows the relationship between the price level and the quantity of output demanded. Recall the quantity equation M V = P For given values of M and V, this equation implies an inverse relationship between P and
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
Shifting the AD curve An increase in the money supply shifts the AD curve to the right. P AD 1 AD 2
Long-Run Aggregate Supply Recall from Chap. 3, output in the long run is determined by K, L, and technology: = F ( K, L) is the full-employment or natural level of output, at which the economy s resources are fully employed.
The long-run aggregate supply curve does not depend on P, so LRAS is vertical. P LRAS = F ( K, L)
Long-run effects of an increase in M P LRAS An increase in M shifts AD to the right. In the long run, this raises the price level P 2 P 1 AD 2 AD 1 but leaves output the same.
Aggregate supply in the short run Many prices are sticky in the short run. We now 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:
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
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
Price Adjustment in the Long Run 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
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 full employment. P P 2 B 2 A C SRAS AD 1 AD 2
Supply shocks A supply shock alters production costs & affects the prices that firms charge. 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.
CASE STUD: 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 Oil price increases are supply shocks because they impact production costs and prices.
CASE STUD: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. In absence of further price shocks, prices will fall over time and economy moves back toward full employment. P 2 P P 1 B 2 LRAS A SRAS 2 SRAS 1 AD
CASE STUD: The 1970s oil shocks Predicted effects of the oil shock: inflation output unemployment and then a gradual recovery. 70% 60% 50% 40% 30% 20% 10% 12% 10% 8% 6% 0% 4% 1973 1974 1975 1976 1977 Change in oil prices (left scale) Inflation rate-cpi (right scale) Unemployment rate (right scale)
CASE STUD: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another supply shock. 60% 50% 40% 30% 20% 10% 14% 12% 10% 8% 6% 0% 4% 1977 1978 1979 1980 1981 Change in oil prices (left scale) Inflation rate-cpi (right scale) Unemployment rate (right scale)
CASE STUD: The 1980s oil shocks 1980s: A favorable supply shock a significant fall in oil prices. As the model predicts, inflation and unemployment fell. 40% 30% 20% 10% 0% -10% -20% -30% -40% 10% 8% 6% 4% 2% -50% 0% 1982 1983 1984 1985 1986 1987 Change in oil prices (left scale) Inflation rate-cpi (right scale) Unemployment rate (right scale)
Stabilization policy Definition: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: Using monetary policy to combat the effects of adverse supply shocks
Stabilizing output with monetary policy 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
Stabilizing output with monetary policy But the Fed accommodates the shock by raising aggregate demand. P 2 P B LRAS C SRAS 2 results: P is permanently higher, but remains at its fullemployment level. P 1 2 A AD 2 AD 1