Chapter 1/9 Introduction to Economic Fluctuations The chapter covers: facts about the business cycle and Okun s Law an introduction to aggregate demand an introduction to aggregate supply in the short run and long run Facts about the business cycle GD growth averages 3 3.5 percent per year over the long run with large fluctuations in the short run. Consumption and investment fluctuate with GD, but consumption tends to be less volatile and investment more volatile than GD. Unemployment rises during recessions and falls during expansions. Okun s Law: the negative relationship between GD and unemployment. 1
Growth rates of real GD, consumption ercent change from quarters earlier 1 8 Real GD Consumption Average growth rate - - 197 1975 198 1985 199 1995 5 1 Growth rates of real GD, consumption, investment ercent change from quarters earlier 3 1 Investment Real GD -1 Consumption - -3 197 1975 198 1985 199 1995 5 1 ercent of labor force 1 1 Unemployment 8 197 1975 198 1985 199 1995 5 1
Okun s Law 1 ercentage change in 8 real GD 198 1951 19 1987 3 u 3 1971 8-1 1991 198 1975 - -3 - -1 1 3 Change in unemployment rate Okun s Law 3 u At steady state, when Δ =, in RGD is equal to 3%. One extra point percentage point of unemployment cost percentage points in RGD growth. Can solve for needed to reduce U by a stated amount. If < 3% => U increases: ΔU = 1.5.5 In today s world the constant term is estimated to be around.. Index of Leading Economic Indicators ublished monthly by the Conference Board. Aims to forecast changes in economic activity -9 months into the future. Used in planning by businesses and govt, despite not being a perfect predictor. 3
= 1 1/8/17 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 New building permits issued Index of stock prices M Money Supply ield spread (1-year minus 3-month) on Treasuries Index of consumer expectations Index of Leading Economic Indicators Note: turns down prior to recession and up prior to the end of a recession 1 11 1 9 8 7 5 Source: 3 Conference 197 Board 1975 198 1985 199 1995 5 1 Time horizons in macroeconomics Long run rices 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.
The model of aggregate demand and supply 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 curve shows the relationship between the price level and the quantity of output demanded. Chapters 11-13 develop the theory of aggregate demand in more detail. AD 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, at which the economy s resources are fully employed. 5
The long-run aggregate supply curve does not depend on, so LRAS is vertical. LRAS F ( K, L) Aggregate supply in the short run Many prices are sticky in the short run. For now (and through Chap. 1), 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: 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. SRAS
The short-run aggregate supply curve In Chapter 13 the SRAS curve is upward sloping The aggregate supply curve LRAS F ( K, L) shocks!!! shocks: exogenous changes in aggregate supply or demand Shocks temporarily push the economy away from full employment. For example: change in G, change in T, change in V. 7