Business Cycles. What are we modelling? Focus on explaining fluctuations in real GDP, Y, and the GDP Deflator, P. Framework reminiscent of the supply.

Business Cycles

What are we modelling?Focus on explaining fluctuations

in real GDP, Y, and the GDP Deflator, P.

Framework reminiscent of the supply and demand model.

SUPPLY

Two Aspects of Potential OutputPotential Output is unrelated to

the price level but is determined by capital infrastructure, efficiency of labor markets, population, technological know-how. ◦Output increases above potential

only if unemployment falls below natural level;

◦if unemployment rises above natural level, output will be below potential.

Potential output and labor market. Potential output can be viewed

as a level consistent with equilibrium in labor market.

When output is above potential output, low unemployment and the search for workers will push up wages.

When output is below potential, high unemployment and the surplus of workers will push down wages.

P

Y

Potential Output

Upward Pressure on Wages

Downward Pressure on Wages

YP

Unemployment below natural rate

Unemployment above natural rate

Sticky Wages & SRASMoney wages paid to workers

adjust dynamically over time through negotiation.

At a given wage, a rise in the price level reduces the cost of labor relative to value of goods produced making hiring labor to produce goods more attractive.

At a given wage rate, higher prices induce higher production → in the short run, supply is positively associated with output.

P

Y

SRAS

Aggregate Supply CurveYP

1. Shift in Potential OutputAdvance in Technology Frontier,

PP& E, or expansion in potential labor force (population, demographics).

Shifts SRAS w/ potential output. 2. Shifts in SRASWhen dollar cost of labor (or prices of

energy) shift, changes in costs are passed on into prices.

Wages and other cost shifters shift SRAS at a given level potential output.

P

Y

SRAS

1. Expansion in Output PotentialYP

YP '

SRAS'

P

Y

SRAS

2. Increase in WagesYP SRAS

'

DEMAND

Expenditure: C + I + G + NX

Wealth Effect – Real value of monetary assets rises as prices fall. This adds to wealth of households stimulating consumption.

Competitiveness Effect – Holding exchange rate constant, a lower price level makes domestic exports more attractive and foreign imports less stimulating net exports.

Prices and Spending

Prices and LiquidityDepending on monetary policy,

there may be a negative relationship between prices and the liquidity that central banks make available.

More on that later.

P

Y

AD

Aggregate Demand Curve

AS-AD MODEL

EquilibriumEquilibrium in the competitive market

occurs when the price is set at a level (P*) such that the amount that consumers want to buy is equal to the amount that sellers want to sell (Y*). Excess Supply If P were above equilibrium,

sellers would want to sell more goods than buyers would want to buy. Competition between sellers would force prices down.

Excess Demand If P were below equilibrium, customers would want to buy more goods than people would want to sell. Competition between buyers would force prices up.

P

Y

SRAS

Equilibrium GDP and Price Level

AD

P*

Y*

P

Y

AS

Output below potential: Recessionary Gap.

YP

AD

P*1

Y*

GAP

P

Y

AS

Output above potential: Inflationary Gap.

YP

AD

P*2

Y*

GAP

Self Correction ProcessBusiness cycles have a natural

end. The equilibrium output may be greater than or less than potential output, however, in that case surplus or shortage of workers in labor markets will be putting downward or upward pressure on wages.

Pressure on wage costs will shift the supply curve until equilibrium output is equal to potential output.

P

Y

AS

Movement to Long Term Equilibrium

AD

P*

YP

2

1W↓

AS1

AS2

W↑

Cyclical FluctuationsPeriod-by-period, different

important events will impact the economy. We will think of these events as primarily driving the demand side of the economy (shifting the AD curve) or primarily driving the supply side (shifting the supply side).

The strength of these will determine the correspondence between movements in output and inflation.

P

Y

AS

Demand side shocks cause output and prices to move together.

AD1

P*

Y*

AD2

Y**

P**

1

2

P

Y

AS

Output below potential. Downward pressure on wages. Cost of production falls and AS shifts down

AD1

YP

AD2

Y**

P***

1

2

AS2

Wages fall

3

As costs fall, competitive prices fall, there is a movement along the AD curve.

P

Y

AS4

Wages will keep falling until the surplus of labor is absorbed – when prices fall enough that demand reaches potential output

AD1

YP

AD2

Y**

P**

4

AS2

Wages fall

3

What shifts the AD curve?

Shift outward in AD Shift inward in AD

Increasing Optimism Increasing Pessimism

Increasing Value of Assets Falling Value of Assets

Increasing Foreign GDP Decreasing Foreign GDP

Expansionary Monetary Policy

Contractionary Monetary Policy

Expansionary Fiscal Policy Contractionary Fiscal Policy

Consumer Confidence and…

http://business.asiaone.com/Business/News/Story/A1Story20091229-188708.html

http://hk.nielsen.com/news/20091103.shtml

..and Business Confidence…

BNP Parabis Research

..and changes in Asset Prices..http://urbanpolicy.berkeley.edu/pdf/CQSAdvMacro2005Web.pdf

AS-AD and Expected inflation

Potential GDP generally increases at a consistent rate.

On average, aggregate quantity of liquid assets tends to increase faster than potential GDP.

Workers wages will tend to rise to match increases in the cost of living.

AD does not always rise evenly with GDP.

P

Y

ASt

Dynamic AS-AD Model: Trend Path

ADt

Yt*

YtP YP

t+1

ADt+1

ASt+

1

Y*t+1

Pt*

P*t+1

Demand expansion matches supply expansion

Average Inflation

P

Y

ASt

Dynamic AS-AD Model: Inflation Acceleration

ADt

Yt*

YtP YP

t+1

ADt+1

ASt+

1

Y*t+1

Pt*

P*t+1

Gap

Demand expands faster than expected

Expected Inflation

Positive Output Gap

Inflation rises more than usual

P

Y

ASt

Dynamic AS-AD Model: Recession, Inflation Deceleration

ADt

Yt*

YtP YP

t+1

ADt+1

ASt+

1

Y*t+1

Pt*P*t+1

Expected Inflation

Gap

Demand expands slower than expected

Negative Output Gap

Inflation rises less than usual

Inflation Acceleration: πt – πt-1

UK 1992-2008

-4

-3

-2

-1

0

1

2

-4 -3 -2 -1 0 1 2 3

Output Gap

Infl

atio

n A

ccel

erat

on

P

Y

AS

Supply side shocks cause output and prices to move in opposite directions: Stagflation

AD1

P*

Y*

AS2

Y**

P**

1

2

Commodity Prices increase..

In 2007, rising commodity & energy prices lead to global inflation

Bank of England Report

Stagflation in the 1970s

Learning Outcomes

Students should be able toExplain how various events will

shift the aggregate supply or demand curves.

Construct an aggregate supply and demand model of business cycles and use it to explain equilibrium outcomes.

Describe the short-term and long-term dynamics of business cycles.