S E V E N T H E D I T I O N C H A P T C H A P T E R E R Introduction to Economic Introduction to Economic Fluctuations Fluctuations 9 9
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Introduction to Economic Introduction to Economic FluctuationsFluctuations
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In this chapter, you will learn: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.”
3CHAPTER 9 Introduction to Economic Fluctuations
Facts about the business cycle What exactly do we mean by “business cycles:? Business cycles are economy wide fluctuations
in total national output, income, and employment, usually lasting for a period of 2 to 10 years, marked by widespread expansion or contraction in most sectors of the economy.
Economists typically divide business cycles into two main phases: recession and expansion. Peaks and troughs mark the turning points of the cycle. The downturn of a business cycle is called a recession. A recession is a recurring period of decline in total output, income, and employment, usually lasting from 6-12 months and marked by contractions in many sectors of the economy. A recession that is large in both in scale and duration is called a depression.
GDP growth averages 3–3.5 percent per year over the long run with large fluctuations 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.
4CHAPTER 9 Introduction to Economic Fluctuations
Time horizons in macroeconomics
Long run Prices are flexible, respond to changes in supply or demand.
Short runMany prices are “sticky” at a predetermined level.
The economy behaves much differently when prices are sticky.
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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.
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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
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The model of aggregate demand and supply
The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy
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
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Aggregate demand (AD) The aggregate demand curve shows the relationship between the price level and the
quantity of output demanded. AD is the total or aggregate quantity of output that is willingly bought at a given price, other things held constant. AD is the desired spending in all product sectors: Consumption, private domestic investment, government purchases of goods and services, and net exports.
AD consists of four components- consumption (C), domestic private investment (I), government spending on goods and services (G), and net exports (NX).
Aggregate demand shifts when there are changes in macroeconomic policies (such as monetary-policy changes or changes in government expenditures or tax rates) or exogenous events change spending ( as would be the case with changes in output, affecting NX, or in business confidence, affecting I).
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Aggregate demand (AD)Impact on AD
Variables:
Monetary policy: Monetary expansion may lower inter interest rates and loosen credit conditions, inducing higher levels of investment and consumption of durable goods. In an open economy, monetary policy also affects the exchange rates and net exports (NX).
Fiscal Policy: Increases in government purchases of goods and services directly increase spending, tax reductions or increases in transfers raise disposable income and induce higher consumption. Tax incentives like investment tax credit can induce higher spending in a particular sector.
10CHAPTER 9 Introduction to Economic Fluctuations
The Quantity Equation as Aggregate Demand
From Chapter 4, recall the quantity equation
M V = P Y
For given values of M and V, this equation implies an inverse relationship between P and Y …
11CHAPTER 9 Introduction to Economic Fluctuations
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.
An increase in the price level causes a fall in real money balances (M/P ),
causing a decrease in the demand for goods & services. Y
P
AD
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Shifting the AD curve
An increase in the money supply shifts the AD curve to the right.
An increase in the money supply shifts the AD curve to the right.
Y
P
AD1
AD2
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Aggregate supply in the long run
Recall from Chapter 3: In the long run, output is determined by factor supplies and technology
is the full-employment or natural level of output, at which the economy’s resources are fully employed.
“Full employment” means that unemployment equals its natural rate (not zero).
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The long-run aggregate supply curve
Y
P LRAS
does not depend on P,
so LRAS is vertical.
does not depend on P,
so LRAS is vertical.
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Long-run effects of an increase in M
Y
P
AD1
LRASAn increase in M shifts AD to the right.
P1
P2In the long run, this raises the price level…
…but leaves output the same.
AD2
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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:
17CHAPTER 9 Introduction to Economic Fluctuations
The short-run aggregate supply curve
Y
P
SRAS
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
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Short-run effects of an increase in M
Y
P
AD1
In the short run when prices are sticky,…
…causes output to rise.
SRAS
Y2Y1
AD2
…an increase in aggregate demand…
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From the short run to the long run
Over time, prices gradually become “unstuck.” When they do, will they rise or fall?
rise
fall
remain constant
In the short-run equilibrium, if
then over time, P will…
The adjustment of prices is what moves the economy to its long-run equilibrium.
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An increase in aggregate demand: The economy begins in long-run equilibrium at point A. An increase in aggregate demand, perhaps due to an increase in the velocity of money, moves the economy from point A to point B, where output is above its natural level. As prices rise, output gradually returns to its natural level, and the economy moves from point B to point C.
The SR & LR effects of ΔM > 0
Y
P
AD1
LRAS
SRAS
P2
Y2
A = initial equilibrium
AB
CB = new short-run
eq’m after central bank increases M
C = long-run equilibrium
AD2
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How shocking!!!
shocks: exogenous changes in agg. supply or demand
Shocks temporarily push the economy away from full employment.
Example: exogenous decrease in velocity
If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.
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SRAS
LRAS
AD2
The effects of a negative demand shock
Y
P
AD1P2
Y2
AD shifts left, depressing output and employment in the short run.
AD shifts left, depressing output and employment in the short run. AB
C
Over time, prices fall and the economy moves down its demand curve toward full-employment.
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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.
Favorable supply shocks lower costs and prices.
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Stabilization policy
def: policy actions aimed at reducing the severity of short-run economic fluctuations. Because output and employment fluctuate around their long-run natural levels, stabilization policy dampens the business cycle by keeping output and employment as close to their natural levels as possible.
Example: Using monetary policy to combat the effects of adverse supply shocks…
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Stabilizing output with monetary policy
SRAS1
Y
P
AD1
B
A
Y2
LRAS
The adverse supply shock moves the economy to point B.
SRAS2
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Stabilizing output with monetary policy
Y
P
AD1
B
A
C
Y2
LRASBut the central bank accommodates the shock by raising agg. demand.
results: P is permanently higher, but Y remains at its full-employment level.
SRAS2
AD2