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Roadmap to this Lecture
ƒ We abandon the view that production is
determined by technology and full employment
of production factors (i.e., there can be
unemployment and capital underutilization)
ƒ Short-run frictions prevent full factor utilization
in the short-run and distort optimal economic
outcomes
ƒ When this happens, what can we do?
Introduction to Economic
Fluctuations
– Monetary Policy
– Fiscal Policy
ƒ The AD/AS model is the basic tool to think
about policy
ECN 101 – MACROECONOMICS
Real GDP Growth in the U.S., 19601960-2004
Time horizons
Percent change from
four quarters earlier
10
8
Peak
Average growth
rate = 3.4%
6
Prices are flexible, respond to changes in
supply or demand
many prices are “sticky” at some
predetermined level (or there are other
frictions, e.g. information)
2
0
Trough
-4
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
ECN 101 – MACROECONOMICS
slide 2
In Classical Macroeconomic Theory,
ƒ Output is determined by the supply side:
– supplies of capital, labor
– technology
The economy behaves much
differently when prices are sticky.
ECN 101 – MACROECONOMICS
slide 3
When prices are sticky
…output and employment also depend on
demand for goods & services,
which is affected by
ƒ Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
ƒ fiscal policy (G and T )
ƒ monetary policy (M )
ƒ Complete price flexibility is a crucial
assumption,
so classical theory applies in the long run.
ECN 101 – MACROECONOMICS
ƒ Long run:
ƒ Short run:
4
-2
slide 1
ƒ other factors, like exogenous changes
in C or I.
slide 4
ECN 101 – MACROECONOMICS
slide 5
1
The model of
aggregate demand and supply
Aggregate demand
ƒ The aggregate demand curve shows the
ƒ the paradigm that most mainstream
relationship between the price level and the
quantity of output demanded.
economists & policymakers use to think
about economic fluctuations and policies
to stabilize the economy
ƒ For now, we derive the AD/AS model
with a simple theory of aggregate demand
based on the Quantity Theory of Money.
ƒ shows how the price level and aggregate
output are determined
ƒ Later we will develop the theory of
ƒ shows how the economy’s behavior is
aggregate demand in more detail.
different in the short run and long run
ECN 101 – MACROECONOMICS
slide 6
The Quantity Equation as Aggregate
Demand
ƒ Recall the quantity equation
MV = PY
than solely determined by technology and
available factors).
P
causing a
decrease in the
demand for goods
& services.
ƒ For given values of M and V, QTM implies
an inverse relationship between P and Y:
slide 7
The downwarddownward-sloping AD curve
An increase in the
price level causes
a fall in real
money balances
(M/P ),
ƒ We now assume that Y is flexible (rather
AD
Y
ECN 101 – MACROECONOMICS
slide 8
ECN 101 – MACROECONOMICS
slide 9
Using Total Differentiation to Make the
Same Point
Shifting the AD curve
ƒ Recall M V = P Y (QTM)
P
ƒ The slope of the aggregate demand curve is
An increase in
the money
supply shifts
the AD curve
to the right.
determined by how prices change when income
changes by one unit, everything else constant
ƒ Totally differentiating QTM:
M dV + V dM = P dY + Y dP
AD2
ƒ Notice, dV = dM = 0
AD1
Y
ECN 101 – MACROECONOMICS
ECN 101 – MACROECONOMICS
slide 10
ƒ Hence: dP/dY = -P/Y < 0
ECN 101 – MACROECONOMICS
slide 11
2
Aggregate Supply in the Long Run
ƒ In the long run, output is determined by
Aggregate Supply in the Long Run
ƒ Recall from chapter 3:
factor supplies and technology
In the long run, output is determined by
factor supplies and technology
Y = F (K , L )
Y = F (K , L )
Y is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
on the price level,
so the long run aggregate supply (LRAS)
curve is vertical:
“Full employment” means that
unemployment equals its natural rate.
ECN 101 – MACROECONOMICS
slide 12
The longlong-run aggregate supply curve
P
ƒ Full-employment output does not depend
ECN 101 – MACROECONOMICS
LongLong-run effects of an increase in M
P
LRAS
The LRAS curve
is vertical at the
full-employment
level of output.
slide 13
In the long run,
this increases
the price level…
LRAS
P2
An increase
in M shifts
the AD curve
to the right.
P1
AD2
AD1
Y
Y
ECN 101 – MACROECONOMICS
slide 14
Aggregate Supply in the Short Run
…but leaves
output the same.
Y
Y
ECN 101 – MACROECONOMICS
slide 15
The short run aggregate supply curve
ƒ In the real world, many prices are sticky in
P
the short run.
The SRAS curve
is horizontal:
ƒ For now, assume that all prices are stuck at
a predetermined level in the short run…
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
ƒ …and that firms are willing to sell as much
at that price level as their customers are
willing to buy (why is this a sensible
exercise?)
ƒ Therefore, the short-run aggregate supply
P
SRAS
Y
(SRAS) curve is horizontal:
ECN 101 – MACROECONOMICS
slide 16
ECN 101 – MACROECONOMICS
slide 17
3
ShortShort-run effects of an increase in M
In the short run
when prices are
sticky,…
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
P
…an increase
in aggregate
demand…
In the short-run
equilibrium, if
SRAS
AD2
AD1
P
…causes output
to rise.
Y1
Y
Y2
ECN 101 – MACROECONOMICS
slide 18
The SR & LR effects of ∆M > 0
A = initial
equilibrium
P
From the short run to the long run
then over time,
the price level will
Y >Y
rise
Y <Y
fall
Y =Y
remain constant
This adjustment of prices is what moves
the economy to its longlong-run equilibrium.
ECN 101 – MACROECONOMICS
slide 19
How shocking!!!
ƒ shocks: exogenous changes in aggregate
LRAS
supply or demand
ƒ Shocks temporarily push the economy away
B = new shortrun eq’m
after Fed
increases M
from full-employment.
C
P2
B
P
ƒ If the money supply is held constant, then a
decrease in V means people will be using their
Y
Y2
Y
exogenous decrease in velocity
SRAS
AD2
AD1
A
C = long-run
equilibrium
ƒ An example of a demand shock:
ECN 101 – MACROECONOMICS
slide 20
The effects of a negative demand shock
The shock shifts
AD left, causing
output and
employment to fall
in the short run
Over time, prices
fall and the
economy moves
down its demand
curve toward fullemployment.
P
P
A
C
P2
ECN 101 – MACROECONOMICS
SRAS
AD1
AD2
Y2
Y
ECN 101 – MACROECONOMICS
slide 21
Supply shocks
A supply shock alters production costs,
affects the prices that firms charge.
(also called price shocks)
LRAS
B
money in fewer transactions, causing a
decrease in demand for goods and services:
Y
Examples of adverse supply shocks:
ƒ Bad weather reduces crop yields, pushing up
food prices.
ƒ Workers unionize, negotiate wage increases.
ƒ 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.)
slide 22
ECN 101 – MACROECONOMICS
slide 23
4
CASE STUDY:
CASE STUDY:
The 1970s oil shocks
The 1970s oil shocks
ƒ Early 1970s: OPEC coordinates a reduction in the
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
supply of oil.
ƒ Oil prices rose
11% in 1973
68% in 1974
16% in 1975
In absence of
further price
shocks, prices will
fall over time and
economy moves
back toward full
employment.
ƒ Such sharp oil price increases are supply shocks
because they significantly impact production costs
and prices (and each unit of GDP required much
more oil to be produced. Now the economy is more
service oriented – a massage requires little oil).
ECN 101 – MACROECONOMICS
slide 24
CASE STUDY:
P
P2
LRAS
B
SRAS2
SRAS1
A
P1
AD
Y2
Y
Y
ECN 101 – MACROECONOMICS
slide 25
CASE STUDY:
The 1970s oil shocks
The 1970s oil shocks
60%
70%
14%
12%
Predicted effects of
the oil price shock:
• inflation ↑
• output ↓
• unemployment ↑
…and then a
gradual recovery.
60%
50%
50%
10%
40%
8%
30%
20%
6%
10%
4%
0%
1973
1974
1975
1976
1977
8%
20%
6%
10%
0%
1977
1978
1979
1980
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
Unemployment rate (right scale)
slide 26
40%
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
1983
1984
1985
ECN 101 – MACROECONOMICS
4%
1981
slide 27
Stabilization policy
The 1980s oil shocks
-50%
1982
10%
30%
Inflation rate-CPI (right scale)
CASE STUDY:
As the model
would predict,
inflation and
unemployment
fell:
12%
40%
Change in oil prices (left scale)
ECN 101 – MACROECONOMICS
1980s:
A favorable
supply shock-a significant fall
in oil prices.
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!!!
1986
ƒ definition: policy actions aimed at
reducing the severity of short-run
economic fluctuations.
ƒ Example: Using monetary policy to
combat the effects of adverse supply
shocks:
0%
1987
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
ECN 101 – MACROECONOMICS
slide 28
ECN 101 – MACROECONOMICS
slide 29
5
Stabilizing output with
monetary policy
The adverse
supply shock
moves the
economy to
point B.
P
P2
Stabilizing output with
monetary policy
LRAS
B
But the Fed
accommodates
the shock by
raising agg.
demand.
SRAS2
A
P1
SRAS1
AD1
Y2
ECN 101 – MACROECONOMICS
Y
Y
slide 30
results:
P is permanently
higher, but Y
remains at its fullemployment level.
P
P2
LRAS
B
C
A
P1
ECN 101 – MACROECONOMICS
SRAS2
AD1
Y2
Y
AD2
Y
slide 31
6