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Advanced Diploma
Paper 2: Macroeconomics
Handout 1: Introduction to Economic Fluctuations
Kamiar Mohaddes
General info and practical matters
• Lectures:
Wednesdays 10:00-11:00, weeks 1–8.
Lecture Block Room 12
• Office Hours:
Wednesdays 11:00-12:00
• Email:
[email protected]
• Webpage:
http://people.ds.cam.ac.uk/km418
• Teaching Assistant: MyunGun Kim ([email protected])
• Assessment:
Mid-term exam (1 hour in January)
Final examination (3 hours at the end of the year)
• Textbook:
Mankiw and Taylor, Macroeconomics, European Ed.
General info and practical matters
• Part 1: The Short-Run: An Introduction
Handout 1:
Introduction to economic fluctuations
Handout 2:
The IS-LM model: A first look
• Part 2: Applying the IS-LM model
Handout 3:
Explaining economic fluctuations using the IS-LM framework
• Part 3: The Open Economy Revisited
Handout 4:
The Mundell-Fleming model and the exchange rate regime
• Part 4: Inflation-Unemployment
Handout 5:
The inflation-unemployment trade-off
Outline




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.”
3
The long run vs the short run
 Long-run models are a guide to how the
economy behaves on average (over long
periods of time)
 At any given time, the economy is very unlikely
to be exactly at the long-run average
Handout 1
4
Potential and actual output
 Potential output: The amount the economy would
produce if all inputs were utilized at their long-run
sustainable levels
Note: Potential output is not necessarily the same as
‘steady state’ output (e.g. if economy is in transition)
 Actual output: The actual amount produced at a given
point in time
 Actual output = Potential output + short-run fluctuations
Handout 1
5
Potential and actual output
𝑌 = 𝑌ത + 𝑌෠
Short-run
fluctuations, or
cyclical component
Actual output
Long run trend
(potential output)
determined in the
long run
Handout 1
6
Short-run output
 Short-run fluctuation
 The difference in actual and potential output,
expressed as a percentage of potential output
 Referred to as “detrended output” or short-run
output:
Handout 1
𝑌 − 𝑌ത
𝑌෨ =
𝑌ത
7
Fluctuations
Handout 1
8
What is a business cycle?
 The business cycle is the short-run fluctuations of
real GDP around estimated potential income (the
trend path)
 The are characterised by recessions (low GDP)
and booms (high GDP)
 A recession begins when actual output falls below
potential, and short-run output becomes negative
 A recession ends when short-run output starts to
rise and becomes less negative
Handout 1
9
The importance of potential output
 Knowing potential output is very important
because it defines:
 Recessions (if actual output is below potential)
and booms (if actual output is above potential)
 The ‘length’ of the short-run, i.e. how long it
takes for an economy to complete a cycle of
fluctuation
 There is no directly observable measure of
potential output in an economy!
Handout 1
10
Ways to measure potential output
 Assume a perfectly smooth trend passes through
quarterly movements of real GDP
 Take averages of the surrounding actual GDP
numbers
 Because it is hard to measure potential output, we
need a (statistically) concrete definition of a recession
 Practitioners use the following definition:
 An economy is in recession if there are two
consecutive quarters of negative GDP growth
rates
Handout 1
11
Handout 1
2015 Q1
2014 Q1
2013 Q1
2012 Q1
2011 Q1
2010 Q1
2009 Q1
2008 Q1
2007 Q1
2006 Q1
2005 Q1
2004 Q1
2003 Q1
2002 Q1
2001 Q1
2000 Q1
1999 Q1
1998 Q1
1997 Q1
1996 Q1
1995 Q1
1994 Q1
1993 Q1
1992 Q1
1991 Q1
1990 Q1
1989 Q1
1988 Q1
1987 Q1
1986 Q1
1985 Q1
1984 Q1
1983 Q1
1982 Q1
1981 Q1
1980 Q1
Two pictures, one story
120
100
80
60
40
20
0
UK Real GDP, Index (Source: ONS)
12
-2
1980 Q1
1980 Q4
1981 Q3
1982 Q2
1983 Q1
1983 Q4
1984 Q3
1985 Q2
1986 Q1
1986 Q4
1987 Q3
1988 Q2
1989 Q1
1989 Q4
1990 Q3
1991 Q2
1992 Q1
1992 Q4
1993 Q3
1994 Q2
1995 Q1
1995 Q4
1996 Q3
1997 Q2
1998 Q1
1998 Q4
1999 Q3
2000 Q2
2001 Q1
2001 Q4
2002 Q3
2003 Q2
2004 Q1
2004 Q4
2005 Q3
2006 Q2
2007 Q1
2007 Q4
2008 Q3
2009 Q2
2010 Q1
2010 Q4
2011 Q3
2012 Q2
2013 Q1
2013 Q4
2014 Q3
2015 Q2
Two pictures, one story
8
6
4
2
0
-4
-6
-8
UK Real GDP growth rate, year-on-year (Source: ONS)
Handout 1
13
Business cycle theory
 Models that describe the short run
 Main assumption: The economy is constantly
being hit by shocks
Shocks
Handout 1
Propagation
mechanism
Fluctuations
in real
GDP
14
The premises of the short-run model
 Potential output is determined in the long-run and
depends on factors or production (=long run aggregate
supply LRAS), and is independent of the price level or
inflation
 In the short run economy is hit by shocks (real and
nominal)
 Short run aggregate supply affects price level
 Price level affects aggregate demand
 Government/policy makers can intervene to smooth
fluctuations
Handout 1
15
Fluctuations in the AD-AS model
 Shocks shift the AD and AS curves (will look at this
in detail)
 Temporary (transitory) shocks, generate
fluctuations, but eventually economy returns to
potential output
 Note: Potential output 𝑌ത changes only via
permanent shocks (e.g. by permanent changes
in productivity)
Handout 1
16
Facts about the business cycle
 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.
Handout 1
17
Growth rates of real GDP and consumption
Percent 10
change
from 4 8
quarters
earlier
Real GDP
growth rate
Consumption
growth rate
6
Average 4
growth
rate 2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Growth rates of real GDP, consumption, and investment
Percent
change 40
from 4
quarters 30
earlier
Investment
growth rate
20
Real GDP
growth rate
10
0
Consumption
growth rate
-10
-20
-30
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Okun’s Law
Percentage 10
change in
real GDP 8
1951
Y
 3  2 u
Y
1966
1984
6
2003
1971
4
1987
2
1975
2001
0
2009
2008
-2
1991
1982
-4
-3
-2
-1
0
1
2
3
Change in unemployment rate
4
Index of Leading Economic Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
6-9 months into the future.
 Used in planning by businesses and
government, despite not being a perfect
predictor.
Handout 1
22
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
Yield spread (10-year minus 3-month) on Treasuries
Index of consumer expectations
Handout 1
23
Index of Leading Economic Indicators,
1970-2012
120
110
2004 = 100
100
90
80
70
60
50
40
30
20
10
Source:
0
Conference
1970
Board
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.
Handout 1
25
Recap of classical macro theory
 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.
Handout 1
26
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
Handout 1
27
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
Handout 1
28
Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 We initially introduce the AD/AS model,
using a simple theory of aggregate demand
based on the quantity theory of money.
 We then develop the theory of aggregate
demand in more detail (Handout 2).
Handout 1
29
The Quantity Equation as Aggregate Demand
 Recall the quantity equation (covered in Lecture
3 of the Preparatory Course)
MV = PY
 For given values of M and V,
this equation implies an inverse relationship
between P and Y …
Handout 1
30
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
Y
Handout 1
31
The downward-sloping AD curve
 MV = PY
 An increase in the price level causes a fall in real
money balances.
 With lower real money balances (or,
equivalently, the same nominal balances but
higher goods prices), people demand a smaller
quantity of goods and services.
Handout 1
32
Shifting the AD curve
P
An increase in
the money supply
shifts the AD
curve to the right.
AD2
AD1
Y
Handout 1
33
Aggregate supply in the long run
 In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y 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).
Handout 1
34
The long-run aggregate supply curve
P
LRAS
Y does not
depend on P,
so LRAS is
vertical.
Y
 F (K , L )
Handout 1
Y
35
Long-run effects of an increase in M
P
In the long run,
this raises the
price level…
LRAS
An increase
in M shifts
AD to the
right.
P2
P1
AD2
AD1
…but leaves
output the same.
Handout 1
Y
Y
36
Aggregate supply in the short run
 Many prices are sticky in the short run.
 For now, 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:
Handout 1
37
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.
Handout 1
P
P
SRAS
Y
38
Short-run effects of an increase in M
In the short run
when prices are
sticky,…
P
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
…causes
output to rise.
Handout 1
Y1
Y2
Y
39
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
then over time,
P will…
Y Y
rise
Y Y
fall
Y Y
remain constant
The adjustment of prices is what moves
the economy to its long-run equilibrium.
Handout 1
40
The SR & LR effects of ΔM > 0
A = initial
equilibrium
B = new shortrun eq’m
after Fed
increases M
C = long-run
equilibrium
Handout 1
P
LRAS
C
P2
P
B
A
Y
Y2
SRAS
AD2
AD1
Y
41
How shocking!!!
 shocks: exogenous changes in aggregate 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.
Handout 1
42
The effects of a negative demand shock
AD shifts left,
depressing output
and employment
in the short run.
Over time,
prices fall and
the economy
moves down its
demand curve
toward full
employment.
Handout 1
P
P
LRAS
B
P2
A
SRAS
C
AD1
AD2
Y2
Y
Y
43
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.
Handout 1
44
Nominal and Real Oil Prices, 1946-2016
Handout 1
45
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
 Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.
Handout 1
46
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.
Handout 1
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD
Y2
Y
Y
47
The 1970s oil shocks
70%
Predicted effects
of the oil shock:
• inflation #
• output $
• unemployment #
…and then a
gradual recovery.
12%
60%
50%
10%
40%
8%
30%
20%
6%
10%
0%
1973
1974
1975
1976
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
4%
1977
The 1970s oil shocks
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!
60%
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
1977
1978
1979
1980
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
4%
1981
The 1980s oil shocks
40%
1980s:
A favorable
supply shock—
a significant fall
in oil prices.
As the model
predicts,
inflation and
unemployment
fell.
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982
1983
1984
1985
1986
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
0%
1987
Handout 1
51
Effects of a negative (short-term) shock to oil prices
using the GVAR-Oil Model
Source: Mohaddes and Pesaran (2016). Oil Prices and the Global Economy: Is It
Different This Time Around? USC-INET Research Paper No. 16–21
Handout 1
52
Stabilization policy
 def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
 Example: Using monetary policy to combat the
effects of adverse supply shocks…
Handout 1
53
Stabilizing output with monetary policy
P
The adverse
supply shock
moves the
economy to
point B.
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD1
Y2
Handout 1
Y
Y
54
Stabilizing output with monetary policy
But the Fed
accommodates
the shock by
raising aggregate
demand.
results:
P is permanently
higher, but Y
remains at its fullemployment level.
Handout 1
P
P2
LRAS
B
C
SRAS2
A
P1
AD1
Y2
Y
AD2
Y
55
Summary
1. Long run: prices are flexible, output and employment
are always at their natural rates, and the classical theory
applies.
Short run: prices are sticky, shocks can push output
and employment away from their natural rates.
2. Aggregate demand and supply: a framework to analyze
economic fluctuations
56
Summary
3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical, because
output depends on technology and factor supplies, but not
prices.
5. The short-run aggregate supply curve is horizontal, because
prices are sticky at predetermined levels.
6. Shocks to aggregate demand and supply cause fluctuations
in GDP and employment in the short run.
7. Monetary Authorities (the Fed, BoE, ECB etc.) can attempt to
stabilize the economy with monetary policy.
57