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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