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IN THIS CHAPTER, YOU WILL LEARN: facts about the business cycle Chapter 10 Introduction to Economic Fluctuations 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.” CHAPTER 10 Introduction to Economic Fluctuations 0 1 Facts about the business cycle Real GDP – Turkey GDP growth averages 3–3.5 (U.S.), 4.0-4.5 (Turkey) 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. CHAPTER 10 Introduction to Economic Fluctuations 2 CHAPTER 10 Introduction to Economic Fluctuations 3 Growth rates of Consumption and Investment -Turkey Real GDP growth rate – Turkey CHAPTER 10 Introduction to Economic Fluctuations 4 Growth rates of real GDP, consumption – U.S. Percent 10 change from 4 8 quarters earlier Real GDP growth rate Consumption growth rate 6 CHAPTER 10 Introduction to Economic Fluctuations 5 Growth rates of real GDP, consump., investment – U.S. Percent change 40 from 4 quarters 30 earlier Investment growth rate 20 Average 4 growth rate 2 10 0 0 -10 -2 -20 -4 1970 Real GDP growth rate 1975 1980 1985 1990 1995 2000 2005 2010 -30 1970 Consumption growth rate 1975 1980 1985 1990 1995 2000 2005 2010 Unemployment Okun’s Law Percent 12 of labor force Percentage 10 change in real GDP 8 10 6 1951 Y 3 2 u Y 1966 1984 2003 8 1971 4 6 1987 2 2001 0 4 1975 2009 2008 -2 1991 2 1982 -4 0 1970 -3 1975 1980 1985 1990 1995 2000 2005 -2 -1 0 1 2 Index of Leading Economic Indicators Components of the LEI index In the U.S. - published monthly by the In Turkey – published monthly by the Central Bank; not as widely used as in the U.S. Aims to forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and govt, despite not being a perfect predictor. CHAPTER 10 Introduction to Economic Fluctuations 10 4 Change in unemployment rate 2010 Conference Board. 3 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 CHAPTER 10 Introduction to Economic Fluctuations 11 Index of Leading Economic Indicators, U.S., Time horizons in macroeconomics 1970-2012 120 Long run 110 Prices are flexible, respond to changes in supply or demand. 2004 = 100 100 90 Short run 80 70 Many prices are “sticky” at a predetermined level. 60 50 40 The economy behaves much differently when prices are sticky. 30 20 10 Source: 0 Conference 1970 Board 1975 1980 1985 1990 1995 2000 2005 CHAPTER 10 2010 Recap of classical macro theory Introduction to Economic Fluctuations 13 When prices are sticky… (Chaps. 3-8) …output and employment also depend on demand, which is affected by: Output is determined by the supply side: supplies of capital, labor technology Changes in demand for goods & services fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in (C, I, G ) only affect prices, not quantities. C or I Assumes complete price flexibility. Applies to the long run. CHAPTER 10 Introduction to Economic Fluctuations 14 CHAPTER 10 Introduction to Economic Fluctuations 15 The model of aggregate demand and supply Aggregate demand The aggregate demand curve shows the The paradigm most mainstream economists relationship between the price level and the quantity of output demanded. and policymakers use to think about economic fluctuations and policies to stabilize the economy For this chapter’s intro to the AD/AS model, Shows how the price level and aggregate output we use a simple theory of aggregate demand based on the quantity theory of money. are determined Shows how the economy’s behavior is different Chapters 10–12 develop the theory of aggregate in the short run and long run CHAPTER 10 Introduction to Economic Fluctuations demand in more detail. 16 The Quantity Equation as Aggregate Demand CHAPTER 10 Introduction to Economic Fluctuations 17 The downward-sloping AD curve From Chapter 4, recall the quantity equation An increase in the price level causes a fall in real money balances (M/P), causing a decrease in the demand for goods & services. MV = PY For given values of M and V, this equation implies an inverse relationship between P and Y … P AD Y CHAPTER 10 Introduction to Economic Fluctuations 18 CHAPTER 10 Introduction to Economic Fluctuations 19 Shifting the AD curve Aggregate supply in the long run Recall from Chap. 3: P In the long run, output is determined by factor supplies and technology An increase in the money supply shifts the AD curve to the right. Y F (K , L ) Y is the full-employment or natural level of AD2 output, at which the economy’s resources are fully employed. AD1 Y CHAPTER 10 Introduction to Economic Fluctuations “Full employment” means that unemployment equals its natural rate (not zero). 20 Introduction to Economic Fluctuations 21 Long-run effects of an increase in M The long-run aggregate supply curve P CHAPTER 10 P LRAS LRAS An increase in M shifts AD to the right. Y does not depend on P, so LRAS is vertical. In the long run, this raises the price level… P2 P1 AD2 AD1 Y F (K , L ) CHAPTER 10 Introduction to Economic Fluctuations Y …but leaves output the same. 22 CHAPTER 10 Y Introduction to Economic Fluctuations Y 23 Aggregate supply in the short run The short-run aggregate supply curve Many prices are sticky in the short run. For now (and through Chap. 12), 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. The price level is fixed at a predetermined level, and firms sell as much as buyers demand. Therefore, the short-run aggregate supply (SRAS) curve is horizontal: CHAPTER 10 Introduction to Economic Fluctuations 24 …an increase in aggregate demand… CHAPTER 10 Introduction to Economic Fluctuations Y2 Introduction to Economic Fluctuations In the short-run equilibrium, if SRAS AD2 AD1 Y1 Y 25 Over time, prices gradually become “unstuck.” When they do, will they rise or fall? P P …causes output to rise. CHAPTER 10 SRAS P From the short run to the long run Short-run effects of an increase in M In the short run when prices are sticky,… P The SRAS curve is horizontal: Y 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. 26 CHAPTER 10 Introduction to Economic Fluctuations 27 How shocking!!! The SR & LR effects of M > 0 A = initial equilibrium B = new shortrun eq’m after Fed increases M P demand Shocks temporarily push the economy away from C P2 full employment. B P A C = long-run equilibrium CHAPTER 10 shocks: exogenous changes in agg. supply or LRAS 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. Y Y2 Y Example: exogenous decrease in velocity SRAS AD2 AD1 Introduction to Economic Fluctuations 28 Over time, prices fall and the economy moves down its demand curve toward full employment. CHAPTER 10 P P A C P2 prices that firms charge. (also called price shocks) Examples of adverse supply shocks: Bad weather reduces crop yields, pushing up SRAS AD1 AD2 Y2 Y Introduction to Economic Fluctuations 29 A supply shock alters production costs, affects the LRAS B Introduction to Economic Fluctuations Supply shocks The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. CHAPTER 10 Y 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. 30 CHAPTER 10 Introduction to Economic Fluctuations 31 CASE STUDY: CASE STUDY: The 1970s oil shocks The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in The oil price shock shifts SRAS up, causing output and employment to fall. the supply of oil. 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. Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. CHAPTER 10 Introduction to Economic Fluctuations 32 CHAPTER 10 P P2 …and then a gradual recovery. 12% 10% 40% 8% 30% 20% 6% 10% 0% 1973 1974 1975 1976 Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 4% 1977 Y Y 33 60% 14% 50% 12% 40% 10% 30% 8% 20% 6% 10% 0% 1977 1978 1979 1980 Change in oil prices (left scale) Change in oil prices (left scale) Inflation rate-CPI (right scale) Inflation rate-CPI (right scale) Introduction to Economic Fluctuations 4% 1981 Unemployment rate (right scale) Unemployment rate (right scale) CHAPTER 10 SRAS1 Introduction to Economic Fluctuations The 1970s oil shocks 50% A Y2 The 1970s oil shocks 60% SRAS2 AD CASE STUDY: Predicted effects of the oil shock: • inflation • output • unemployment B P1 CASE STUDY: 70% LRAS 34 CHAPTER 10 Introduction to Economic Fluctuations 35 CASE STUDY: Stabilization policy 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% 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… -10% 4% -20% -30% 2% -40% -50% 1982 1983 1984 1985 1986 0% 1987 Change in oil prices (left scale) Inflation rate-CPI (right scale) CHAPTER 10 Unemployment rate (right scale) Introduction to Economic Fluctuations 36 Stabilizing output with monetary policy P The adverse supply shock moves the economy to point B. P2 B But the Fed accommodates the shock by raising agg. demand. SRAS2 A P1 SRAS1 results: P is permanently higher, but Y remains at its fullemployment level. AD1 CHAPTER 10 Introduction to Economic Fluctuations 37 Stabilizing output with monetary policy LRAS Y2 CHAPTER 10 Y Introduction to Economic Fluctuations Y 38 CHAPTER 10 P P2 LRAS B C SRAS2 A P1 AD1 Y2 Y Introduction to Economic Fluctuations AD2 Y 39 CHAPTER SUMMARY CHAPTER 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. 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. 2. Aggregate demand and supply: a framework to analyze economic fluctuations 40 CHAPTER SUMMARY 6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. 7. The Fed can attempt to stabilize the economy with monetary policy. 42 41