Download Chapter 10 Introduction to Economic Fluctuations

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.”
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Introduction to Economic Fluctuations
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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.
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Growth rates of Consumption and
Investment -Turkey
Real GDP growth rate – Turkey
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Introduction to Economic Fluctuations
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Growth rates of real GDP, consumption – U.S.
Percent 10
change
from 4 8
quarters
earlier
Real GDP
growth rate
Consumption
growth rate
6
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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
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








 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.
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Introduction to Economic Fluctuations
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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
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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
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2010
Recap of classical macro theory
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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.
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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
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Introduction to Economic Fluctuations
demand in more detail.
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The Quantity Equation as
Aggregate Demand
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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
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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
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Introduction to Economic Fluctuations
“Full employment” means that
unemployment equals its natural rate (not zero).
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Introduction to Economic Fluctuations
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Long-run effects of an increase in M
The long-run aggregate supply curve
P
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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 )
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Introduction to Economic Fluctuations
Y
…but leaves
output the same.
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Y
Introduction to Economic Fluctuations
Y
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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:
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…an increase
in aggregate
demand…
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Introduction to Economic Fluctuations
Y2
Introduction to Economic Fluctuations
In the short-run
equilibrium, if
SRAS
AD2
AD1
Y1
Y
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Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
P
P
…causes
output to rise.
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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.
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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
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 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
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Over time,
prices fall and
the economy
moves down its
demand curve
toward full
employment.
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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
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 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.
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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.
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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.
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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
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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)
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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
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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)
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Unemployment rate (right scale)
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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
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Stabilizing output with
monetary policy
LRAS
Y2
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Y
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Y
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P
P2
LRAS
B
C
SRAS2
A
P1
AD1
Y2
Y
Introduction to Economic Fluctuations
AD2
Y
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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.
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