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Readings
Lecture 6
• Review: Mankiw;
Busienss cycle fluctuations.
Introduction and review
dr Joanna Siwińska
slide 1
Time horizons
Real GDP Growth in the United States
10
Percent change
from 4 quarters
8
earlier
Average growth
rate = 3.5%
• Long run:
Prices are flexible, respond to changes in
supply or demand
6
• Short run:
many prices are “sticky” at some
predetermined level
4
2
0
The economy behaves much
differently when prices are sticky.
-2
-4
1960
1965
1970
1975
1980
1985
1990
1995
2000
slide 2
slide 3
1
In Classical Macroeconomic Theory
When prices are sticky
• 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.
• Complete price flexibility is a crucial assumption,
so classical theory applies in the long run.
…output and employment also depend on
demand for goods & services,
which is affected by
fiscal policy (G and T )
monetary policy (M )
other factors, like exogenous changes
in C or I.
slide 4
slide 5
Deriving the AD curve
Aggregate demand
LM(P2)
r
• The aggregate demand curve shows the relationship
between the price level and the quantity of output
demanded.
Intuition for slope
of AD curve:
↑P ⇒ ↓(M/P )
• We may use a simple ISLM model to derive aggregate
demand curve.
IS
⇒ LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
slide 6
LM(P1)
r2
r1
P
Y2
Y1
Y2
Y1
Y
P2
P1
AD
Y
slide 7
2
Monetary policy and the AD curve
The Fed can increase
aggregate demand:
↑M ⇒ LM shifts right
Fiscal policy and the AD curve
LM(M1/P1)
r
LM(M2/P1)
r1
r2
⇒ ↑I
P
⇒ ↑Y at each
value of P
P1
Y1
Y
Y2
r
LM
r2
r1
IS2
↓T ⇒ ↑C
IS
⇒ ↓r
Expansionary fiscal policy
(↑G and/or ↓T )
increases agg. demand:
IS1
⇒ IS shifts right
P
Y1
Y
Y2
⇒ ↑Y at each
value
Y1
Y2
P1
of P
AD2
AD1
Y
Y1
slide 8
Y2
AD2
AD1
Y
slide 9
Aggregate Supply in the Long Run
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.
• In the long run, output is determined by
factor supplies and technology
P
Y = F (K , L )
Y
AD
Y
is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate.
slide 10
slide 11
3
Aggregate Supply in the Long Run
The long-run aggregate supply curve
• In the long run, output is determined by
factor supplies and technology
P
Y = F (K , L )
LRAS
The LRAS curve is
vertical at the
full-employment
level of output.
Full-employment output does not depend
on the price level,
so the long run aggregate supply (LRAS)
curve is vertical:
Y
slide 12
In the long run,
this increases
the price level…
• In the real world, many prices are sticky in the short run.
• For now we assume that all prices are stuck at a
predetermined level in the short run…
• …and that firms are willing to sell as much as their
customers are willing to buy at that price level.
• Therefore, the short-run aggregate supply (SRAS) curve is
horizontal:
LRAS
An increase in
M shifts the
AD curve to
the right.
P2
P1
slide 13
Aggregate Supply in the Short Run
Long-run effects of an increase in M
P
Y
AD2
AD1
…but leaves
output the same.
Y
Y
slide 14
slide 15
4
The short run aggregate supply curve
Short-run effects of an increase in M
P
The SRAS curve is
horizontal:
The price level is
fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
In the short run
when prices are
sticky,…
SRAS
P
P
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
Y
…causes output
to rise.
Y1
Y2
Y
slide 16
The SR & LR effects of ∆M > 0
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
A = initial equilibrium
then over time,
the price level will
Y >Y
Y <Y
rise
Y =Y
remain constant
slide 17
B = new short-run
eq’m after
increase in M
P
C = long-run
equilibrium
This adjustment of prices is what moves
the economy to its longlong-run equilibrium.
slide 18
C
P2
P
fall
LRAS
B
A
Y
Y2
SRAS
AD2
AD1
Y
slide 19
5
The effects of a negative demand shock
Shocks
• shocks: exogenous changes in aggregate supply or
demand
• Shocks temporarily push the economy away from fullemployment.
The shock shifts AD
left, causing output
and employment to
fall in the short run
P
P
Over time, prices
fall and the
economy moves
down its demand
curve toward fullemployment.
LRAS
A
B
C
P2
SRAS
AD1
AD2
Y2
Y
Y
slide 20
Supply shocks
slide 21
Stabilization policy
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.)
slide 22
• 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:
slide 23
6
Stabilizing output with
monetary policy
The adverse
supply shock
moves the
economy to
point B.
P
P2
Stabilizing output with
monetary policy
But the Fed
accommodates
the shock by
raising agg.
demand.
LRAS
B
SRAS2
A
P1
SRAS1
results:
P is permanently
higher, but Y
remains at its fullemployment level.
AD1
Y2
Y
Y
P
P2
LRAS
B
SRAS2
C
A
P1
AD2
AD1
Y2
Y
Y
slide 24
Summary
slide 25
Summary
1. Long run: prices are flexible, output and employment are
always at their natural rates, and the classical theory
applies.
3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical, because
Short run: prices are sticky, shocks can push output and
employment away from their natural rates.
output depends on technology and factor supplies, but not
prices.
5. The short-run aggregate supply curve is horizontal, because
2. Aggregate demand and supply:
prices are sticky at predetermined levels.
a framework to analyze economic fluctuations
slide 26
slide 27
7
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.
slide 28
8