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10 Introduction to Economic Fluctuations MACROECONOMICS N. Gregory Mankiw PowerPoint ® Slides by Ron Cronovich © 2013 Worth Publishers, all rights reserved IN THIS CHAPTER, YOU WILL LEARN: 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.” 1 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. CHAPTER 10 Introduction to Economic Fluctuations 2 Growth rates of real GDP, 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 Growth rates of real GDP, consump., 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 Unemployment Percent 12 of labor force 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 Okun’s Law Percentage 10 change in real GDP 8 6 1951 Y 3 2 u Y 1966 1984 2003 1971 4 1987 2 2001 0 1975 2009 2008 -2 1991 1982 -4 -3 -2 -1 0 1 2 3 4 Change in unemployment rate 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. CHAPTER 10 Introduction to Economic Fluctuations 7 Recap of classical macro theory (Chaps. 3-8) 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. CHAPTER 10 Introduction to Economic Fluctuations 8 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 CHAPTER 10 Introduction to Economic Fluctuations 9 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 CHAPTER 10 Introduction to Economic Fluctuations 10 Aggregate demand The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the quantity theory of money. Chapters 10–12 develop the theory of aggregate demand in more detail. CHAPTER 10 Introduction to Economic Fluctuations 11 The Quantity Equation as Aggregate Demand From Chapter 4, recall the quantity equation MV = PY For given values of M and V, this equation implies an inverse relationship between P and Y … CHAPTER 10 Introduction to Economic Fluctuations 12 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 CHAPTER 10 Introduction to Economic Fluctuations 13 Shifting the AD curve P An increase in the money supply shifts the AD curve to the right. AD2 AD1 Y CHAPTER 10 Introduction to Economic Fluctuations 14 Aggregate supply in the long run Recall from Chap. 3: 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). CHAPTER 10 Introduction to Economic Fluctuations 15 The long-run aggregate supply curve P LRAS Y does not depend on P, so LRAS is vertical. Y F (K , L ) CHAPTER 10 Introduction to Economic Fluctuations Y 16 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. CHAPTER 10 Y Introduction to Economic Fluctuations Y 17 Aggregate supply in the short run 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. Therefore, the short-run aggregate supply (SRAS) curve is horizontal: CHAPTER 10 Introduction to Economic Fluctuations 18 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. CHAPTER 10 P P Introduction to Economic Fluctuations SRAS Y 19 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. CHAPTER 10 Y1 Introduction to Economic Fluctuations Y2 Y 20 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. CHAPTER 10 Introduction to Economic Fluctuations 21 The SR & LR effects of M > 0 A = initial equilibrium B = new shortrun eq’m after Fed increases M C = long-run equilibrium CHAPTER 10 P LRAS C P2 P B A Y Introduction to Economic Fluctuations Y2 SRAS AD2 AD1 Y 22 How shocking!!! shocks: exogenous changes in agg. 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. CHAPTER 10 Introduction to Economic Fluctuations 23 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. CHAPTER 10 P P LRAS B P2 A SRAS C AD1 AD2 Y2 Y Introduction to Economic Fluctuations Y 24 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. CHAPTER 10 Introduction to Economic Fluctuations 25 CASE STUDY: 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. CHAPTER 10 Introduction to Economic Fluctuations 26 CASE STUDY: 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. CHAPTER 10 P P2 LRAS B SRAS2 A P1 SRAS1 AD Y2 Y Introduction to Economic Fluctuations Y 27 CASE STUDY: 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 4% 1977 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) CHAPTER 10 Introduction to Economic Fluctuations 28 CASE STUDY: 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 4% 1981 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) CHAPTER 10 Introduction to Economic Fluctuations 29 CASE STUDY: 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 0% 1987 Change in oil prices (left scale) Inflation rate-CPI (right scale) CHAPTER 10 Unemployment rate (right scale) Introduction to Economic Fluctuations 30 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… CHAPTER 10 Introduction to Economic Fluctuations 31 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 CHAPTER 10 Y Introduction to Economic Fluctuations Y 32 Stabilizing output with monetary policy But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its fullemployment level. CHAPTER 10 P P2 LRAS B C SRAS2 A P1 AD1 Y2 Y Introduction to Economic Fluctuations AD2 Y 33 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. 2. Aggregate demand and supply: a framework to analyze economic fluctuations 34 CHAPTER 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. 35 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. 36