Introduction to Economic Fluctuations
C H A P T E R
9 Introduction to Economic
Fluctuations
SIXTH EDITION
SIXTH EDITION
ACROECONOMICS M ACROECONOMICS M . REGORY ANKIW
N G M . REGORY ANKIW
N G M ®
®
PowerPoint Slides by Ron Cronovich
PowerPoint Slides by Ron Cronovich
© 2007 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.”
CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
Growth rates of real GDP, consumption Growth rates of real GDP, consumption
10 Percent
Real GDP
change
growth rate
from 4
8 Consumption quarters
growth rate
earlier
6
4 Average
growth rate
2
- 2
- 4 1970 1975 1980 1985 1990 1995 2000 2005
Growth rates of real GDP, consumption, investment Growth rates of real GDP, consumption, investment
40 Percent change
Investment
from 4
30
growth rate
quarters earlier
20 Real GDP
growth rate
10 Consumption
growth rate
- 10
- 20
- 30 1970 1975 1980 1985 1990 1995 2000 2005
Unemployment Unemployment
Percent
12 of labor force
10
8
6
4
2 1970 1975 1980 1985 1990 1995 2000 2005
Okun’s Law Okun’s Law
10 Percentage
Y
3.5 2 u
1966
change in
1951
8 Y real GDP
1984
6
2003
4
1987
2
1975 2001
- 2
1982 1991
- 4
- 3 -2 -1
1
2
3
4 Change in unemployment rate
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 govt, despite not being a perfect predictor.
CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations Components of the LEI index
Index of Leading Economic Indicators Index of Leading Economic Indicators 160 140 120
1 100
=
6
9
80
19
60
40
20 Source:
1970 1975 1980 1985 1990 1995 2000 2005 Conference
Time horizons in macroeconomics
Long run: Prices are flexible, respond to changes in supply or demand.
Short run: Many prices are “sticky” at some predetermined level.
The economy behaves much
differently when prices are sticky.
CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
The Quantity Equation as Aggregate Demand
From Chapter 4, recall the quantity equation
M V = P Y
For given values of M and V, this equation implies an inverse relationship between P and Y :
CHAPTER 9 Introduction to Economic Fluctuations
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.
An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services.
Y P
AD
CHAPTER 9 Introduction to Economic Fluctuations The downward-sloping AD
curve An increase in the money supply shifts the AD curve to the right.
An increase in the money supply shifts the AD curve to the right.
Y P
AD 1 AD 2
CHAPTER 9 Introduction to Economic Fluctuations Shifting the AD
Recall from Chapter 3: In the long run, output is determined by factor supplies and technology
, ( ) Y F K L
is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed.
Y
“Full employment” means that
unemployment equals its natural rate (not zero).
CHAPTER 9 Introduction to Economic Fluctuations Aggregate supply in the long run
curve Y P
LRAS
does not depend on P, so LRAS is vertical. does not depend on P, so LRAS is vertical.
Y ( )
,
Y F K L
CHAPTER 9 Introduction to Economic Fluctuations The long-run aggregate supply
1 LRAS
Y
An increase in M shifts AD to the right.
P 1 P 2 In the long run,
this raises the price level… …but leaves output the same.
AD 2
CHAPTER 9 Introduction to Economic Fluctuations Long-run effects of an increase in M Y P AD
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 9 Introduction to Economic Fluctuations Aggregate supply in the short run
curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
CHAPTER 9 Introduction to Economic Fluctuations The short-run aggregate supply curve Y P P SRAS The SRAS
1 In the short run
when prices are sticky,…
…causes output to rise.
P
SRAS
Y 2 Y 1 AD 2
…an increase in aggregate demand…
CHAPTER 9 Introduction to Economic Fluctuations Short-run effects of an increase in M Y P AD
Y Y
Y Y
rise fall remain constant
In the short-run equilibrium, if then over time, P will…
The adjustment of prices is what moves the
economy to its long-run equilibrium.CHAPTER 9 Introduction to Economic Fluctuations From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? Y Y
M > 0 The SR & LR effects of
P A = initial
LRAS
equilibrium
B = new short- C
P 2
run eq’m after Fed B SRAS
P
increases M A AD 2 AD 1 C = long-run
Y equilibrium
Y Y 2 CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
The effects of a negative demand shock AD shifts left, P
LRAS
AD shifts left, depressing output depressing output and employment and employment in the short run. in the short run.
A B SRAS
P Over time,
Over time, prices fall and prices fall and
C AD 1 P 2
the economy the economy
AD
moves down its 2 moves down its demand curve demand curve
Y Y Y toward full- 2 toward full- employment. employment.
CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
1 P
SRAS 1 Y
P
AD LRAS
Y Y 2 CASE STUDY: The 1970s oil shocks
The oil price shock shifts SRAS up, causing output and employment to fall.
The oil price shock shifts SRAS up, causing output and employment to fall.
A B
In absence of further price shocks, prices will fall over time and economy moves back toward full employment.
In absence of further price shocks, prices will fall over time and economy moves back toward full employment.
2 P
SRAS 2 A
CHAPTER 9 Introduction to Economic Fluctuations
CASE STUDY: The 1970s oil shocks 70%
12% 60% Predicted effects
50% of the oil shock:
10%
- 40%
inflation
- 8% 30%
output
- 20%
unemployment 6% 10%
…and then a 0%
4% gradual recovery. 1973 1974 1975 1976 1977
Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations
was recovering, oil prices shot up again, causing another huge supply shock!!!
0% 10% 20% 30% 40% 50% 60% 1977 1978 1979 1980 1981
4% 6% 8% 10% 12% 14%
Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations CASE STUDY: The 1970s oil shocks Late 1970s: As economy
CASE STUDY: The 1980s oil shocks 40%
10% 30% 1980s:
8% 20% A favorable
10% supply shock--
6% 0% a significant fall
- 10%
4% in oil prices.
- 20%
As the model
- 30%
2% predicts, -40%
- 50%
0% inflation and
1982 1983 1984 1985 1986 1987 unemployment fell:
Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale)
CHAPTER 9 Introduction to Economic Fluctuations
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 9 Introduction to Economic Fluctuations
monetary policy
1 P
SRAS 1 Y
P
AD 1 B A
Y 2 LRAS Y The adverse supply shock moves the economy to point B.
The adverse supply shock moves the economy to point B.
2 P
SRAS 2
CHAPTER 9 Introduction to Economic Fluctuations Stabilizing output with
monetary policy
1 P Y P
AD 1 B A C
Y 2 LRAS Y But the Fed accommodates the shock by raising agg. demand.
But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level. results: P is permanently higher, but Y remains at its full- employment level.
2 P
SRAS 2 AD 2
CHAPTER 9 Introduction to Economic Fluctuations Stabilizing output with
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.2. Aggregate demand and supply: a framework to analyze economic fluctuations
CHAPTER 9 Introduction to Economic Fluctuations
Chapter Summary 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.
CHAPTER 9 Introduction to Economic Fluctuations
Chapter Summary 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.