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.

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