Chapter 10 Introduction to Economic Fluctuations 1 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 2 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 3 Growth rates of real GDP consumption Percent change from 4 quarters earlier Average growth rate 10 Real GDP growth rate 8 Consumption growth rate 6 4 2 0 2 4 1970 1975 1980 1985 1990 1995 2000 2005 2010 4 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 5 Unemployment Percent of labor force 12 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 6 Okun s Law Percentage 10 change in real GDP 8 6 1951 DY 3 2 Du Y 1966 1984 2003 1971 4 2 1987 2001 0 1975 4 3 2009 2008 2 2 1 0 1991 1 1982 2 3 4 Change in unemployment rate 7 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 8 Recap of classical macro theory Chaps 3 7 Output is determined by the supply side supplies of capital labor technology Monetary neutrality changes in money supply only affect prices not quantities Assumes complete price flexibility Applies to the long run 9 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 10 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 11 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 11 13 develop the theory of aggregate demand in more detail 12 The Quantity Equation as Aggregate Demand From Chapter 5 recall the quantity equation MV PY For given values of M and V this equation implies an inverse relationship between P and Y 13 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 14 Shifting the AD curve P An increase in the money supply shifts the AD curve to the right AD AD 1 2 Y 15 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 16 The long run aggregate supply curve P LRAS Y does not depend on P so LRAS is vertical Y F K L Y 17 Long run effects of an increase in M P In the long run this raises the price level LRAS P2 An increase in M shifts AD to the right P1 AD AD but leaves output the same 1 Y 2 Y 18 Aggregate supply in the short run Many prices are sticky in the short run For now and through Chap 13 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 19 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 P P SRAS Y 20 Short run effects of an increase in M In the short run when prices are sticky P an increase in aggregate demand SRAS P AD AD2 1 causes output to rise Y1 Y2 Y 21 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 22 The SR LR effects of M 0 A initial equilibrium B new shortrun eq m after Fed increases M C long run equilibrium P LRAS C P2 P B A SRAS AD AD2 1 Y Y2 Y 23 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 24 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 P P LRAS B P2 A SRAS C AD AD1 2 Y2 Y Y 25 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 26 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 27 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 P P2 LRAS B SRAS2 A P1 SRAS1 AD Y2 Y …