Chapter 10IN THIS CHAPTER, YOU WILL LEARN:Facts about the business cycleGrowth rates of real GDP, consumptionGrowth rates of real GDP, consump., investmentUnemploymentOkun’s LawTime horizons in macroeconomicsRecap of classical macro theory (Chaps. 3-7)When prices are sticky…The model of aggregate demand and supplyAggregate demandThe Quantity Equation as Aggregate DemandThe downward-sloping AD curveShifting the AD curveAggregate supply in the long runThe long-run aggregate supply curveLong-run effects of an increase in MAggregate supply in the short runThe short-run aggregate supply curveShort-run effects of an increase in MFrom the short run to the long runThe SR & LR effects of M > 0How shocking!!!The effects of a negative demand shockSupply shocksCASE STUDY: The 1970s oil shocksCASE STUDY: The 1970s oil shocksStabilization policyStabilizing output with monetary policyStabilizing output with monetary policyCHAPTER SUMMARYCHAPTER SUMMARYCHAPTER SUMMARY1Chapter 10Introduction to Economic Fluctuations2IN 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.”23Facts 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.41970 1975 1980 1985 1990 1995 2000 2005 2010-4-20246810Growth rates of real GDP, consumptionPercent change from 4 quarters earlierAverage growth rateReal GDP growth rateConsumption growth rate51970 1975 1980 1985 1990 1995 2000 2005 2010-30-20-10010203040Growth rates of real GDP, consump., investmentInvestment growth rateReal GDP growth rateConsumption growth ratePercent change from 4 quarters earlier61970 1975 1980 1985 1990 1995 2000 2005 2010024681012UnemploymentPercent of labor force7-3 -2 -1 0 1 2 3 4-4-20246810Okun’s LawPercentage change in real GDPChange in unemployment rate197519821991200119841951196620031987200819712009= -3 2YuYDD8Time horizons in macroeconomicsLong run Prices are flexible, respond to changes in supply or demand.Short runMany prices are “sticky” at a predetermined level.The economy behaves much differently when prices are sticky.9Recap of classical macro theory (Chaps. 3-7)Output is determined by the supply side:supplies of capital, labortechnologyMonetary neutrality: changes in money supplyonly affect prices, not quantities.Assumes complete price flexibility. Applies to the long run.10When 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 I11The 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 run12Aggregate 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.13The Quantity Equation as Aggregate DemandFrom Chapter 5, recall the quantity equationM V = P Y For given values of M and V, this equation implies an inverse relationship between P and Y …14The downward-sloping AD curveAn 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 PAD15Shifting the AD curveAn 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 PAD1AD216Aggregate supply in the long runRecall from Chap. 3: In the long run, output is determined by factor supplies and technologyis 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).,= ( )Y F K LY17The long-run aggregate supply curveY PLRAS does not depend on P, so LRAS is vertical. does not depend on P, so LRAS is vertical. Y( )= ,YF K L18Long-run effects of an increase in MY PAD1LRASAn increase in M shifts AD to the right. P1P2In the long run, this raises the price level……but leaves output the same.AD2Y19Aggregate 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:20The short-run aggregate supply curveY PSRASThe SRAS 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.P21Short-run effects of an increase in MY PAD1In the short run when prices are sticky,……causes output to rise.SRASY2Y1AD2…an increase in aggregate demand…P22From the short run to the long runOver time, prices gradually become “unstuck.” When they do, will they rise or fall? risefallremain constantIn the short-run equilibrium, ifthen over time, P will…The adjustment of prices is what moves the economy to its long-run equilibrium.Y Y>Y Y<Y Y=23The SR & LR effects of M > 0Y PAD1LRASSRASP2Y2A = initial equilibriumABCB = new short-run eq’m after Fed increases MC = long-run equilibriumAD2YP24How shocking!!!shocks: exogenous changes in agg. supply or demandShocks temporarily push the economy away from