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BU ECON 362 - Chapter 10 Slides

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Chapter 10: Introduction Economic Fluctuations Recap of Classical Macro Theory - Chapter 3: A country’s long run output is assumed given; only mentions that it depends on the production function and factor inputs - Chapter 8-9 answer the question: what determines a country’s long-run output o Three proximate causes and three ultimate causes - In the classical theory, changes in demand for goods & services (C,I,G) only affect prices, not quantities - Assumes complete price flexibility - Applies to the long run Case Studies: Are Prices Flexible? - We often hear the term “housing bubble.” - This happens when housing prices are too high – higher than what’s justified by economic fundamentals - But housing bubbles do not “burst” – housing prices decline quite slowly Housing Price Decline Slowly - Prices are sticky but not stuck - Appreciation slows at first, along with declining sales and rising inventories - Then prices start to decline - Then, about a year or so after the price peaks, prices really start to decline for a couple of years, followed by a couple more years of modest declines - Sellers often use recent sales price to set their asking price - Buyers will typically wait for lower prices - Result: market does not “clear” - Rather, trading volume will decline first, followed by declining prices Flexible Price? - So, are housing prices flexible? - It depends on the time horizon you use. - If your time horizon is seven years, then the answer is “yes”: the market surplus leads to low prices and the market eventually clears. - If your time horizon is shorter, then the answer is “no”: between 1991 and 1997, most ofthe time the housing market was not low enough to clear the market Sticky Price - The housing price is not special - Many prices are sticky in our economy - So within a short time horizon, the classical theory does not work - Price is not “just a measurement”: many houses could not be sold- A real variable (quantity sold) is affected: the classical dichotomy does not hold Time Horizons in Macroeconomics - The economy behaves much differently when prices are sticky. Ask Firms Why They Have Sticky Prices - A lot of answers: Consequence of Sticky Price - So what’s the big deal? - Consider our circular flow model- We will compare the flexible price case and the sticky price case - Now suppose in the goods market, prices are sticky. - Imagine all prices are fixed at a certain level for some time. - If demand goes down, and prices cannot decrease, then production must be under capacity- When production is under capacity, firms do not need many workers - If wages are flexible, workers get paid less - If wages are sticky, then lay-offs will happen - Either way, real income goes down. Less income leads to lower demand, triggers more production cuts, and exacerbates the situation. - We have a recession Flexible Price: The Classical Case - Suppose all prices are flexible - Now suppose there is a decrease in demand - Producers lower their prices, can still sell everything - Producers receive less revenue in dollar terms, so they will pay their workers less wages - But since prices go down, workers’ real wage (W/P) is not affected! When Prices are Sticky…- There is no recession in the classical theory - But when sticky price is considered, recessions can arise within a similar framework - So sticky price is a big deal In This Chapter, You Will Learn…- Facts about business cycles - A sticky price model, the aggregate demand and supply model, that we can use to analyze short run macroeconomics - We will then use this model to understand booms and recessions Definitions and Facts- A business cycle has two phases, expansion and recession, and two turning point, a peakand a trough. - The task of identifying and dating business-cycle phases and turning points is performed by a private research organization, the National Bureau of Economic Research (NBER) - Recessiono A period of significance decline in total output, income, employment, and trade, usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy U.S. Business-Cycle History - The NBER has identified 33 complete cycles starting from a trough in December 1854- Over all 33 complete cycles: o The average length of an expansion is 42 months (more than 3 years), the average length of a recession is 16 months o The average time from trough to trough is 56 months (more than 4 ½ years) - Between 1945 and 2009, o The average length of an expansion is 59 months (almost 5 years), the average length of a recession is 11 months o The average time from trough to trough is 73 months (more than 6 years) - So over the 156 years since 1854, the U.S. economy has been in: o Recession for about one third of the time o Expansion for about two thirds of the time - The 156-year averages hide significant changes that have occurred in the length of a cycle and the relative length of the recession and expansion phases 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 volatile and investment more volatile than GDP - Unemployment rises during recessions and falls during expansions Now you try…- If the unemployment rate increases from 5% to 7%, what happens to the growth rate of real GDP? - 3% - 2x(7%-5%) = -1% Index of Leading Economic Indicators - How do economists forecast the future? - They use leading indicators.- The LEI is 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 gov’t, despite not being a perfect predictorComponents of the LEI Index - Average workweek in manufacturing o Businesses adjust workweek before hiring or laying-off workers o Longer workweek signals higher demand and better economy - Initial weekly claims for unemployment insuranceo The higher the number of claims, the lower the LEI - New orders for consumer goods and materials - New orders, nondefense capital goods - Vendor performance o A measure of companies receiving slower deliveries from supplier o The slower the delivery, the higher the LEI- New building permits issued- Index of stock prices - M2 - Yield spread (10-year minus 3-months) on Treasuries - Index of consumer expectations The Model of Aggregate Demand and


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