Chapter 9 Introduction to Economic FluctuationsFacts about the business cycleGrowth rates of real GDP, consumptionGrowth rates of real GDP, consump., investmentUnemploymentOkun’s LawOkun’s Confounding LawTime horizons in macroeconomicsSlide Number 9The Quantity Equation as Aggregate DemandAggregate supply in the long runLong-run effects of an increase in MAggregate supply in the short runThe short-run aggregate supply curveShort-run effects of an increase in MThe SR & LR effects of M > 0ShocksThe effects of a negative demand shockSupply shocksCASE STUDY: The 1970s oil shocksCASE STUDY: The 1970s oil shocksStabilizing output with monetary policyChapter SummaryChapter Summary0 CHAPTER 9 Introduction to Economic Fluctuations Chapter 9 Introduction to Economic Fluctuations  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.”1 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.-4-202468101970 1975 1980 1985 1990 1995 2000 2005 2010Growth rates of real GDP, consumption Percent change from 4 quarters earlier Average growth rate Real GDP growth rate Consumption growth rate-30-20-100102030401970 1975 1980 1985 1990 1995 2000 2005 2010Growth rates of real GDP, consump., investment Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate Consumption growth rate0246810121970 1975 1980 1985 1990 1995 2000 2005 2010Unemployment Percent of labor forceOkun’s Law Percentage change in real GDP Change in unemployment rate -4-20246810-3 -2 -1 0 1 2 3 4= −32YuY∆∆1975 1982 1991 2001 1984 1951 1966 2003 1987 2008 19716 CHAPTER 1 The Science of Macroeconomics Okun’s Confounding Law7 CHAPTER 9 Introduction to Economic Fluctuations 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. In reality, quantities are adjusted faster than prices.8 CHAPTER 9 Introduction to Economic Fluctuations Table 9.1 The Frequency of Mankiw: Macroeconomics, S9 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 …10 CHAPTER 9 Introduction to Economic Fluctuations Aggregate supply in the long run  Recall from Chapter 3: In the long run, output is determined by factor supplies and technology ,= ()Y FKL is the full-employment or natural level of output, at which the economy’s resources are fully employed. Y“Full employment” means that unemployment equals its natural rate (not zero).11 CHAPTER 9 Introduction to Economic Fluctuations Long-run effects of an increase in M Y P AD1 LRAS YAn increase in M shifts AD to the right. P1 P2 In the long run, this raises the price level… …but leaves output the same. AD212 CHAPTER 9 Introduction to Economic Fluctuations Aggregate supply in the short run  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:13 CHAPTER 9 Introduction to Economic Fluctuations The short-run aggregate supply curve Y P PSRAS The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.14 CHAPTER 9 Introduction to Economic Fluctuations Short-run effects of an increase in M Y P AD1 In the short run when prices are sticky,… …causes output to rise. PSRAS Y2 Y1 AD2 …an increase in aggregate demand…15 CHAPTER 9 Introduction to Economic Fluctuations The SR & LR effects of ∆M > 0 Y P AD1 LRAS YPSRAS P2 Y2 A = initial equilibrium A B C B = new short-run eq’m after Fed increases M C = long-run equilibrium AD216 CHAPTER 9 Introduction to Economic Fluctuations Shocks  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.17 CHAPTER 9 Introduction to Economic Fluctuations PSRAS LRAS AD2 The effects of a negative demand shock Y P AD1 YP2 Y2 AD shifts left, depressing output and employment in the short run. A B C Over time, prices fall and the economy moves down its demand curve toward full-employment.18 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.19 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.20 CHAPTER 9 Introduction to Economic Fluctuations 1PSRAS1 Y P AD LRAS YY2 CASE STUDY: The 1970s oil shocks 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.