Introduction to Economic Fluctuations Chapter 9 Introduction to Economic Fluctuations (Continued) CHAPTER 9 Introduction to Economic Fluctuations

Stabilization Policies Economic fluctuations (or business cycles) refer to deviations of real GDP growth from its long – run average growth rate. These deviations are caused by changes in AD or change in AS in the short – run. Shifts in AD: Demand Shock Shifts in AS: Supply Shock Stabilization policies are the policies that aim to decrease short – run fluctuations. Monetary policy Fiscal policy CHAPTER 9 Introduction to Economic Fluctuations

Shocks to Aggregate Demand What causes shifts in AD? ∆M or ∆V Example: If the money supply is held constant, an increase in V means people will be using their money in more transactions, causing a increase in demand for goods and services. nominal spending ↑: AD↑ CHAPTER 9 Introduction to Economic Fluctuations

Y P AD1 LRAS SRAS P2 Y2 A B C AD2 CHAPTER 9 Introduction to Economic Fluctuations

AD1 → AD2 (due to ↑V) and AD2 → AD1 (due to contraction in M) If the Fed knows the impact of financial innovations on the economy (Y2 >Ybar ) and the long-term inflation, it may try to counter-act by implementing a contractionary MP at the same time that AD shifts to right. AD1 → AD2 (due to ↑V) and AD2 → AD1 (due to contraction in M) This is an example of a “stabilization policy” which aims to prevent the fluctuations in output in the short run and prices in the long run CHAPTER 9 Introduction to Economic Fluctuations

The effects of a negative demand shock AD1 AD shifts left, depressing output and employment in the short run. Y P AD2 LRAS SRAS B A Over time, prices fall and the economy moves down its demand curve toward full-employment. Y2 C P2 Note the economy’s “self-correction” mechanism: When in a recession, the economy --- left to its own devices --- “fixes” itself: the gradual adjustment of prices helps the economy recover from the shock and return to full employment. Of course, before the economy has finished self-correcting, a period of low output and high unemployment is endured. 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. Oil price shocks (say due to a cartel or war) Favorable supply shocks lower costs and prices. CHAPTER 9 Introduction to Economic Fluctuations

Example The adverse supply shock moves the economy to point B. P Y LRAS The adverse supply shock moves the economy to point B. SRAS2 B Y2 SRAS1 A CHAPTER 9 Introduction to Economic Fluctuations

P1 → P2 (New short run equilibrium at B) SRAS1 Y P AD LRAS Y2 A B SRAS2 1 SRAS1 → SRAS2: P1 → P2 (New short run equilibrium at B) At point B, YB <Ybar : Because the economy is producing below its full capacity, in the long run prices fall: movement form point B→A along AD. CHAPTER 9 Introduction to Economic Fluctuations

What can the policy maker do to reduce the fluctuation? Do nothing: The natural forces will bring the economy from B to A eventually. Cost: You need to suffer the recession. If you want to minimize the recession period the Fed can offset the contractionary influence of the supply shock by implementing an expansiony MP. Or, government can implement expansionary FP CHAPTER 9 Introduction to Economic Fluctuations

Stabilizing output with monetary policy AD2 AD1 Y P But the Fed accommodates the shock by raising agg. demand. LRAS SRAS2 B C Y2 A results: P is permanently higher, but Y remains at its full-employment level. Note: If the Fed correctly anticipates the sign and magnitude of the shock, then the Fed can respond as the shock occurs rather than after, and the economy never would go to point B - it would go immediately to point C. CHAPTER 9 Introduction to Economic Fluctuations

End of chapter problem 1 Economy initially in LR equilibrium Banks start paying interest on checking accounts How does this affect the demand for money,velocity If there is no MP action, what happens to prices and output in SR and LR How can the Fed stabilize prices How can the Fed stabilize output CHAPTER 9 Introduction to Economic Fluctuations

Less velocity means less transactionsAD (down) Interest payment on checking accountsDemand for checking accounts (up) Demand for M=C+D (up) M (up)V=PY/M (down) Less velocity means less transactionsAD (down) Y declines and P constant in SR. Y constant and P declines in LR. Expansionary MP to stabilize output and prices Bu soruda ilginc olan su. Sadece bonds and money olan bir two asset world’de insanlar bonolari bozdurup bankaya yatiriyorlar. Dolayisi ile MB expansionary MP yapmasa da piyasadaki para arzi artiyor. Ama bu sefer para transactions icin kullanilmayip savings olarak kullaniliyor. Dolayisi ile transactionlar ve AD sola shift ediyor. CHAPTER 9 Introduction to Economic Fluctuations

End of chapter problem 2 Fed reduces the money supply by five percent What happens to AD, output and prices in SR and LR? According to Okun’s law, what happens to unemployment in SR and LR? What happens to r in SR and LR? CHAPTER 9 Introduction to Economic Fluctuations

Y declines in SRUnemp. increases in SR AD shifts left. Output declines, P constant in SR. Output returns back to potential, prices decline in LR. Using quantity theory, prices decline by 5 percent in LR. Y declines in SRUnemp. increases in SR Y is constant in LRUnemp. constant (i.e. back to natural rate) In SR Y (down)S (down)r (up) In LR Y (constant)S(constant)r(constant) CHAPTER 9 Introduction to Economic Fluctuations

End of chapter problem 3 Fed A only cares about keeping prices stable Fed B only cares about keeping output and employment at their natural levels Explain how each Fed would respond to Exogenous decrease in velocity An exogenous increase in the price of oil CHAPTER 9 Introduction to Economic Fluctuations

Hint: Decline in velocity shifts AD to the left Expansionary MP by Fed A and Fed B Fed A: Do nothing Fed B: Expansionary MP CHAPTER 9 Introduction to Economic Fluctuations