CHAPTER 9 INTRODUCTION TO ECONOMIC FLUCTUATIONS ECON 2003 MACROECONOMICS CHAPTER 9 INTRODUCTION TO ECONOMIC FLUCTUATIONS Assoc. Prof. Yesim Kustepeli

Recessions: periods of falling incomes and rising unemployment Business cycle: short run fluctuations in outut and employment Short run fluctuations Assoc. Prof. Yesim Kustepeli

TIME HORIZONS IN MACROECONOMICS Classical theory applies to the long run, not the short run. The key difference between short run and long run is the behaviour of prices. In the long run, output and velocity of money are fixed; a change in the money supply affects directly prices. Assoc. Prof. Yesim Kustepeli

Economic fluctuations short run price stickiness In short run, prices are not fully flexible; thus a change in the money supply may affect output and employment. Economic fluctuations short run price stickiness classical dichotomy no longer holds nominal variables affect real variables. Assoc. Prof. Yesim Kustepeli

Model of AS and AD Flexible prices are crucial for the classical theory. When prices are sticky, output depends on the demand for goods and services. Because monetary and fiscal policies can influence the economy’s output over the time horizon when prices are sticky, there is a rationale for why these policies may be useful in stabilizing the economy in the short run. Assoc. Prof. Yesim Kustepeli

Short run: prices are sticky ; capital and labor are sometimes not fully employed. Long run: classical model; prices are flexible; capital and labor are fully employed. Very long run: basic theory of economic growth, cpital stock, labor force and technology can change. Assoc. Prof. Yesim Kustepeli

AGGREGATE DEMAND Aggregate demand is the relationship between quantity of output demanded and aggregate price level. The quantity equation as aggregate demand : M*V = P*Y M/P = kY For any fixed money supply and velocity, the quantity equation yields a negative relationship between P and Y. Assoc. Prof. Yesim Kustepeli

Once PY is fixed, if P goes up, Y must go down. The aggregate demand curve is drawn for a fixed value of the money supply. If the money supply changes, the aggregate demand shifts. If the velocity of money changes, the aggregate demand shifts. Assoc. Prof. Yesim Kustepeli

AGGREGATE SUPPLY Aggregate supply is the relationship between the quantity of goods and services supplied and the price level. The long run: the vertical aggregate supply curve According to the classical model, output doesnot depend on the price level. The verical AS curve satisfies the classical dichotomy; output is at its full-employment or natural level. Assoc. Prof. Yesim Kustepeli

The short run: the horizontal aggregate supply curve Some prices are sticky and donot adjust to changes in demand. Changes in aggregate demand affet the level of output. From short run to the long run Long run equilibrium is where short run AS, long run AS and AD intersect. Changes in aggregate demand affect the level of output in short run but return to the long run level . Assoc. Prof. Yesim Kustepeli

STABILIZATION POLICY Exogenous changes in AS or AD are called shocks to the economy. Shocks to AD: demand shock Shocks to AS: supply shock One goal of the AS and AD model is to show how shocks cause economic fluctuations. Another goal of the model is to evaluate how macroeconomic policy can respond to these shocks:: stabilization policy Assoc. Prof. Yesim Kustepeli