Chapter 9 Introduction to Economic Fluctuations MACROECONOMICS Chapter 9 Introduction to Economic Fluctuations

Short Run Fluctuations What causes them? Can policymakers avoid recessions? Plan of the chapter Data describing short run fluctuations Difference between long run and short run The basic model of AS-AD

Figure 9.1 Real GDP Growth in the United States Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 3

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Investments are much more volatile than consumption expenditures. 5 Figure 9.2 Growth in Consumption and Investment Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 5

http://data. bls. gov/pdq/SurveyOutputServlet http://data.bls.gov/pdq/SurveyOutputServlet?data_tool=latest_numbers&series_id=LNS14000000

Okun’s Law %Δ in Y = 3% - 2(Change in Unemployment Rate from one year to another) Sep 08 to Sep 09 unemployment went from 6.2% to 9.8%, 3.6% increase. Predicted change in Y will be -4.2% 7

http://www.econ.yale.edu/alumni/conf2011/shiller-presentation.pdf

Why Different Time Horizons? 10

Why Different Time Horizons? In the long run prices are flexible; complete adjustment. Money neutrality: changes in money supply does not affect real variables. In the short run prices are sticky. Real variables do respond to money in te short run.

Long Run In the long run, Y is determined with K, L, and technology. In the long run all the resources are fully employed. The long run Y is thus fixed. The circular flow is in equilibrium because any shock is dealt with price adjustment. How do you show the supply of output (Y) in a diagram where Y is the horizontal axis?

Figure 9.7 The Long-Run Aggregate Supply Curve Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 13

Aggregate Demand If money supply and velocity were given (fixed), then any change in the price level will have to be compensated by a change in Y to keep the nominal GDP fixed. What happens to the AD, if Money supply increases? Money supply decreases? Velocity increases (money demand decreases)?

Velocity increase will bring an outward shift. Money demand increase will bring an inward shift. Our aggregate demand theory will include all the expenditures by consumers, businesses, government, and the rest of the world in future chapters. 15

Long Run Adjustment 16

Short Run Suppose no prices adjust in the short run; and when they do start to adjust, all the prices adjust slowly, together. What will the short run aggregate supply curve look like this year? Next year? How will the economy react in the short run to a shift in AD? The equilibrium in the circular flow model is now achieved through output adjustment.

Figure 9.9 The Short-Run Aggregate Supply Curve Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 18

Figure 9.10 Shifts in Aggregate Demand in the Short Run Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 19

Long and Short Run Equilibrium 20

From SR to LR 21

From SR to LR There may be many reasons for an aggregate demand increase. The model in this chapter will allow us to either increase the velocity of money or increase the money supply. Either one will shift the AD to the right. 22

An Adverse Supply Shock A general increase in union negotiated wages; sudden increase in the prices of widely used inputs; regulation that adds up to costs; crop failure… STAGFLATION initially but back at the starting point in the long run. 23

Accommodating an Adverse Shock No unemployment increase but permanent increase in the price level. 24