CHAPTER 9 Introduction to Economic Fluctuations slide 0 Econ 101: Intermediate Macroeconomic Theory Larry Hu Lecture 10: Introduction to Economic Fluctuation

CHAPTER 9 Introduction to Economic Fluctuations slide 1 Real GDP Growth in the United States Average growth rate = 3.5%

CHAPTER 9 Introduction to Economic Fluctuations slide 2 Time horizons  Long run: Prices are flexible, respond to changes in supply or demand  Short run: many prices are “sticky” at some predetermined level The economy behaves much differently when prices are sticky.

CHAPTER 9 Introduction to Economic Fluctuations slide 3 In Classical Macroeconomic Theory, Output is determined by the supply side: –supplies of capital, labor –technology  Changes in money only affect prices, not quantities.  Complete price flexibility is a crucial assumption, so classical theory applies in the long run.

CHAPTER 9 Introduction to Economic Fluctuations slide 4 The model of aggregate demand and supply  shows how the price level and aggregate output are determined  shows how the economy’s behavior is different in the short run and long run

CHAPTER 9 Introduction to Economic Fluctuations slide 5 The Quantity Equation as Agg. Demand  From Chapter 4, recall the quantity equation M V = P Y it implies: M/P = k Y where V = 1/k = velocity.  For given values of M and V, these equations imply an inverse relationship between P and Y:

CHAPTER 9 Introduction to Economic Fluctuations slide 6 The downward-sloping AD curve An increase in the price level causes a fall in real money balances (M/P ), causing a decrease in the demand for goods & services. Y P AD

CHAPTER 9 Introduction to Economic Fluctuations slide 7 Shifting the AD curve An increase in the money supply shifts the AD curve to the right. Y P AD 1 AD 2

CHAPTER 9 Introduction to Economic Fluctuations slide 8 Aggregate Supply in the Long Run  Recall from chapter 3: In the long run, output is determined by factor supplies and technology is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. “Full employment” means that unemployment equals its natural rate.

CHAPTER 9 Introduction to Economic Fluctuations slide 9 Aggregate Supply in the Long Run  Recall from chapter 3: In the long run, output is determined by factor supplies and technology  Full-employment output does not depend on the price level, so the long run aggregate supply (LRAS) curve is vertical:

CHAPTER 9 Introduction to Economic Fluctuations slide 10 The long-run aggregate supply curve Y P LRAS The LRAS curve is vertical at the full-employment level of output.

CHAPTER 9 Introduction to Economic Fluctuations slide 11 Long-run effects of an increase in M Y P AD 1 AD 2 LRAS An increase in M shifts the AD curve to the right. P1P1 P2P2 In the long run, this increases the price level… …but leaves output the same.

CHAPTER 9 Introduction to Economic Fluctuations slide 12 Aggregate Supply in the Short Run  In the real world, many prices are sticky in the short run.  For now (and throughout Chapters 9-12), we assume that all prices are stuck at a predetermined level in the short run…  …and that firms are willing to sell as much as their customers are willing to buy at that price level.  Therefore, the short-run aggregate supply (SRAS) curve is horizontal:

CHAPTER 9 Introduction to Economic Fluctuations slide 13 The short run aggregate supply curve Y P SRAS The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

CHAPTER 9 Introduction to Economic Fluctuations slide 14 Short-run effects of an increase in M Y P AD 1 AD 2 …an increase in aggregate demand… In the short run when prices are sticky,… …causes output to rise. SRAS Y2Y2 Y1Y1

CHAPTER 9 Introduction to Economic Fluctuations slide 15 The SR & LR effects of  M > 0 Y P AD 1 AD 2 LRAS SRAS P2P2 Y2Y2 A = initial equilibrium A B C B = new short- run eq’m after Fed increases M C = long-run equilibrium

CHAPTER 9 Introduction to Economic Fluctuations slide 16 How shocking!!!  shocks: exogenous changes in aggregate supply or demand  Shocks temporarily push the economy away from full-employment.  An example of a demand shock: exogenous decrease in velocity  If the money supply is held constant, then a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services:

CHAPTER 9 Introduction to Economic Fluctuations slide 17 LRAS AD 2 SRAS The effects of a negative demand shock Y P AD 1 P2P2 Y2Y2 The shock shifts AD left, causing output and employment to fall in the short run A B C Over time, prices fall and the economy moves down its demand curve toward full- employment.

CHAPTER 9 Introduction to Economic Fluctuations slide 18 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.)

CHAPTER 9 Introduction to Economic Fluctuations slide 19 CASE STUDY: The 1970s oil shocks  Early 1970s: OPEC coordinates a reduction in the supply of oil.  Oil prices rose 11% in % in % in 1975  Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

CHAPTER 9 Introduction to Economic Fluctuations slide 20 SRAS 1 Y P AD LRAS Y2Y2 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. SRAS 2 CASE STUDY: The 1970s oil shocks A

CHAPTER 9 Introduction to Economic Fluctuations slide 21 Stabilizing output with monetary policy Y P AD 1 B SRAS 2 A C Y2Y2 LRAS AD 2 But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full- employment level.

CHAPTER 9 Introduction to Economic Fluctuations slide 22 In this chapter you will learn  the IS curve, and its relation to – the Keynesian Cross – the Loanable Funds model  the LM curve, and its relation to – the Theory of Liquidity Preference  how the IS-LM model determines income and the interest rate in the short run when P is fixed

CHAPTER 9 Introduction to Economic Fluctuations slide 23 The Keynesian Cross  A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes)  Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure  Difference between actual & planned expenditure: unplanned inventory investment

CHAPTER 9 Introduction to Economic Fluctuations slide 24 Elements of the Keynesian Cross consumption function: for now, investment is exogenous: planned expenditure: Equilibrium condition: govt policy variables:

CHAPTER 9 Introduction to Economic Fluctuations slide 25 Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1

CHAPTER 9 Introduction to Economic Fluctuations slide 26 Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45 º

CHAPTER 9 Introduction to Economic Fluctuations slide 27 The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income

CHAPTER 9 Introduction to Economic Fluctuations slide 28 An increase in government purchases Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 YY At Y 1, there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium GG