Business cycles and intro to AD-AS model 0VS452 + 5EN253 Lecture 8 – part I Business cycles and intro to AD-AS model Eva Hromádková, 12.4 2010

Overview of Lecture 8 – part I Business cycles: Why do we need other than classical model? Puzzle of Great Depression Prices in the short vs. long run Intro to AD and AS curves Effect of shocks in AD-AS model Stabilization policy – tools and goals

Motivation Failure of classical economy in the case of Great Depression Before – period of rapid growth (GDP, stocks) October 24, 1929 – Black Thursday Crash of stock market –> sell-off Fall of wealth, savings => depression of real sector Output, consumption, investment falling Unemployment: 1929 – 3%, 30’ – 9%, 33’ – 25%, 39’ – 17%

Motivation Failure of classical economy in the case of Great Depression Reality Assumption of self- regulating economy Prices are flexible Unemployment and excess supply will disappear as soon as prices will adjust Deflation (30’ = -10%) Still, high unemployment Keynes: Economy is inherently unstable Need for government intervention Debate lasts until now

Business cycles Terminology – What do we mean by inherently unstable? Recession: typically defined as a decline in real GDP for two or more consecutive quarters, accompanied with high unemployment Depression: any economic downturn where real GDP declines by more than 10 percent, longer and more severe than recession

Business cycles (fluctuations) Real world – example of USA

Business cycles (fluctuations) Real world – Summary of example of USA Real GDP growth in US: long-run growth of 3.5% not steady – fluctuations around trend: Great Depression WWII – growth by 19%, all people employed 46’-48’ – postwar depression (military production) 80’s oil crisis

Business cycles (fluctuations) Stylized facts No simple regular or cyclical pattern Distributed unevenly over the components of output Stable: consumption of non-durables and services, net export Unstable: consumption of durables, housing, inventories Asymmetries between rises and falls in output Long time slightly above and short time far below the mean value

Business fluctuations Role of macro theory Macro theory tries to explain why we observe alternating periods of growth and contraction in short run; together with long-term trends Main difference Long-run: prices are flexible, respond to changes in supply or demand Short run: many prices are “sticky” Examples of sticky prices: menus, magazines, … Question WHY the prices are sticky (and why only some of them) is very interesting – not a clear microeconomic explanation The economy behaves much differently when prices are sticky.

Business fluctuations Comparison of long-term and short-term determinants Long-term (classical economy) Short term (business cycles) Price flexibility Output determined by supply side ( F(K,L) ) Change in demand only affects prices, not quantities Say’s law: supply creates demand Price stickiness Output determined also by demand – affected by exogenous changes Ex: firm – how much we are able to sell at given price

Model of AD and AS the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined simultaneously shows how the economy’s behavior is different in the short run and long run

Aggregate demand The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For this lecture’s intro to the AD/AS model, we use a very simple theory of aggregate demand based on the Quantity Theory of Money. In this and next lecture we develop the theory of aggregate demand in more detail.

Aggregate demand Quantity theory of money From Lecture 3, recall the quantity equation M V = P Y and the money demand function it implies: (M/P )d = k Y where V = 1/k = velocity. For given values of M and V, these equations imply an inverse relationship between P and Y: P = (M V) / Y

Aggregate demand Downward-sloping curve Real balances effect: Increase in price level causes fall in real money balances => decrease in demand Y P AD

Aggregate demand Shift of AD curve – Ex.: increase in the money supply Increase in money supply => shift of AD curve to the right Explanation: Can buy more at the same price P = (M V) / Y Rise in M

Aggregate supply Long run AS curve In the long run, output is determined by factor supplies and technology full-employment or natural level of output, the level of output at unemployment equals its natural rate (no inflationary pressures). does not depend on the price level, so the long run aggregate supply (LRAS) curve is vertical: Why not at the level of full employment – everybody employed?

Aggregate supply Long run - graph Long run AS curve is vertical at optimal Y Classical assumption Y P LRAS

AD-AS model Long-run effects of AD shift (increase in M) Y P LRAS An increase in M shifts the AD curve to the right. In the long run, this increases the price level… P2 P1 Notice that the results in this graph are exactly as we learned in neoclassical model: a change in the money supply affects the price level, but not the quantity of output. …but leaves output the same.

AD-AS model Long-run - Implications In the long run – change in the money supply does not have any effect on real variable, only on the price level Deviation only as long as price adjusts Not what we observe in reality! Consider a long term outcome Self-adjusting deviations Economic growth based on the growth of real variables: capital, labor, technology Analyze departures

Aggregate supply Short run In the real world, many prices are sticky in the short run. From now on 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: (simplification – in reality, upward sloping) Could you come up with an example like this from the real world – remember this is short run! (catalogue prices)

Aggregate supply Short run AS curve SRAS is horizontal: Price level fixed at a predetermined level Firms sell as much as buyers demand SRAS

AD-AS model Long-run effects of AD shift (increase in M) Y P In the short run when prices are sticky,… …an increase in aggregate demand… SRAS Y2 In reality, SRAS is assumed to be upward sloping => partial effect on Y and partial increase in price level …causes output to rise. Y1

AD-AS model Short-run - Implications In the short run – change in the AD (money supply) has full effect on real variable + no on price level Equilibrium may be undesirable – higher or lower output (and corresponding prices) than in natural level Lower output – recessionary gap – high unemployment rate Higher output – inflationary gap – pressure to increase prices

AS-AD model From the short run to the long run Over time, prices gradually become “unstuck.” When they do, will they rise or fall? In the short-run equilibrium, if then over time, the price level will ? ? Y > natural Y => prices will rise Y < natural Y => prices will fall Y = natural Y => prices will remain constant Why? Instead, suppose that output is below its natural rate. With lower than normal output, firms won’t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the “natural rate of unemployment.” The high unemployment rate puts downward pressure on wages. Even though wages and prices are “stuck” in the short run, but over time, they fall in response to these pressures. ?

AD-AS model Short and Long-run effects of AD shift (increase in M) Y P LRAS A = initial equilibrium B = new short-run equilib. after increase M C P2 SRAS B A Y2 Put pieces together: Economy starts at A; output at their “natural” rates. Central Bank increases the money supply, shifting AD to right. In short run, prices are sticky, so output rises. The new short-run equilibrium is at point B in the graph. In order for firms to increase output, they hire more workers, so unemployment falls below the natural rate of unemployment, putting upward pressure on wages. The high level of demand for goods & services at point B puts upward pressure on prices. Over time, as prices become “unstuck,” they begin to rise in response to these pressures. The price level rises and the economy moves up its (new) AD curve, from point B toward point C. This process stops when the economy gets to point C: C = long-run equilibrium

AD-AS model Summary of basic model Bad news – recessions are inevitable Good news – hope for adjustment BUT!!! Reality strikes back Money supply changes are predictable (CB), however, other shocks may shift both curves – unpredictable and even simultaneous Adjustment takes a long time – do we need “nudge” from government?

AD-AS model 1. Introduction of shocks exogenous changes in aggregate supply or demand temporarily push the economy away from full-employment AD shocks AS shocks Lower export demand Lower consumer confidence Taxation Changing import prices Natural disasters changing input costs

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. Q1: How would this situations look depicted in AD-AS framework? Oil: -used for heating Fuel for trucks, airplanes, etc.. Intermediate good

CASE STUDY: The 1970s oil shocks AD Y P LRAS The oil price shock shifts SRAS up, causing output and employment to fall. SRAS2 B Y2 In absence of further price shocks, prices will fall over time and economy moves back toward full employment. SRAS1 A A Initial point = A Oil price shock – move to point B in the short run Q2: What are the implications of the model for he behavior of output inflation and unemployment?

CASE STUDY: The 1970s oil shocks Predicted effects of the oil price shock: inflation  output  unemployment  …and then a gradual recovery. This slide first summarizes the model’s predictions from the preceding slide, and then presents data that supports the model’s predictions.

CASE STUDY: The 1970s oil shocks Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

CASE STUDY: The 1980s oil shocks 1980s: A favorable supply shock-- a significant fall in oil prices. As the model would predict, inflation and unemployment fell: A few slides back, we did the analysis of an adverse supply shock. It might be worth noting that the predicted effects of a favorable supply shock are just the opposite: in the short run, the price level (or inflation rate) falls, output rises, and unemployment falls. Looking at the graph: at first glance, it may seem that the fall in oil prices doesn’t occur until 1986. But 0 is in the middle, not at the bottom. Oil prices fell about 10% in 1982, and generally were generally falling during most years between 1982 and 1986.

AS-AD model 2. Stabilization policy Definition: policy actions aimed at reducing the severity of short run economic fluctuations Types: Laissez faire – no action, economy will self-adjust to optimal position Fiscal policy: gvt expenditures, taxation (AD side) Fiscal multiplier Monetary policy: money supply and interest rates Money multiplier Supply side policy: incentives for work, saving, investment Trade policy: e.g. reducing trade barriers Example with multiplier – how the effect of government expenditures affect consumption and investment Remind multiplier effect of money

AS-AD model 2. Stabilization policy – example of supply shock LRAS The adverse supply shock moves the economy to point B. SRAS2 B Y2 SRAS1 A We only consider short term effect of supply shock – i.e. moving SRAS upwards Long-term effect: e.g. decreasing natural level of output = shift LRAS to the left Supply shock = higher prices & lower output = STAGFLATION We can either wait until economy “recovers” – gets back to A

AS-AD model 2. Stabilization policy – example of supply shock But CB can accommodate the shock by raising agg. demand. Y P LRAS SRAS2 B C Y2 A results: P is permanently higher, but Y remains at its full-employment level. CB raises aggregate demand by increasing M It accommodates the shock – economy moves almost directly to point C What other policies can be employed??

AD-AS model Stabilization policy - concerns Which type of policy tool is optimal? What would be the final result? Can we account for all the injections (multiplication) and leakages? How do we account for changing expectations? How do we trade between inflation and unemployment?