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

2. 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

3. 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

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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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