1. Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281
Macroeconomics & The Global Economy Ace Institute of Management Chapter 9: Economic Fluctuation (Business Cycle Theory)
Instructor
Sandeep Basnyat

2. Introduction
Continual ups and downs in the rate of growth of national income
Business cycle is the alternating periods of expanding and contracting economic activity.

3. Growth rates of real GDP, consumption
Percent change from 4 quarters earlier
Real GDP growth rate
Consumption growth rate
Average growth rate

4. Growth rates of real GDP, consumption, investment
Percent change from 4 quarters earlier
Investment growth rate
Real GDP growth rate
Consumption growth rate

5. Unemployment
Percent of labor force

6. Phases of Business Cycle
There are four phases of business cycle
Prosperity or Boom
Recession
Depression or Slump
Recovery or Revival
Output
Recession
Revival
Prosperity
Depression
Periods

7. Why does this happen? What are its implications to an economy?
Different behavior of Price in short and long run
Demand and supply shocks

8. Behaviour of Price
Short run Many prices are “sticky” at a predetermined level.
Long run Prices are flexible, respond to changes in supply or demand.
The economy behaves much differently when prices are sticky than flexible.

9. Aggregate demand
The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.
Also. from quantity equation
M V = P Y
If M and V are constant then, this equation implies an inverse relationship between P and Y causing downward sloping AD curve

10. The downward-sloping AD curveY P AD

11. Shifting the AD curve Y P
AD2
An increase in the money supply shifts the AD curve to the right.
AD1

12. The short-run aggregate supply curve
The SRAS curve is horizontal:
The price level is fixed at a predetermined level, and firms sell as much as buyers demand.
SRAS

13. The long-run aggregate supply curve
Increase in price is followed by increase in cost and suppliers do not have incentives to increase supply Y P
LRAS
has enough time to respond to fixed K,L: does not depend on P, so LRAS is vertical.
Notes for students:
In the long run, supply has enough time to respond to fixed factors of production and becomes vertical.
A 10% increase in P costs EVERYTHING 10% more- firm get 10% more revenue and also pays 10% more in wages, prices of intermediate goods, advertising, and so on. Thus, the firm has no incentive to increase output and supply curve becomes vertical.

14. The Aggregate Demand and supply curves
LRAS AD
SRAS

15. From short run to Long runY P
In the short run when prices are sticky,…
…an increase in aggregate demand…
AD2
AD1
SRAS Y2
…causes output to rise. Y1

16. Short-run effects of an increase in M
A = initial equilibrium Y P
LRAS
AD2
AD1
B = new short-run eq’m after Central Bank increases M C
SRAS B A Y2
C = long-run equilibrium

17. Long-run effects of an increase in MY P
LRAS
AD2
AD1
Net Effect
Short run and long run effects of price cause business cycle P2 P1

18. How shocking!!! shocks: exogenous changes in agg. supply or demand
Shocks temporarily push the economy away from full employment.
CHAPTER 9 Introduction to Economic Fluctuations

19. The effects of a negative demand shock
AD shifts left, depressing output and employment in the short run. Y P
LRAS
AD1
AD2
SRAS B A
Over time, prices fall and the economy moves down its demand curve toward full- employment. Y2 C P2
CHAPTER 9 Introduction to Economic Fluctuations

20. 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

21. 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

22. CASE STUDY: The 1970s oil shocks
The oil price shock shifts SRAS up, causing output and employment to fall. Y P
LRAS AD
SRAS2 B
In absence of further price shocks, prices will fall over time and economy moves back toward full employment. Y2
SRAS1 A A
CHAPTER 9 Introduction to Economic Fluctuations

23. Thank You