Introduction to EconomicFluctuations
Instructor: Dmytro Hryshko
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Outline
facts about the business cycle
how the short run differs from the long run
an introduction to aggregate demand
an introduction to aggregate supply in theshort run and long run
how the model of aggregate demand andaggregate supply can be used to analyze theshort-run and long-run effects of “shocks.”
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Facts about the business cycle
GDP growth averages 3–3.5 percent per yearover the long run (n + g in the Solow model),with large fluctuations in the short run. Fig
Consumption and investment fluctuate withGDP, but consumption tends to be lessvolatile and investment more volatile thanGDP. Fig
Unemployment rises during recessions andfalls during expansions. Fig
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GPD growth in the US
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Consumption and investment growth in the US
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Consumption and investment growth in the US
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Time horizons in macroeconomics
Long run: Prices are flexible, respond tochanges in supply or demand.
Short run: Many prices are “sticky” at apredetermined level (e.g., nominal wages arepreset in contracts).
The economy behaves much differently whenprices are sticky.
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Recap of classical macro theory
Output is determined by the supply side(supplies of capital, labor and technology)
Changes in demand for goods & services (C,I, G ) only affect prices, not quantities.
Assumes complete price flexibility.
Applies to the long run.
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When prices are sticky
Output and employment also depend on demand,which is affected by:
fiscal policy (G and T)
monetary policy (M)
other factors, like exogenous changes in C or I
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Aggregate DemandAggregate Demand (AD) is the relationship between thequantity of total output demanded and the aggregate pricelevel.
Use the quantity of money equation as the aggregatedemand curve:
M × V = P × Y
(M/P )d = k × Y ⇒M/P = (M/P )d = k × Y.
For any given k (and so V), and money supply, M,there is a negative relationship between the aggregateprice level and total output.
For a given M and V, aggregate demand shows thecombinations of P and Y that satisfy the quantityequation of money.
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An increase in the price level causes a fall in realmoney balances (M/P), causing a decrease in thedemand for goods & services.
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Shifts in Aggregate Demand
AD curve is defined for given (fixed) values ofM and V.
AD shifts following the changes in M or V.
Assume V is constant. Then AD shifts whenM changes.
M × V = P × Y
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Aggregate Supply
Aggregate Supply (AS) is the relationshipbetween the total quantity of goods andservices supplied and the aggregate price level.
AS curve differs in the LR, when the pricesare flexible, and SR, when the prices aresticky.
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Long Run AS Curve (LRAS)
In the LR,
Y = F (K, L) = Y
and output does not depend on prices. Thus,LRAS curve is vertical, i.e., output in the LRis insensitive to the price level. Fig
Thus, changes in AD affect the price level inthe LR, not the level of output. Fig
Y is called the full employment, ornatural level of output, i.e., the level ofoutput when the economy’s unemploymentrate is at its natural rate.
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Short Run AS Curve (SRAS)
Extreme case: all of the prices are sticky inthe short run. Then, the SRAS ishorizontal—firms produce as much asconsumers are willing to buy at the fixedprice level. Fig
Equilibrium in the SR: at the intersection ofthe SRAS and AD curves. Fig
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Short-run and long-run effects of reduction in M
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From the short run to the long run
Over time, prices gradually become “unstuck.”When they do, will they rise or fall?
If in the SR eqm then over time, P willY > Y ↑Y < Y ↓Y = Y remain constant
The adjustment of prices is what moves theeconomy to its long-run equilibrium.
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Shocks
Exogenous changes in aggregate supply ordemand⇒source of fluctuations
Shocks temporarily push the economy awayfrom full employment.
Example: exogenous decrease in velocity. Ifthe money supply is held constant, a decreasein V means people will be using their moneyin fewer transactions, causing a decrease indemand for goods and services.
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Short-run and long-run effects of reduction in V
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Supply shocks
A supply shock alters production costs, affectsthe prices that firms charge (also called priceshocks)
Examples of adverse supply shocks:–Bad weather reduces crop yields, pushing upfood prices–Workers unionize, negotiate wage increases–New environmental regulations require firmsto reduce emissions. Firms charge higherprices to help cover the costs of compliance
Favorable supply shocks lower costs andprices (e.g., a positive TFP shock)
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Example: an increase in the price of oil
SRAS curve shifts upwards, since the costs ofproducing one unit of good increases
If AD is unchanged, the P rises and Y falls
A phenomenon of falling output and risingprices is called stagflation
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Adverse supply shock
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Stabilization policy
Policy actions aimed at reducing the severity ofshort-run economic fluctuations
Example: Using monetary policy to combatthe effects of adverse supply shocks
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Adverse supply shock and monetary policy
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Summary
Long run: prices are flexible, output and employmentare always at their natural rates, and the classicaltheory applies.
Short run: prices are sticky, shocks can push outputand employment away from their natural rates.
Aggregate demand and supply: a framework to analyzeeconomic fluctuations
The aggregate demand curve slopes downward
The long-run aggregate supply curve is vertical,because output depends on technology and factorsupplies, but not prices.
The short-run aggregate supply curve is horizontal,because prices are sticky at predetermined levels.
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Readings
Mankiw and Scarth. Fifth Canadian Edition. Chapter 9.
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