Lecture08 - Introduction to Economic Fluctuations Roadmap...

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Unformatted text preview: Introduction to Economic Fluctuations Roadmap to this Lecture We abandon the view that production is determined by technology and full employment of production f t f d ti factors (i (i.e., th there can b be unemployment and capital underutilization) Short run Short-run frictions prevent full factor utilization in the short-run and distort optimal economic outcomes When this happens what can we do? happens, Monetary Policy Fiscal Policy The AD/AS model is the basic tool to think about policy ECN 101 MACROECONOMICS slide 1 Real GDP Growth in the U.S., 1960-2004 196010 Perce chang from ent ge four quarters earlier q s 8 6 4 2 0 -2 Peak Average growth rate = 3.4% Trough T h -4 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 ECN 101 MACROECONOMICS slide 2 Time horizons Long run: Prices are flexible respond to changes in flexible, supply or demand Short run: many prices are "sticky" at some predetermined level (or there are other frictions, e.g. information) The economy behaves much differently when prices are sticky. ECN 101 MACROECONOMICS slide 3 In Classical Macroeconomic Theory, Output is determined by the supply side: supplies of capital, labor capital technology Changes in demand for goods & services (C, I, G ) only affect prices, not quantities. Complete price flexibility is a crucial C l t i fl ibilit i i l assumption, so classical theory applies in the long run run. ECN 101 MACROECONOMICS slide 4 When prices are sticky ...output and employment also depend on demand for goods & services services, which is affected by fiscal li fi l policy (G and T ) d monetary policy (M ) other factors, like exogenous changes in C or I. ECN 101 MACROECONOMICS slide 5 The model of aggregate demand and supply gg g pp y 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 d determined i d shows how the economy's behavior is y different in the short run and long run ECN 101 MACROECONOMICS slide 6 Aggregate demand The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For F now, we d i the AD/AS model derive th d l with a simple theory of aggregate demand based on the Quantity Theory of Money. Money Later we will develop the theory of aggregate d t demand in more detail. di d t il ECN 101 MACROECONOMICS slide 7 The Quantity Equation as Aggregate Demand Recall the quantity equation MV = PY We now assume that Y is flexible (rather ( than solely determined by technology and ) available factors). For given values of M and V, QTM implies an i inverse relationship between P and Y l ti hi b t d Y: ECN 101 MACROECONOMICS slide 8 The downward-sloping AD curve downwardAn increase in the price level causes a fall in real money balances y (M/P ), causing a decrease in the demand for goods & services. P AD Y ECN 101 MACROECONOMICS slide 9 Shifting the AD curve P An increase in the money y supply shifts the AD curve to the right right. AD2 AD1 Y ECN 101 MACROECONOMICS slide 10 Using Total Differentiation to Make the Same Point Recall M V = P Y (QTM) The l Th slope of the aggregate d f th t demand curve is d i determined by how prices change when income changes by one unit, everything else constant Totally differentiating QTM: M dV + V dM = P dY + Y dP Notice, dV = dM = 0 Hence: dP/dY = -P/Y < 0 ECN 101 MACROECONOMICS slide 11 Aggregate Supply in the Long Run In the long run, output is determined by factor supplies and technology Y = F (K , L ) Y iis the f ll th full-employment or natural l l t t l level of l f output, the level of output at which the economy s economy's resources are fully employed employed. "Full employment" means that unemployment equals its natural rate rate. ECN 101 MACROECONOMICS slide 12 Aggregate Supply in the Long Run Recall from chapter 3: In the long run, output is determined by run factor supplies and technology Y = F (K , L ) Full-employment output d F ll l t t t does not d t depend d on the price level, so th l the long run aggregate supply (LRAS) t l curve is vertical: ECN 101 MACROECONOMICS slide 13 The long-run aggregate supply curve longP LRAS The LRAS curve is vertical at the full-employment level of output. Y ECN 101 MACROECONOMICS Y slide 14 LongLong-run effects of an increase in M P LRAS An i A increase in M shifts the AD curve to the right. In the long run, this increases the price level... P2 P1 AD2 AD1 ...but leaves output the same same. ECN 101 MACROECONOMICS Y Y slide 15 Aggregate Supply in the Short Run In the real world, many prices are sticky in the short run run. For now, assume that all prices are stuck at a predetermined level in the short run run... ...and that firms are willing to sell as much at that price level as their customers are willing to buy (why is this a sensible exercise?) Therefore, the short-run aggregate supply (SRAS) curve is horizontal: ECN 101 MACROECONOMICS slide 16 The short run aggregate supply curve P The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. P SRAS Y ECN 101 MACROECONOMICS slide 17 ShortShort-run effects of an increase in M In the short run when prices are sticky,... P ...an increase in aggregate demand... demand P SRAS AD2 AD1 Y1 Y2 ...causes output to i t rise. ECN 101 MACROECONOMICS Y slide 18 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, equilibrium if then over time, the price level will Y >Y Y <Y rise fall remain constant Y =Y This adjustment of prices is what moves the economy to its long-run equilibrium. th t it longl ilib i ECN 101 MACROECONOMICS slide 19 The SR & LR effects of M > 0 A = initial equilibrium B = new shortshort run eq'm after Fed increases M i C = long-run equilibrium P LRAS P2 C B A P SRAS AD2 AD1 Y Y2 Y ECN 101 MACROECONOMICS slide 20 How shocking!!! shocks: exogenous changes in aggregate supply or demand Shocks temporarily push the economy away from full employment. 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: ECN 101 MACROECONOMICS slide 21 The effects of a negative demand shock The shock shifts AD left causing left, output and employment to fall in the short run Over time prices time, fall and the economy moves down its demand curve toward fullemployment. P LRAS P P2 B A C SRAS AD1 AD2 Y2 Y Y ECN 101 MACROECONOMICS slide 22 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 d i i Fi h hi h i t help cover the costs of compliance. (Favorable supply shocks lower costs and prices ) prices.) ECN 101 MACROECONOMICS slide 23 CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil. pp y 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 (and each unit of GDP required much more oil to be produced. Now the economy is more service oriented a massage requires little oil). ECN 101 MACROECONOMICS slide 24 CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, hift causing output and employment to fall. p y In absence of further price shocks, prices will fall over time and economy moves back toward full employment. p y P LRAS P2 B A SRAS2 SRAS1 AD P1 Y2 Y Y ECN 101 MACROECONOMICS slide 25 CASE STUDY: The 1970s oil shocks 70% 12% Predicted effects of the oil price shock: at o inflation output unemployment ...and then a gradual recovery. 60% 50% 40% 30% 20% 10% 0% 1973 4% 1977 8% 10% 6% 1974 1975 1976 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) ECN 101 MACROECONOMICS slide 26 CASE STUDY: The 1970s oil shocks 60% 50% 40% 10% 30% 8% 20% 10% 0% 1977 6% 4% 1981 14% 12% Late 1970s: As economy was recovering, oil prices shot up again, again causing another huge supply shock!!! 1978 1979 1980 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) ECN 101 MACROECONOMICS slide 27 CASE STUDY: The 1980s oil shocks 40% 10% 8% 6% 4% 2% 0% 1987 1980s: A favorable supply shock-a significant fall in oil prices. As the model would predict, inflation and unemployment fell: 30% 20% 10% 0% -10% -20% -30% -40% -50% 1982 1983 1984 1985 1986 Change in oil prices (left scale) Inflation rate-CPI (right scale) Unemployment rate (right scale) ECN 101 MACROECONOMICS slide 28 Stabilization policy definition: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: U i monetary policy to E l Using t li t combat the effects of adverse supply shocks: ECN 101 MACROECONOMICS slide 29 Stabilizing output with monetary p y policy y The adverse supply shock moves the economy to point B. P LRAS P2 B A SRAS2 SRAS1 AD1 P1 Y2 ECN 101 MACROECONOMICS Y Y slide 30 Stabilizing output with monetary p y policy y But the Fed accommodates the shock by raising agg. agg demand. results: P is permanently higher, b t highe but Y remains at its fullp y employment level. P LRAS P2 B C A SRAS2 AD2 P1 AD1 Y2 Y Y ECN 101 MACROECONOMICS slide 31 ...
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