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slides_ch9 - Introduction to Economic Fluctuations Chapter...

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Introduction to Economic Fluctuations Chapter Nine
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Introduction The primary objective of this chapter and the ones that follow is to study the causes and consequences of short-run economic fluctuations in output and employment – business cycle Short-run fluctuations are a recurring phenomenon is the U.S. economy (see graph on next slide): Economy experiences on average 3.5% real GDP growth per year This growth is not steady; there are recessions (periods of falling income and rising unemployment) and there are expansions (periods of rising income and falling unemployment) Recession of 1990: real GDP fell by 2.2% from peak to trough and unemployment rose to 7.7% Expansion of 1997: real GDP growth rose to a high of 6.1% Notice that business cycles are very common but also very irregular/unpredictable In this chapter we will begin to develop a different model that is able to explain the short-run economic fluctuations depicted in the graph.
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Real GDP Growth in the United States -4 -2 0 2 4 6 8 10 1960 1965 1970 1975 1980 1985 1990 1995 2000 Percent change from 4 quarters earlier Average growth rate = 3.5%
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Time Horizons in Macroeconomics: How the Short Run and Long Run Differ Why do we need a different model to study the economy in the short- run? Because the classical model applies to what time horizon? The key differences between the short and long run is the behavior of prices: In the long-run prices are flexible and can respond to changes in supply and demand In the short-run many prices are “sticky” at some predetermined level and thus cannot fully respond to changes in supply and demand Consider the effects of a 5% money supply reduction in the long run: How does this affect Y , C , I , S , NX ? Why? How does this affect P ? What is this separation in the classical model called? In the long-run, changes in the money supply do not cause fluctuations in output or employment
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… Time Horizons in Macroeconomics In order to explain the short-run economic fluctuations that are so obvious from the graph, we need to develop a model in which changes in nominal variables can affect output and employment – in other words, we need a model where the classical dichotomy fails. Consider the effects of a 5% money supply reduction in the short run: The reduction in the money supply does not immediately cause all firms to lower their prices and wages – price stickiness Thus, the short-run impact of a money supply reduction will not be the same as the impact in the long-run where prices absorb all of the change in the money supply We will see that the failure of prices to fully and quickly adjust implies that output and employment must do some of the adjusting instead
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The Model of Aggregate Supply and Aggregate Demand To see how the presence of sticky prices causes short-run fluctuations we need to look at a model of supply and demand (for output) In the classical model, does the amount of output depend on the demand or the economy’s ability to supply goods and services?
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