Chapter 20 PP Slides - 4/30/2010 Introduction Over the long...

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4/30/2010 1 Introduction to Business Cycle Theory: Aggregate Demand and Aggregate Supply Material corresponding to Mankiw, Chapter 20 Introduction Over the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend. Recessions : periods of falling real incomes and rising unemploymen 1 and rising unemployment Depressions : severe recessions (very rare) Expansions : periods of rising real incomes and rising employment Short-run economic fluctuations are often called business cycles . 10,000 12,000 14,000 Three Facts About Economic Fluctuations U.S. real GDP, billions of 2000 dollars FACT 1 : Economic fluctuations are irregular and unpredictable. 0 2,000 4,000 6,000 8,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2 The shaded bars are recessions 2,000 2,500 Three Facts About Economic Fluctuations FACT 2 : Most macroeconomic quantities fluctuate together. Investment spending, billions of 2000 dollars 0 500 1,000 1,500 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 3
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4/30/2010 2 Growth rates of real GDP, consumption 4 6 8 10 Percent change from 4 quarters earlier Average Real GDP growth rate Consumption growth rate -4 -2 0 2 1970 1975 1980 1985 1990 1995 2000 2005 2010 growth rate Growth rates of real GDP, consumption, investment 10 20 30 40 Percent change from 4 quarters earlier Investment growth rate Real GDP growth rate -30 -20 -10 0 1970 1975 1980 1985 1990 1995 2000 2005 2010 Consumption growth rate 8 10 12 Three Facts About Economic Fluctuations FACT 3 : As output falls, unemployment rises. Unemployment rate, percent of labor force 0 2 4 6 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 6 Classical Economics—A Recap The previous chapters are based on the ideas of classical economics, especially: The Classical Dichotomy , the separation of variables into two groups: Real – quantities relative prices 7 Real quantities, relative prices Nominal – measured in terms of money The neutrality of money : Changes in the money supply affect nominal but not real variables.
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4/30/2010 3 Classical Economics—A Recap Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect 8 real variables (like Y or the u-rate). To study the short run, we use a new model. The Model of Aggregate Demand and Aggregate Supply P SRAS P 1 The price level The model “Short-Run Aggregate 9 Y AD Y 1 Real GDP, the quantity of output determines the eq’m price level and eq’m output (real GDP). “Aggregate Demand” Supply” Why the AD Curve Slopes Downward Y = C + I + G + NX Assume G fixed by govt policy. To understand P P 2 10 the slope of AD , must determine how a change in P affects C , I , and NX . Y AD P 1 Y 1 Y 2 The Wealth Effect ( P and C ) Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer.
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Chapter 20 PP Slides - 4/30/2010 Introduction Over the long...

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