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Modified by the instructor

MACROECONOMICS MACROECONOMICS

Topic 7

Introduction to Economic Fluctuations

(Chapter 9)

Instructor: Tuan Khai Vu

ICU, Winter Term 2011

Principles of Macroeconomics

Learning objectives

Learning objectives

In this chapter, we will learn :

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facts about the business cycle

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how the short run differs from the long run

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an introduction to aggregate demand and

aggregate supply in the short run and long run

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how the model of aggregate demand and

aggregate supply can be used to analyze the

Facts about the business cycle

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GDP growth averages 3–3.5 percent per year over the long run with large fluctuations in the short run.

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Consumption and investment fluctuate with

GDP, but consumption tends to be less volatile and investment more volatile than GDP.

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Unemployment rises during recessions and falls during expansions.

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Okun’s Law: the negative relationship between

Grow th rates of real GDP, consumption

Percent change from 4 quarters earlier

Average growth rate

Real GDP growth rate

Consumption growth rate

Shaded areas

Grow th rates of real GDP, consumption, investment

Percent change from 4 quarters earlier

Investment growth rate

Real GDP growth rate

Consumption growth rate

U n e m p lo y m e n t

Okun’s Law

Percentage change in real GDP

1975 1991 1982

2001 1984

1951 ¹⁹⁶⁶

2003

1987

2008 1971

I ndex of Leading Economic I ndicators ( LEI )

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Published monthly by the Conference Board.

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Aims to forecast changes in economic activity 6-9 months into the future.

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Used in planning by businesses and the government, despite not being a perfect predictor.

Components of the LEI index

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Average workweek in manufacturing

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Initial weekly claims for unemployment insurance

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New orders for consumer goods and materials

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New orders, nondefense capital goods

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Vendor performance

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New building permits issued

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Index of stock prices

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^M2

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Yield spread (10-year minus 3-month) on

I ndex of Leading Economic I ndicators

2004 = 100

Time horizons in macroeconomics

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^{Long run}

Prices are flexible, respond to changes in supply or demand.

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^{Short run}

Many prices are “sticky” at a predetermined level.

The economy behaves much differently when prices are sticky.

a fact observed from data

Also refer to slide

#9 of topic 6a.

Recap of classical macro theory

( Chaps. 3- 8)

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Applies to the long run.

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Assumes complete price flexibility.

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Output is determined by the supply side:

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supplies of capital, labor

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^technology

Recap of classical macro theory

( Chaps. 3- 8)

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Changes in demand for goods &

services (C, I , G ) only affect prices, not quantities.

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Changes in money supply (M) causes proportional changes in prices, without affecting quantities.

This is called the neutrality of money

When prices are sticky…

… firms output and employment also depend on demand, which is affected by:

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fiscal policy (G and T )

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monetary policy (M )

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other factors, like exogenous changes in

C or I

Think of a situation in which firms cannot change their prices ÆThey will sell as much output as their customers demand. Æ Demand affects output and thus employment!

Why are prices sticky ?

… many possible reasons:

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costly to change prices

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prices are set in contracts which specify that prices are fixed for some period.

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competition strategy with rivals

prevents firm from changing prices (_Æ strategic relationships)

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^...

The model of

aggregate demand and supply

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The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy

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Shows how the price level and aggregate output are determined

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Shows how the economy’s behavior is different in the short run and long run

The model of

aggregate demand and supply

A quick math review: draw the graph of the

following functions (with y on the vertical axis, and x on the horizontal)

i.

^{y = 2 + x and y = 3 + x}

ii.

^{y = ax+ b , with a,b} being constants

iii.

^{y = 12/ x and y = 24/ x}

iv.

^{y = 3}

v.

^{x = 3}

Aggregate demand

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The aggregate demand curve shows the

relationship between the price level and the quantity of output demanded.

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For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the quantity theory of money.

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Chapters 10-12 develop the theory of aggregate demand in more detail.

The Quantity Equation as

Aggregate Demand

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From Chapter 4, recall the quantity equation M V = P Y

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For given values of M and V,

this equation implies an inverse relationship between P and Y …

The dow nw ard- sloping AD curve

An increase in the price level causes a fall in real

money balances (M/P ),

causing a

decrease in the demand for goods An increase in the price level causes a fall in real

money balances (M/P ),

causing a

decrease in the demand for goods

P

AD

Shifting the AD curve

An increase in the money

supply shifts the AD curve to the right.

An increase in the money

supply shifts the AD curve to the right.

Y P

AD₁

AD₂

The Quantity Equation as

Aggregate Demand: A numerical example

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Let’s work with a numerical example using Excel to demonstrate the results in the previous two

slides

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Set: M= 10, V= 2

Æ the graph of AD …

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Now set a new value M’= 12^, while V remains the same (V= 2).

Aggregate supply in the long run

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Recall from Chapter 3:

In the long run, output is determined by factor supplies and technology

is the full-employment or natural level of

output, at which the economy’s resources are fully employed.

“Full employment” means that

The long- run aggregate supply curve

P _LRAS

does not depend on P, so LRAS is vertical.

does not depend on P, so LRAS is vertical.

Long- run effects of an increase in M

Y P

AD₁ LRAS

An increase in M shifts AD to the right.

P₁ P₂ In the long run,

this raises the price level…

…but leaves

AD₂

Aggregate supply in the short run

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Many prices are sticky in the short run.

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For now (and through Chap. 12), we assume

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all prices are fixed at a predetermined level in the short run.

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firms are willing to sell as much at that price level as their customers are willing to buy.

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Therefore, the short-run aggregate supply

The short- run aggregate supply curve

Y P

SRAS

The SRAS curve is horizontal:

The price level is fixed at a

predetermined level, and firms sell as much as buyers demand. The SRAS

curve is horizontal:

The price level is fixed at a

predetermined level, and firms sell as much as buyers demand.

Short- run effects of an increase in M

P

AD₁

In the short run when prices are sticky,…

SRAS AD₂

…an increase in aggregate demand…

From the short run to the long run

Over time, prices gradually become “unstuck.” When they do, will they rise or fall?

rise fall

remain constant In the short-run

equilibrium, if

then over time, P will…

The adjustment of prices is what moves

The SR & LR effects of ^Δ M > 0

P

AD₁ LRAS

SRAS

P₂ A = initial

equilibrium

A

B C

B = new short- run eq’m after Fed increases M

C = long-run

AD₂

How shocking!!!

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shocks: exogenous changes in aggregate supply or aggregate demand

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Shocks temporarily push the economy away from full employment.

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Example: exogenous decrease in velocity

If the money supply is held constant, a decrease in V means people will be using their money in

fewer transactions, causing a decrease in demand

SRAS LRAS

AD₂

The effects of a negative demand shock

P

AD₁

P₂

AD shifts left, depressing output and employment in the short run. AD shifts left, depressing output and employment

in the short run. _{B A}

C

Over time,

prices fall and the economy moves down its

Supply shocks

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A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)

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Examples of adverse supply shocks:

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Bad weather reduces crop yields, pushing up food prices.

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Workers unionize, negotiate wage increases.

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New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance.

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CASE STUDY:

The 1970s oil shocks

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Early 1970s: OPEC coordinates a reduction in the supply of oil.

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Oil prices rose 11% in 1973

68% in 1974 16% in 1975

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Such sharp oil price increases are supply

SRAS₁

Y P

AD LRAS

Y

CASE STUDY:

The 1970s oil shocks

The oil price shock shifts SRAS up,

causing output and employment to fall. The oil price shock shifts SRAS up,

causing output and employment to fall.

A B

In absence of further price

shocks, prices will fall over time and economy moves back toward full

SRAS₂ A

CASE STUDY:

The 1970s oil shocks

Predicted effects of the oil shock:

• inflation ^↑

• output ^↓

• unemployment ^↑

…and then a gradual recovery.

CASE STUDY:

The 1970s oil shocks

Late 1970s: As economy was recovering, oil prices shot up again, causing another huge supply shock!!!

CASE STUDY:

The 1980s oil shocks

1980s:

A favorable supply shock-- a significant fall in oil prices. As the model predicts,

inflation and unemployment

Stabilization policy

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definition: policy actions aimed at reducing the severity of short-run economic fluctuations.

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Example: Using monetary policy to combat the effects of adverse supply shocks…

Stabilizing output w ith

monetary policy

SRAS₁

P

AD₁ B

A LRAS

The adverse supply shock moves the economy to point B.

SRAS₂

Stabilizing output w ith

monetary policy

Y P

AD₁ B

A C

But the Fed LRAS

accommodates the shock by raising agg. demand.

results:

P is permanently higher, but Y

remains at its full-

SRAS₂

AD₂

Chapter Summary

Chapter Summary

1. Long run: prices are flexible, output and

employment are always at their natural rates, and the classical theory applies.

Short run: prices are sticky, shocks can push output and employment away from their natural rates.

2. Aggregate demand and supply:

a framework to analyze economic fluctuations

Chapter Summary

Chapter Summary

3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.

Chapter Summary

Chapter Summary

6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.

7. The Fed can attempt to stabilize the economy with monetary policy.

Supplement

Model in economics revisited

What is an macroeconomic model?

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A definition: a mathematical representation of the economy in question.

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Recall: macroeconomists view the economy as a systems.

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relations and interactions inside the system are expressed using equations

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endogenous vs. exogenous (variables)

Model in economics revisited

Solving a model:

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Solving for the endogenous variables in terms of exogenous variables.

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Why do so? _Æ from these results we can see how an endogenous variables are determined. E.g.: How GDP is determined?

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To put it more generally, this is exactly what we use a model for:

(i) We use a model to explain reality.

Model in economics revisited

Simulating a model:

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In general, the solutions of endogenous

variables will depend on exogenous variables. Æ these solutions will change when the

exogenous variables change.

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Simulating a model is to change an exogenous variable and see how endogenous variables

respond to that change.

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Model in economics revisited

A quick math review: Solving equations Solve the following equations (in x):

i.

^{x + 2 = 5 and 3x – 7 = x + 1}

ii.

ax + b = 0, with a,b being constants

Solve the following systems of equations (in x^,y):

§ 2x - y = 4

3x + 2y = - 1

i.

^{ax + by = c}

5 0

e l in e c o n o m ic s r e v is it e d

:

Why use math in economics

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Things in our world have two aspects: qualitative and quantitative, and they are closely related with each other.

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^Æ Need to understand both.

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This is especially true for economics.

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To deal quantitative issues we need math.

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Examples of qualitative and quantitative issues: ...

Why use math in economics

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Math helps us to make our reasoning clear and precise, and to avoid fallacy.

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The process of reasoning: deriving a conclusion B from a fact A, given a set of assumptions Z.

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This is common to both natural and socially sciences, as well as our daily thinking.

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Math is especially helpful for this.

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After all, math is a language!

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The level of math required in this course: