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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Back

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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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Back

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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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