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# MACROECONOMICS-CH9

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Intro to Economic Fluctuations

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• This chapter has two main objectives. First, to motivate the study of business cycles, the subject of the five chapters in Part IV. Second, to introduce the model of aggregate supply and demand, thus providing students with an overall context for what follows. Having this context will allow students to better understand the role played by each of the more detailed pieces of the model (Keynesian Cross, IS-LM, theories of short-run aggregate supply, etc) as students learn them in the following chapters. This chapter is less difficult and a bit shorter than most other chapters in the text, and all of the concepts it introduces are all developed in more detail in the following chapters of Part IV. Therefore, you might consider spending a little less class time on this chapter than on other chapters in the book. This chapter derives the AD curve from the Quantity Theory of Money, a simple theory that students learned in an earlier chapter; hence, this provides a simple and quick way of deriving an AD curve from theory. As a theory of aggregate demand, though, the Quantity Theory is very incomplete - it omits fiscal policy, interest rates, and net exports, among other things. But, this chapter merely aims to introduce the AD curve and the AD/AS model, and makes clear that the following three chapters will develop the theory of aggregate demand in greater detail. Some professors, when teaching this chapter, merely present the downward-sloping AD curve rather than deriving it from the Quantity Theory. Although this is more ad hoc or “hand-waving” than deriving the AD curve from a theory, these professors offer the following arguments: First, they note that this saves time. Second, they believe that deriving the AD curve from the Quantity Theory requires students to learn things that they will have to “un-learn” in the following three chapters (such as the intuition for the AD curve’s negative slope). Third, most students are familiar with the AD curve already, having seen it in a principles of economics course, and therefore will accept it without seeing it derived from a theory. (Indeed, deriving the AD curve from the Quantity Theory may seem to them contrary to what they learned in their principles course). I think good arguments can be made for either position, and encourage you to do whatever you find most appropriate, effective, and comfortable for you and your students.
• ### MACROECONOMICS-CH9

1. 2. Chapter objectives <ul><li>difference between short run & long run </li></ul><ul><li>introduction to aggregate demand </li></ul><ul><li>aggregate supply in the short run & long run </li></ul><ul><li>see how model of aggregate supply and demand can be used to analyze short-run and long-run effects of “shocks” </li></ul>
2. 3. Real GDP Growth in the United States Average growth rate = 3.5%
3. 4. Time horizons <ul><li>Long run: Prices are flexible, respond to changes in supply or demand </li></ul><ul><li>Short run: many prices are “sticky” at some predetermined level </li></ul>The economy behaves much differently when prices are sticky.
4. 5. In Classical Macroeconomic Theory, <ul><li>(what we studied in chapters 3-8) </li></ul><ul><li>Output is determined by the supply side: </li></ul><ul><ul><li>supplies of capital, labor </li></ul></ul><ul><ul><li>technology </li></ul></ul><ul><li>Changes in demand for goods & services ( C , I , G ) only affect prices, not quantities. </li></ul><ul><li>Complete price flexibility is a crucial assumption, </li></ul><ul><li>so classical theory applies in the long run. </li></ul>
5. 6. When prices are sticky <ul><li>… output and employment also depend on demand for goods & services, </li></ul><ul><li>which is affected by </li></ul><ul><ul><li>fiscal policy ( G and T ) </li></ul></ul><ul><ul><li>monetary policy ( M ) </li></ul></ul><ul><ul><li>other factors, like exogenous changes in C or I . </li></ul></ul>
6. 7. The model of aggregate demand and supply <ul><li>the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy </li></ul><ul><li>shows how the price level and aggregate output are determined </li></ul><ul><li>shows how the economy’s behavior is different in the short run and long run </li></ul>
7. 8. Aggregate demand <ul><li>The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. </li></ul><ul><li>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. </li></ul><ul><li>Chapters 10-12 develop the theory of aggregate demand in more detail. </li></ul>
8. 9. The Quantity Equation as Agg. Demand <ul><li>From Chapter 4, recall the quantity equation </li></ul><ul><li>M V = P Y </li></ul><ul><li>and the money demand function it implies: </li></ul><ul><li>( M / P ) d = k Y where V = 1/ k = velocity. </li></ul><ul><li>For given values of M and V , these equations imply an inverse relationship between P and Y : </li></ul>
9. 10. The downward-sloping AD curve <ul><li>An increase in the price level causes a fall in real money balances ( M / P ), </li></ul><ul><li>causing a decrease in the demand for goods & services. </li></ul>Y P AD
10. 11. Shifting the AD curve <ul><li>An increase in the money supply shifts the AD curve to the right. </li></ul>Y P AD 1 AD 2
11. 12. Aggregate Supply in the Long Run <ul><li>Recall from chapter 3: In the long run, output is determined by factor supplies and technology </li></ul>is the full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. “ Full employment” means that unemployment equals its natural rate.
12. 13. Aggregate Supply in the Long Run <ul><li>Recall from chapter 3: In the long run, output is determined by factor supplies and technology </li></ul><ul><li>Full-employment output does not depend on the price level, </li></ul><ul><li>so the long run aggregate supply (LRAS) curve is vertical: </li></ul>
13. 14. The long-run aggregate supply curve <ul><li>The LRAS curve is vertical at the full-employment level of output. </li></ul>Y P LRAS
14. 15. Long-run effects of an increase in M <ul><li>An increase in M shifts the AD curve to the right. </li></ul>P 1 Y P AD 1 AD 2 LRAS P 2 In the long run, this increases the price level… … but leaves output the same.
15. 16. Aggregate Supply in the Short Run <ul><li>In the real world, many prices are sticky in the short run. </li></ul><ul><li>For now (and throughout Chapters 9-12), we assume that all prices are stuck at a predetermined level in the short run… </li></ul><ul><li>… and that firms are willing to sell as much as their customers are willing to buy at that price level. </li></ul><ul><li>Therefore, the short-run aggregate supply (SRAS) curve is horizontal: </li></ul>
16. 17. The short run aggregate supply curve <ul><li>The SRAS curve is horizontal: </li></ul><ul><li>The price level is fixed at a predetermined level, and firms sell as much as buyers demand. </li></ul>Y P SRAS
17. 18. Short-run effects of an increase in M <ul><li>… an increase in aggregate demand… </li></ul>Y 1 Y P AD 1 AD 2 In the short run when prices are sticky,… … causes output to rise. SRAS Y 2
18. 19. From the short run to the long run <ul><li>Over time, prices gradually become “unstuck.” When they do, will they rise or fall? </li></ul>rise fall remain constant In the short-run equilibrium, if then over time, the price level will This adjustment of prices is what moves the economy to its long-run equilibrium.
19. 20. The SR & LR effects of  M > 0 <ul><li>A = initial equilibrium </li></ul>A B C B = new short-run eq’m after Fed increases M C = long-run equilibrium Y P AD 1 AD 2 LRAS SRAS P 2 Y 2
20. 21. How shocking!!! <ul><li>shocks : exogenous changes in aggregate supply or demand </li></ul><ul><li>Shocks temporarily push the economy away from full-employment. </li></ul><ul><li>An example of a demand shock: exogenous decrease in velocity </li></ul><ul><li>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: </li></ul>
21. 22. The effects of a negative demand shock <ul><li>The shock shifts AD left, causing output and employment to fall in the short run </li></ul>A B C Over time, prices fall and the economy moves down its demand curve toward full-employment. LRAS AD 2 SRAS Y P AD 1 P 2 Y 2
22. 23. Supply shocks <ul><li>A supply shock alters production costs, affects the prices that firms charge. (also called price shocks ) </li></ul><ul><li>Examples of adverse supply shocks: </li></ul><ul><ul><li>Bad weather reduces crop yields, pushing up food prices. </li></ul></ul><ul><ul><li>Workers unionize, negotiate wage increases. </li></ul></ul><ul><ul><li>New environmental regulations require firms to reduce emissions. Firms charge higher prices to help cover the costs of compliance. </li></ul></ul><ul><li>( Favorable supply shocks lower costs and prices.) </li></ul>
23. 24. CASE STUDY: The 1970s oil shocks <ul><li>Early 1970s: OPEC coordinates a reduction in the supply of oil. </li></ul><ul><li>Oil prices rose 11% in 1973 68% in 1974 16% in 1975 </li></ul><ul><li>Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. </li></ul>
24. 25. <ul><li>The oil price shock shifts SRAS up, causing output and employment to fall. </li></ul>CASE STUDY: The 1970s oil shocks A B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. A SRAS 1 Y P AD LRAS Y 2 SRAS 2
25. 26. CASE STUDY: The 1970s oil shocks <ul><li>Predicted effects of the oil price shock: </li></ul><ul><ul><li>inflation  </li></ul></ul><ul><ul><li>output  </li></ul></ul><ul><ul><li>unemployment  </li></ul></ul><ul><li>… and then a gradual recovery. </li></ul>
26. 27. CASE STUDY: The 1970s oil shocks <ul><li>Late 1970s: </li></ul><ul><li>As economy was recovering, oil prices shot up again, causing another huge supply shock!!! </li></ul>
27. 28. CASE STUDY: The 1980s oil shocks <ul><li>1980s: A favorable supply shock-- a significant fall in oil prices. </li></ul><ul><li>As the model would predict, inflation and unemployment fell: </li></ul>
28. 29. Stabilization policy <ul><li>def: policy actions aimed at reducing the severity of short-run economic fluctuations. </li></ul><ul><li>Example: Using monetary policy to combat the effects of adverse supply shocks: </li></ul>
29. 30. Stabilizing output with monetary policy B A The adverse supply shock moves the economy to point B. SRAS 1 Y P AD 1 SRAS 2 Y 2 LRAS
30. 31. Stabilizing output with monetary policy B A C But the Fed accommodates the shock by raising agg. demand. results: P is permanently higher, but Y remains at its full-employment level. Y P AD 1 SRAS 2 Y 2 LRAS AD 2
31. 32. Chapter summary <ul><li>1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies. </li></ul><ul><li>Short run: prices are sticky, shocks can push output and employment away from their natural rates. </li></ul><ul><li>2. Aggregate demand and supply: a framework to analyze economic fluctuations </li></ul>
32. 33. Chapter summary <ul><li>3. The aggregate demand curve slopes downward. </li></ul><ul><li>4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices. </li></ul><ul><li>5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels. </li></ul>
33. 34. Chapter summary <ul><li>6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run. </li></ul><ul><li>7. The Fed can attempt to stabilize the economy with monetary policy. </li></ul>