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CHAPTE

Introduction to Economic
Fluctuations
University of Wisconsin
Charles Engel

In this chapter, you will


learn
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 the short
run and long run

how the model of aggregate demand and


aggregate supply can be used to analyze the
short-run and long-run effects of shocks.
CHAPTER 9.01

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Facts about the business cycle


GDP growth averages 33.5 percent per year over
the long run with large fluctuations in the short run.

Consumption and investment fluctuate with GDP,


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

Unemployment rises during recessions and falls


during expansions.

Okuns Law: the negative relationship between


GDP and unemployment.
CHAPTER 9.01

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Growth
Growth rates
rates of
of real
real GDP,
GDP, consumption
consumption
Percent 10
change
from 4 8
quarters
earlier 6

Real GDP
growth rate
Consumption
growth rate

Average 4
growth
rate 2
0
-2
-4
1970

1975

1980

1985

1990

1995

2000

2005

Growth
Growth rates
rates of
of real
real GDP,
GDP, consumption,
consumption, investment
investment
Percent 40
change
from 4 30
quarters
earlier 20

Investment
growth rate
Real GDP
growth rate

10
0

Consumption
growth rate

-10
-20
-30
1970

1975

1980

1985

1990

1995

2000

2005

Unemployment
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1970

1975

1980

1985

1990

1995

2000

2005

Okuns
Okuns Law
Law
Percentage 10
change in
real GDP 8

1951

Y
3.5 2 u
Y

1966

1984

2003

4
1987

2
0

1975
2001

-2

1991 1982

-4
-3

-2

-1

Change in unemployment rate

Increased stability of GDP


reading by Trehan

Why have fluctuations in GDP been smaller in


the past 20 years?
Fewer shocks?
Better policy? We will move now into the
examination of macro policy.

While some argue that structural features of the


economy have changed, so real shocks (oil price
increase) have a smaller effect, that may in fact
be a result of better policy.
CHAPTER 9.01

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Time horizons in
macroeconomics

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

Short run:
Many prices are sticky at some predetermined
level.
The economy behaves much
differently when prices are sticky.
CHAPTER 9.01

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Recap of classical macro


theory
(Chaps. 3-8)

Output is determined by the supply side:


supplies of capital, labor
technology.
Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.

Assumes complete price flexibility.


Applies to the long run.
CHAPTER 9.01

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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.

CHAPTER 9.01

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The model of
aggregate demand and
supply

the paradigm most mainstream economists


and policymakers use to think about economic
fluctuations and policies to stabilize the economy

shows how the price level and aggregate output


are determined

shows how the economys behavior is different


in the short run and long run

CHAPTER 9.01

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Aggregate demand

The aggregate demand curve shows the


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

For this chapters intro to the AD/AS model,


we use a simple theory of aggregate demand
based on the quantity theory of money.

Chapters 10-12 develop the theory of aggregate


demand in more detail.
CHAPTER 9.01

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The Quantity Equation as


Aggregate Demand

From Chapter 4, recall the quantity equation


MV = PY

For given values of M and V,


this equation implies an inverse relationship
between P and Y :

CHAPTER 9.01

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The downward-sloping AD curve


An
An increase
increase in
in the
the
price
price level
level causes
causes
aa fall
fall in
in real
real money
money
balances
balances (M/P
(M/P),),
causing
causing aa
decrease
decrease in
in the
the
demand
demand for
for goods
goods
&
& services.
services.

CHAPTER 9.01

AD

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Shifting the AD curve


P

An
An increase
increase in
in
the
the money
money supply
supply
shifts
shifts the
the AD
AD
curve
curve to
to the
the right.
right.
AD
AD
1

CHAPTER 9.01

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Aggregate supply in the long


run

Recall from Chapter 3:


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

Y F (K , L)
Y is the full-employment or natural level of
output, the level of output at which the
economys resources are fully employed.
Full employment means that
unemployment equals its natural rate (not zero).
CHAPTER 9.01

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The long-run aggregate supply


curve
P

LRAS

Y does
does not
not

depend
depend on
on P,
P,
so
so LRAS
LRAS is
is
vertical.
vertical.

Y
F (K , L)
CHAPTER 9.01

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Long-run effects of an increase


in M
P

In the long run,


this raises the
price level

LRAS

P2

An increase
in M shifts
AD to the
right.

P1

AD
AD

but leaves
output the same.
CHAPTER 9.01

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Aggregate supply in the short


run

Many prices are sticky in the short run.


For now (and through Chap. 12), we assume
all prices are stuck at a predetermined level in
the short run.

firms are willing to sell as much at that price


level as their customers are willing to buy.

Therefore, the short-run aggregate supply


(SRAS) curve is horizontal:
CHAPTER 9.01

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The short-run aggregate supply


curve
The
The SRAS
SRAS
curve
curve is
is
horizontal:
horizontal:
The
The price
price level
level
is
is fixed
fixed at
at aa
predetermined
predetermined
level,
level, and
and firms
firms
sell
sell as
as much
much as
as
buyers
buyers demand.
demand.

CHAPTER 9.01

SRAS

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Short-run effects of an increase


in M
In the short run
when prices are
sticky,

an increase
in aggregate
demand

SRAS

AD
AD2
1

causes output
to rise.
CHAPTER 9.01

Y1

Y2

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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?
In the short-run
equilibrium, if

then over time,


P will

Y Y

rise

Y Y

fall

Y Y

remain constant

The adjustment of prices is what moves the


economy to its long-run equilibrium.
CHAPTER 9.01

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The SR & LR effects of M > 0


A = initial
equilibrium
B = new shortrun eqm
after Fed
increases M

C = long-run
equilibrium
CHAPTER 9.01

LRAS

P2

B
A

SRAS
AD
AD2
1

Y2

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Shock!!!
shocks: exogenous changes in agg. supply or
demand

Shocks temporarily push the economy away from


full employment.

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
for goods and services.
CHAPTER 9.01

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The effects of a negative demand


shock
AD
AD shifts
shifts left,
left,
depressing
depressing output
output
and
and employment
employment
in
in the
the short
short run.
run.
Over
Over time,
time,
prices
prices fall
fall and
and
the
the economy
economy
moves
moves down
down its
its
demand
demand curve
curve
toward
toward fullfullemployment.
employment.
CHAPTER 9.01

LRAS

P2

SRAS

AD
AD1
2

Y2

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

Examples of adverse supply shocks:


Bad weather reduces crop yields, pushing up
food prices.
Workers unionize, negotiate wage increases.
New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.

Favorable supply shocks lower costs and prices.


CHAPTER 9.01

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CASE STUDY:

The 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in


the supply of oil.

Oil prices rose


11% in 1973
68% in 1974
16% in 1975

Such sharp oil price increases are supply shocks


because they significantly impact production
costs and prices.
CHAPTER 9.01

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CASE STUDY:

The 1970s oil shocks


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

In
In absence
absence of
of
further
further price
price
shocks,
shocks, prices
prices will
will
fall
fall over
over time
time and
and
economy
economy moves
moves
back
back toward
toward full
full
employment.
employment.
CHAPTER 9.01

P2

LRAS

SRAS2
A

P1

SRAS1
AD

Y2

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CASE STUDY:

The 1970s oil shocks


Predicted effects
of the oil shock:
inflation
output
unemployment
and then a
gradual recovery.

CHAPTER 9.01

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CASE STUDY:

The 1970s oil shocks


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

CHAPTER 9.01

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CASE STUDY:

The 1980s oil shocks


1980s:
A favorable
supply shock-a significant fall
in oil prices.
As the model
predicts,
inflation and
unemployment
fell:
CHAPTER 9.01

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Stabilization policy

def: policy actions aimed at reducing the


severity of short-run economic fluctuations.

Example: Using monetary policy to combat the


effects of adverse supply shocks:

CHAPTER 9.01

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Stabilizing output with


monetary policy
P

The
The adverse
adverse
supply
supply shock
shock
moves
moves the
the
economy
economy to
to
point
point B.
B.

P2

LRAS

SRAS2
A

P1

SRAS1
AD
1

Y2
CHAPTER 9.01

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Stabilizing output with


monetary policy
But
But the
the Fed
Fed
accommodates
accommodates
the
the shock
shock by
by
raising
raising agg.
agg.
demand.
demand.
results:
results:
P
P is
is permanently
permanently
higher,
higher, but
but Y
Y
remains
remains at
at its
its fullfullemployment
employment level.
level.
CHAPTER 9.01

P2

LRAS

SRAS2

C
A

P1

AD
AD

Y2

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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 9

Introduction to Economic Fluctuations

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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 9

Introduction to Economic Fluctuations

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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.

CHAPTER 9

Introduction to Economic Fluctuations

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