Topic 8:

Introduction to
Economic Fluctuations
(chapter 9)

CHAPTER 9 Introduction to Economic Fluctuations slide 0

 Chapter objectives
 difference between short run & long run
 introduction to aggregate demand
 aggregate supply in the short run & long
run
 see how model of aggregate supply and
demand can be used to analyze short-run
and long-run effects of “shocks”

CHAPTER 9 Introduction to Economic Fluctuations slide 1

 Real GDP Growth in the United States
10
Percent change
from 4 quarters Average growth
8
earlier rate = 3.5%
6

-2

-4
1960 1965 1970 1975 1980 1985 1990 1995 2000

CHAPTER 9 Introduction to Economic Fluctuations slide 2

Growth in Consumption & Investment

CHAPTER 9 Introduction to Economic Fluctuations slide 3

 Unemplyment

CHAPTER 9 Introduction to Economic Fluctuations slide 4

 Unemployment & Okun’s Law
 What relationship should we expect to find
between unemployment and real GDP?
 Okun’s Law : The negative relationship
between unemployment and GDP is called
Okun’s law
 Example:
Percentage Change in Real GDP= 3% − 2 ×
Change in the Unemployment Rate. ( If
Unemployment changes from 5% to 7%)

CHAPTER 9 Introduction to Economic Fluctuations slide 5

 Unemployment & Okun’s Law

CHAPTER 9 Introduction to Economic Fluctuations slide 6

 Time horizons
 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 Introduction to Economic Fluctuations slide 7

In Classical Macroeconomic Theory,
(what we studied in chapters 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.
 Complete price flexibility is a crucial
assumption,
so classical theory applies in the long run.

CHAPTER 9 Introduction to Economic Fluctuations slide 8

 When prices are sticky
…output and employment also depend on
demand for goods & services,
which is affected by
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes
in C or I.

CHAPTER 9 Introduction to Economic Fluctuations slide 9

 The model of
aggregate demand and supply
 the paradigm that most mainstream
economists & 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 economy’s behavior is
different in the short run and long run

CHAPTER 9 Introduction to Economic Fluctuations slide 10

 Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 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.
 Chapters 10-12 develop the theory of
aggregate demand in more detail.

CHAPTER 9 Introduction to Economic Fluctuations slide 11

The Quantity Equation as Agg. Demand
 From Chapter 4, recall the quantity equation
MV = PY
and the money demand function it implies:
(M/P )d = k Y
where V = 1/k = velocity.
 For given values of M and V, these
equations imply an inverse relationship
between P and Y:
P = (M V) / Y
CHAPTER 9 Introduction to Economic Fluctuations slide 12
 The downward-sloping AD curve

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

CHAPTER 9 Introduction to Economic Fluctuations slide 13

 Shifting the AD curve

P
P = (M V) / Y
An increase in Rise in M
the money
supply shifts
the AD curve
to the right.
AD2
AD1
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 14

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
economy’s resources are fully employed.
“Full employment” means that
unemployment equals its natural rate.
CHAPTER 9 Introduction to Economic Fluctuations slide 15
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 )

 Full-employment output does not depend

on the price level,
so the long run aggregate supply (LRAS)
curve is vertical:

CHAPTER 9 Introduction to Economic Fluctuations slide 16

The long-run aggregate supply curve

P LRAS

The LRAS curve

is vertical at the
full-employment
level of output.

Y
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 17

Long-run effects of an increase in M

P LRAS
An increase
in M shifts
the AD curve
to the right.
In the long run, P2
this increases
the price level… P1 AD2
AD1

…but leaves Y
output the same.
Y

CHAPTER 9 Introduction to Economic Fluctuations slide 18

Aggregate Supply in the Short Run
 In the real world, many prices are sticky in
the short run.
 For now (and throughout Chapters 9-12),
we assume that all prices are stuck at a
predetermined level in the short run…
 …and that firms are willing to sell as much
as their customers are willing to buy at that
price level.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:
CHAPTER 9 Introduction to Economic Fluctuations slide 19
The short run aggregate supply curve

P
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined SRAS
P
level, and firms
sell as much as
buyers demand.
Y
Consider example of catalogue company: publishes price,
and takes orders for quantity
CHAPTER 9 Introduction to Economic Fluctuations slide 20
Short-run effects of an increase in M

P
In the short run
when prices are …an increase
sticky,… in aggregate
demand…

SRAS
P
AD2
AD1
Y
…causes output Y1 Y2
to rise.
CHAPTER 9 Introduction to Economic Fluctuations slide 21
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 then over time,

equilibrium, if the price level will
Y Y rise
Y Y fall

Y Y remain constant
This adjustment of prices is what moves
the economy to its long-run equilibrium.
CHAPTER 9 Introduction to Economic Fluctuations slide 22
 The SR & LR effects of M > 0
A = initial P LRAS
equilibrium

B = new short-
run eq’m P2 C
after Fed
B SRAS
increases M P A AD2
AD1
C = long-run
equilibrium Y
Y Y2

CHAPTER 9 Introduction to Economic Fluctuations slide 23

 How shocking!!!
 shocks: exogenous changes in aggregate
supply or demand
 Shocks temporarily push the economy away
from full-employment.
 An example of a demand shock:
exogenous decrease in velocity
 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:

CHAPTER 9 Introduction to Economic Fluctuations slide 24

The effects of a negative demand shock

The shock shifts P LRAS

AD left, causing
output and
employment to fall
in the short run
B A SRAS
P
Over time, prices
fall and the P2 C AD1
economy moves AD2
down its demand
curve toward full- Y
Y2 Y
employment.

CHAPTER 9 Introduction to Economic Fluctuations slide 25

 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 Introduction to Economic Fluctuations slide 26
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 Introduction to Economic Fluctuations slide 27

 CASE STUDY:
The 1970s oil shocks
The oil price shock P LRAS
shifts SRAS up,
causing output and
employment to fall.
B SRAS2
In absence of P2
further price A SRAS1
P1
shocks, prices will
fall over time and AD
economy moves
back toward full Y
employment. Y2 Y

CHAPTER 9 Introduction to Economic Fluctuations slide 28

 CASE STUDY:
The 1970s oil shocks
70%
12%
60%
Predicted effects of
the oil price shock: 50% 10%

• inflation  40%
8%
• output  30%

• unemployment  20%
6%
10%
…and then a
0% 4%
gradual recovery. 1973 1974 1975 1976 1977

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

CHAPTER 9 Introduction to Economic Fluctuations slide 29

 CASE STUDY:
The 1970s oil shocks
60% 14%

50%
12%
Late 1970s:
40%
As economy 10%
30%
was recovering, 8%
oil prices shot up 20%

again, causing 10%

6%

another huge 0% 4%
supply shock!!! 1977 1978 1979 1980 1981

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)

CHAPTER 9 Introduction to Economic Fluctuations slide 30

 CASE STUDY:
The 1980s oil shocks
40% 10%

1980s: 30%

A favorable 20% 8%

supply shock-- 10%

6%
0%
a significant fall -10%
in oil prices. -20%
4%

As the model -30% 2%

would predict, -40%

-50% 0%
inflation and 1982 1983 1984 1985 1986 1987
unemployment Change in oil prices (left scale)
fell: Inflation rate-CPI (right scale)
Unemployment rate (right scale)

CHAPTER 9 Introduction to Economic Fluctuations slide 31

 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 Introduction to Economic Fluctuations slide 32

 Stabilizing output with
monetary policy

The adverse P LRAS

supply shock
moves the
economy to
B SRAS2
point B. P2
A SRAS1
P1
AD1

Y
Y2 Y

CHAPTER 9 Introduction to Economic Fluctuations slide 33

 Stabilizing output with
monetary policy
But the Fed P LRAS
accommodates
the shock by
raising agg.
demand. B C SRAS2
P2
A
results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y

CHAPTER 9 Introduction to Economic Fluctuations slide 34

 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.

CHAPTER 9 Introduction to Economic Fluctuations slide 35

 Chapter summary
2. Aggregate demand and supply framework:
The aggregate demand curve slopes
downward.
The long-run aggregate supply curve is
vertical, because output depends on
technology and factor supplies, but not
prices.
The short-run aggregate supply curve is
horizontal, because prices are sticky.
CHAPTER 9 Introduction to Economic Fluctuations slide 36
 Chapter summary
3. Shocks to aggregate demand and supply
cause fluctuations in GDP and employment
in the short run.
4. The Fed can attempt to stabilize the
economy with monetary policy.

CHAPTER 9 Introduction to Economic Fluctuations slide 37