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Business Cycle Theory: The Economy in the Short Run

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INTRODUCTION TO ECONOMIC FLUCTUATIONS INTRODUCTION TO ECONOMIC FLUCTUATIONS

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10-1 The Facts About the Business Cycle 10-1 The Facts About the Business Cycle 10-2 Time Horizons in Macroeconomics 10-3 Aggregate Demand 10-4 Aggregate Supply 10-5 Stabilization Policy 10-6 Conclusion

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10-1 The Facts About the Business Cycle When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession. U↑ , Y↓ Economists call these short-run fluctuations in output and employment the business cycle. Before thinking about the theory of business cycles, let’s look at the facts that describe SRF in economic activity. --------------------------- The official arbiter of when recessions begin and end is the National Bureau of Economic Research (NBER): the stating date of each recession = the business cycle peak the ending date = the business cycle trough.

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Real GDP Growth in the United States Growth in real GDP averages about 3% per year, but there are substantial fluctuations around this average. Real GDP Growth in the United States Growth in real GDP averages about 3% per year, but there are substantial fluctuations around this average. The shaded areas represent periods of recession.

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Growth in Consumption and Investment Growth in Consumption and Investment When the economy heads into a RECESSION, growth in real consumption and investment spending both decline. Investment spending, shown in panel (b), is considerably more volatile than consumption spending, shown in panel (a). The shaded areas represent periods of recession

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Unemployment The U rises significantly during periods of recession, shown here by the shaded areas.

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Okun’s Law This figure is a scatter plot of the change in the UR on the horizontal axis and the % change in real GDP on the vertical axis, using data on the U.S economy. Each point represents one year. The figure shows that increases in U tend to be associated with lower-than-normal growth in real GDP. The correlation between these two variables is –0.89.

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10-1 The Facts About the Business Cycle What relationship should we expect between U and real GDP? Unemployed workers do not help to produce G&S => in↑ in the U rate should be associated with de↓ in real GDP. This negative relationship between U and GDP is called Okun’s law. Example: The line drawn through the scatter of points tells us that % Change in Real GDP= 3% − 2 x Change in U. If the U remains the same, real GDP grows by about 3 % ; If the U rises from 5 to 7%, then real GDP growth would be % Change in Real GDP = 3% − 2 x (7% − 5%)= −1%. Okun’s law says that GDP would fall by 1 % , indicating that the economy is in a recession.

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10-1 The Facts About the Business Cycle GDP and Its Components Unemployment and Okun’s Law Leading Economic Indicators

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10-1 The Facts About the Business Cycle Economists arrive at their forecasts is by looking at leading indicators, which are variables that tend to fluctuate in advance of the overall economy. Forecasts can differ in part because economists hold varying opinions about which leading indicators are most reliable. The Conference Board announces the index of leading economic indicators. This index includes ten data series They are often used to forecast changes about 6-10 months into the future.

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10-1 The Facts About the Business Cycle Average WORKWEEK of production workers in manufacturing. A shorter workweek => lay off workers cut back production Average initial weekly claims for unemployment INSURANCE. An in↑ in the number of new claims for U insurance => lay off workers cutting back production New orders for CONSUMER goods and materials, adjusted for inflation.↑↑ New orders for nondefense CAPITAL goods.↑↑ Index of supplier deliveries. Slower deliveries indicate a future increase in economic activity. New BUILDING permits issued↑↑ Index of STOCK prices. ↑↑ Money SUPPLY, adjusted for inflation. ↑↑ INTEREST rate spread. A large spread => r are expected to rise, economic activity increases. Index of CONSUMER expectations. ↑↑

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10-2 Time Horizons in Macroeconomics The theoretical separation of real and nominal variables is called the classical dichotomy. The irrelevance of the M for the determination of real variables is called monetary neutrality.

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2 If You Want to Know Why Firms Have Sticky Prices, Ask Them

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10-2 Time Horizons in Macroeconomics How does the introduction of StP change our view of how the economy works? By S&D:

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10-2 Time Horizons in Macroeconomics How the Short Run and Long Run Differ The Model of Aggregate Supply and Aggregate Demand

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10-3 Aggregate Demand Aggregate demand (AD) is the relationship between the quantity of Y demanded and the aggregate P. The AD curve tells us the quantity of G&S people want to buy at any given P. Here we use the quantity theory of money to provide a simple derivation of the AD curve. --------------------------- From Ch.5 If V is constant => M determines the nominal value of Y, nominal value of Y is the product of P & amount of Y. The equation can be rewritten in terms of the S&D for real money balances (RMB):

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10-3 Aggregate Demand The Quantity Equation as Aggregate Demand Why the Aggregate Demand Curve Slopes Downward Shifts in the Aggregate Demand Curve

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10-3 Aggregate Demand The Quantity Equation as Aggregate Demand Why the Aggregate Demand Curve Slopes Downward Shifts in the Aggregate Demand Curve

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10-3 Aggregate Demand We have assumed => M determines the $ value of all transactions Why the AD Curve Slopes Downward. 2 explanations: If the P r↑, each transaction requires > $$, → the # of transactions and => the quantity of G&S purchased If Y is ↑er, people engage in > transactions and need ↑er M/P. For a , ↑er M/P imply a ↓er P. the ↑er level of M/P allows a > volume of transactions => > quantity of Y is demanded.

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10-3 Aggregate Demand The Quantity Equation as Aggregate Demand Why the Aggregate Demand Curve Slopes Downward Shifts in the Aggregate Demand Curve

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Shifts in the Aggregate Demand Curve Changes in the M shift the AD curve. In panel (a), a ↘ in the M reduces the nominal value of output PY. For any given P, output Y is lower. → a ↘ in the M shifts the aggregate demand curve inward from AD1 to AD2. In panel (b), an ↗ in the M raises the nominal value of output PY. For any given P, output Y is higher. → an ↗in the M shifts the aggregate demand curve outward from AD1 to AD2.

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10-4 Aggregate Supply The Long Run: The Vertical Aggregate Supply Curve The Short Run: The Horizontal Aggregate Supply Curve From the Short Run to the Long Run

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10-4 Aggregate Supply The Long-Run Aggregate Supply Curve In the lR, the level of output is determined by the amounts of K & L and by the T/L; it does not depend on the price level. The long-run aggregate supply curve, LRAS, is vertical.

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10-4 Aggregate Supply Shifts in Aggregate Demand in the Long Run A reduction in the M shifts the aggregate demand curve downward from AD1 to AD2. The equilibrium for the economy moves from point A to point B. Because the AS curve is vertical in the long run, the reduction in AD affects the P but not the level of output.

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10-4 Aggregate Supply The Short-Run Aggregate Supply Curve In this extreme example, all prices are fixed in the short run. Therefore, the short-run aggregate supply curve, SRAS, is horizontal.

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10-4 Aggregate Supply Shifts in Aggregate Demand in the Short Run A reduction in the M shifts the AD curve downward from AD1 to AD2. The equilibrium for the economy moves from point A to point B. Because the AS curve is horizontal in the SR, the reduction in AD reduces the level of Y.

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10-4 Aggregate Supply Long-Run Equilibrium In the LR, the economy finds itself at the intersection of the LR AS curve and the AD curve. Because prices have adjusted to this level, the SRAS curve crosses this point as well.

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10-4 Aggregate Supply A Reduction in Aggregate Demand The economy begins in long-run equilibrium at point A. A reduction in AD, perhaps caused by a decrease in the M , moves the economy from point A to point B, where output is below its natural level. As prices fall, the economy gradually recovers from the recession, moving from point B to point C.

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A Monetary Lesson From French History The story begins with the unusual nature of French money at the time. The money stock in this economy included a variety of gold and silver coins that, in contrast to modern money, did not indicate a specific monetary value. Instead, the monetary value of each coin was set by government decree, and the government could easily change the monetary value and thus the M . Sometimes this would occur literally overnight. It is almost as if, while you were sleeping, every $1 bill in your wallet was replaced by a bill worth only 80 cents. Indeed, that is what happened on September 22, 1724. Every person in France woke up with 20 % less money than he or she had the night before. Over the course of seven months, the nominal value of the money stock was reduced by about 45 % . The goal of these changes was to reduce prices in the economy to what the government considered an appropriate level.

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David Hume on the Real Effects of Money Here is how Hume described a monetary injection in his 1752 essay Of Money: To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the increase of gold and silver, yet it follows not immediately upon that increase; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the increasing quantity of gold and silver is favorable to industry.

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10-5 Stabilization Policy Fluctuations in the economy as a whole come from changes AS or AD. Economists call exogenous events that shift these curves shocks to the economy. a shock that shifts the AD curve is called a demand shock. a shock that shifts the AS curve is called a supply shock. These shocks disrupt the economy by pushing output and employment away from their natural levels. Goals of the model of AS & AD: to show how shocks cause economic fluctuations. to evaluate how macroeconomic policy can respond. The stabilization policy is a policy aimed to reduce the severity of SR economic fluctuations.

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10-5 Stabilization Policy An Increase in Aggregate Demand The economy begins in long-run equilibrium at point A. An increase in AD, perhaps due to an increase in the velocity of money, moves the economy from point A to point B, where Y is above its natural level. As prices rise, output gradually returns to its natural level, and the economy moves from point B to point C.

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10-5 Stabilization Policy Because supply shocks have a direct impact on the price level, they are sometimes called price shocks. Examples: ■ A drought that destroys crops. The reduction in food supply pushes up food P. ■ A new environmental protection law that requires firms to reduce their emissions of pollutants. Firms in↗ P. ■ An increase in union aggressiveness. This pushes up wages and the prices. ■ The organization of an international oil cartel. By curtailing competition, the major oil producers can raise the world P of oil. All these events are adverse supply shocks, which means they push costs and prices upward. A favorable supply shock reduces costs and prices.

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10-5 Stabilization Policy An Adverse Supply Shock An adverse supply shock pushes up costs and thus prices. If AD is held constant, the economy moves from point A to point B, leading to stagflation - a combination of increasing prices and falling output. Eventually, as prices fall, the economy returns to the natural level of Y, point A.

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10-5 Stabilization Policy Accommodating an Adverse Supply Shock In response to an adverse supply shock, the Fed can increase AD to prevent a reduction in output. The economy moves from point A to point C. The cost of this policy is a permanently higher level of prices.

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How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the 1980s

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10-6 Conclusion This chapter introduced a framework to study economic fluctuations: the model of aggregate supply and aggregate demand. The model is built on the assumption that prices are sticky in the short run and flexible in the long run. It shows how shocks to the economy cause output to deviate temporarily from the level implied by the classical model. The model also highlights the role of monetary policy. On the one hand, poor monetary policy can be a source of destabilizing shocks to the economy. On the other hand, a well-run monetary policy can respond to shocks and stabilize the economy.