Transcript The Macroeconomy in the Short-Run

The Macroeconomy in the
Short-Run
Introduction to Economic
Fluctuations
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
1
Introduction to Economic
Fluctuations
• Business Cycle: Short-run fluctuations in output
and employment
– Recessions: periods of falling incomes and rising
unemployment
– Booms: periods of rising incomes and falling
unemployment
• In previous topic we developed models to
identify the long-run determinants of national
income, unemployment and inflation
– But we didn’t examine why these variables fluctuate
from year to year
• Here we develop a model to explain these shortrun fluctuations
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
2
Time Horizons in Macroeconomics
• Key difference between the short-run and
long-run is the behaviour of prices
• In the long-run: prices are flexible and can
respond to changes in supply or demand
• In the short-run: many prices are ‘sticky’ at
some predetermined level
• Therefore, economic policies have
different effects over different time
horizons
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
3
Time Horizons in Macroeconomics
• Example:
– Central Bank decreases money supply by 5%
– According to the quantity theory (classical
model): a 5% decrease in money supply,
decreases all prices by 5%, while all real
variables stay the same (classical dichotomy).
This describes the economy in the long run:
change in money supply does not cause
fluctuations in output or employment
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
4
Time Horizons in Macroeconomics
• Example (cont’d):
– In short-run: many prices do not respond to
changes in money supply
– A reduction in money supply does not
immediately cause firms to change their
prices and lower their wages
– Instead prices are sticky
– Failure of prices to adjust immediately means
output and employment adjust
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
5
Time Horizons in Macroeconomics
• During the time horizon over which prices
are sticky, the classical dichotomy does
not hold: nominal variables can affect real
variables
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
6
Model of Aggregate Demand and
Aggregate Supply
• Use the model of aggregate supply and
aggregate demand:
– ‘economy-size’ version of the demand and
supply model for a single good although more
sophisticated (see this later in lectures)
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
7
Aggregate Demand
• Aggregate Demand (AD): relationship
between the quantity of output demanded
and the aggregate price level
– Tells us the quantity of goods and services
people want to buy at any given level of prices
– AD: chapters 10 & 11 develop the theory of
AD in detail. Here, as an introduction, we will
use the quantity theory of money to provide a
simple but incomplete derivation of AD curve
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
8
Aggregate Demand
• Quantity equation and AD:
– Quantity theory says: MV = PY
– Quantity equation can be rewritten in terms of
supply and demand for real money balances:
– M/P = (M/P)d = kY, where k = 1/V
– For fixed money supply (M) and velocity (V),
the quantity equation shows a negative
relationship between the price level (P) and
output (Y)
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
9
Aggregate Demand
• Downward sloping AD curve
– The combinations of P and Y that satisfy the
quantity equation holding M and V constant
– Explanation for downward sloping AD curve: if
output is higher, people engage in more
transactions and need higher real money
balances M/P. For M fixed, higher money
balances implies a lower price level, P.
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
10
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
11
Aggregate Demand
• Shifts in AD:
– AD curve is drawn for a fixed value of money
supply – tells us the possible combinations of
P and Y for a give value of M
– If the central bank changes M, then the AD
curve shifts
– E.g. Central bank reduces money supply.
Quantity equation: MV = PY
Reduction in M leads to a reduction in PY
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
12
Aggregate Demand
• Shifts in AD (cont’d):
– For any given level of output, the price level is lower
and for any given price level, output is lower (see
figure a). Decrease in M, causes AD curve to shift to
the left.
– If central bank increase money supply, M leads to an
increase in PY. For any given level of output, the price
level is higher and for any given price level, output is
higher (see figure b). Increase in M causes AD curve
to shift to the right.
– A change in velocity may also affect AD curve
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
13
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
14
Aggregate Supply
• Aggregate Supply (AS) is the relationship
between quantity of goods and services
supplied and the price level
– AD and AS together determine the economy’s
price level and quantity of output
– Firms that supply goods and services have
flexible prices in the long run and sticky prices
in the short run
– LRAS: Long run AS curve
– SRAS: Short run AS curve
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
15
Long Run AS Curve
• Classical model: deals with the long run
– Use this to derive the LRAS curve
• Amount of output (Y) depends on the
factors of production and the production
function
– Factors of production are fixed (K, L)
– Y = F(K, L)
–Y
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
16
Long Run AS Curve
• According to classical model: output does
not depend on the price level
• Output is fixed
• Therefore, a vertical AS curve (see graph)
• Intersection of AD with the vertical AS
curve gives the price level
• If AS is vertical: changes in AD affect
prices and not output
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
17
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
18
Long Run AS Curve
• If money supply falls: AD curve shifts downward
• Economy moves from equilibrium point A to
equilibrium point B
• And prices fall (see graph)
• Vertical AS curve satisfies the classical
dichotomy i.e. level of output is independent of
money supply
• At Y: unemployment is at its natural rate. It’s
called full-employment or natural level of output
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
19
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
20
Short Run AS Curve
• In short-run some prices are sticky
• Because the price level is fixed: a
horizontal AS curve (see graph)
• Price level fixed: e.g. suppose all firms
have issued price catalogs and it’s
expensive for them to issue new ones.
Prices are stuck
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
21
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
22
Short-Run AS Curve
• Short-run equilibrium of the economy: the
intersection of the AD curve and the short-run
AS curve (see graph)
• Changes in AD do affect the level of output
• E.g. if the central bank reduces money supply
–
–
–
–
AD curve shifts to the left
Economy moves from intersection point A to B
Decline in output
Fixed price level
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
23
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
24
Short Run AS curve
• A fall in aggregate demand reduces output
in the short run because prices do not fall
instantly
– After fall in demand firms are stuck with high
prices, firms sell less of the product, so
production falls and workers are laid off
– There is a recession in the economy
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
25
From the Short Run to the Long
Run
Summary
• Over long periods of time:
– prices are flexible
– AS curve is vertical
– Changes in aggregate demand affect prices not
output
• Over short periods of time:
– Prices are sticky
– AS curve is flat
– Changes in aggregate demand affect the economy’s
output
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
26
From the Short Run to the Long
Run
Transition from short run to long run:
• See graph: three curves – AD curve, longrun AS curve and short run AS curve
• Long run equilibrium = where long-run AS
curve crosses AD curve
– Prices have adjusted to reach this equilibrium
• Therefore, when economy is in long-run
equilibrium, short-run AS curve crosses
this point as well
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
27
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
28
From the Short-Run to the LongRun
• Suppose the central bank decreases money
supply:
– AD curve shifts to the left
– In short-run: prices are sticky, economy moves from
point A to point B
– At point B: output and employment falls below natural
levels and economy is in recession
– Over time: wages and prices will fall in response to
change in demand
– There is a gradual movement in the economy to point
C = the new long-run equilibrium
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
29
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
30
From the Short-run to the Long-run
At point C:
• output and unemployment are back to
their natural levels
• Prices are lower
A shift in AD affects output in the short run,
but his dissipates over time as firms adjust
prices
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
31
Stabilisation Policy
• Fluctuations in the economy come from
– Changes in AS or AD
•
•
•
•
Exogenous changes: called shocks
Demand shock: shifts the AD curve
Supply shock: shifts the AS curve
Stabilisation policy = actions reduce
severity of short run economic fluctuations
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
32
Shocks to AD
• Example of a demand shock: introduction
of credit cards:
– Reduce quantity of money people hold
– Reduction in quantity of money demanded
– Velocity of money increases (money moves
from hand to hand quicker)
– If money supply is held constant, nominal
spending rises and AD curve shifts outward
– Economy moves from A to B
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
33
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
34
Shocks to AD
• Cont’d:
– Over time high AD pulls up wages and prices
– As price rises, output demand falls
– Economy moves to C
– But the Central Bank could offset the increase
in velocity by reducing money supply thereby
eliminating the demand shock
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
35
Shocks to AS
• Supply shocks: alters the cost of
producing goods and services e.g. oil
prices
• Raising the world price of oil = adverse
supply shock
• Adverse supply shock: shifts the short run
supply curve upwards
• If AD is held constant economy moves
from A to B (see graph)
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
36
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
37
Shocks to AS
•
•
At point B: price level rises, output falls
Central bank has two options:
1.
Hold AD constant, lower output and employment.
Eventually prices will fall and economy back to point A
but will have gone through a recession
Expand AD to coincide with the AS shock: so economy
immediately goes from point A to C but the price level
is permanently higher
2.
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
38
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
39
Summary: AD and AS model
• Framework for studying economic fluctuations:
AD and AS model
• Prices are sticky in the short run and flexible in
the long run
• In this chapter, AD was derived very simply
using the quantity theory of money but this
derivation is incomplete for fully understanding
AD
• Next few chapters derives the AD curve in a
complete fashion
Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9,
Fifth edition Chapter 9
40