Transcript Introduction to Economic Fluctuations

®
CHAPTER 9
Introduction to Economic Fluctuations
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
1
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
Chapter Nine
A recent recession began in late 2007
From the 4th quarter of 2007 to the 3rd
quarter of 2008, the economy’s
production of goods and services
expanded by a paltry .7%-- well below
the normal rate of growth. In the 4th
quarter of 2008, real GDP fell at an
annualized rate of 3.8 percent.
The unemployment rate rose from 4.7 percent in November
2007 to 7.6 percent in January 2009. In early 2009, as this
book was going to press, the end of the recession was not yet in
sight, and many feared that the downturn would get significantly
worse before getting better. As the book was going to press, the end
of the recession was not in sight. Not surprisingly, the recession
dominated the economic news of the time and the problem was high
on the agenda of the newly elected president, Barack Obama.
Chapter Nine
2
Short-run fluctuations in output and employment are
called the business cycle. In previous chapters, we
developed theories to explain how the economy
behaves in the long run; now we’ll seek to understand
how the economy behaves in the short run.
Chapter Nine
3
GDP is the first place to start when analyzing the business cycle,
since it is the largest gauge of economic conditions.
The National Bureau of Economic Research (NBER) is the official
determiner of whether the economy is suffering from a recession.
A recession is usually defined by a period in which there are two
consecutive declines in real GDP.
In recessions, both consumption and investment decline; however,
investment (business equipment, structures, new housing and
inventories) is even more susceptible to decline.
Chapter Nine
4
In recessions, unemployment rises. This negative (when one rises,
the other falls) relationship between unemployment and GDP is
called Okun’s Law, after Arthur Okun, the economist who first
studied it. In short, it is defined as:
Percentage Change in Real GDP =
3.5% - 2  the Change in the Unemployment Rate
If the unemployment rate remains the same, real GDP grows by
about 3.5 percent. For every percentage point the unemployment rate
rises, real GDP growth typically falls by 2 percent. Hence, if the
unemployment rate rises from 5 to 8 percent, then real GDP growth
would be:
Percentage Change in Real GDP = 3.5% - 2  (8% - 5%) = - 2.5%
In this case, GDP would fall by 2.5%, indicating that the economy
is in a recession.
Chapter Nine
5
Many economists in business and government have the role
of forecasting short-run fluctuations in the economy. One way
that economists arrive at forecasts is through looking at leading
indicators.
Each month, the Conference Board, a private economics
Research announces the index of leading economic indicators,
which consists of 10 data series.
Chapter Nine
6
1) Average workweek of production workers in manufacturing
2) Average initial weekly claims for unemployment insurance
3) New orders for consumer goods and materials adjusted for inflation
4) New orders, nondefense capital goods
5) Vendor performance
6) New building permits issued
7) Index of stock prices
8) Money-supply (M2) adjusted for inflation
9) Interest rate spread: the yield spread between 10-year Treasury
notes and 3-month treasury bills
10) Index of consumer expectations
Chapter Nine
7
The Crystal Ball
of Economic Indicators
How has the crystal ball done lately? Here is what the Conference
Board announced in 2007 press release:
The leading index decreased sharply for the second consecutive
month in November, and it has been down in four of the last
six months. Most of the leading indicators contributed negatively
to the index in November, led by large declines in stock prices,
initial claims for unemployment insurance, index of consumer
expectations, and the real money supply (M2)…The leading
index fell 1.2 percent (a decline of 2.3 percent annual rate) from
May to November, the largest six-month decrease in the index
in six years.
As predicted, the economy in 2008 and 2009 headed into a
recession.
Chapter Nine
8
Classical macroeconomic theory applies to the long run but not to
the short run–WHY?
The short run and long run differ in terms of the treatment 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.
Because prices behave differently in the short run
than in the long run, economic policies have
different effects over different time horizons.
Let’s see this in action.
Chapter Nine
9
Recall from Chapter 4, the theoretical separation of real and nominal
variables is called…
Economists call the separation of the determinants of real
and nominal variables the classical dichotomy. A
simplification of economic theory, it suggests that changes in
the money supply do not influence real variables.
This irrelevance of money for real variables is called
monetary neutrality. Most economists believe that these
classical ideas describe how the economy works in the long
run.
Chapter Nine
10
P
LRAS
Y
P
P
Chapter Nine
P
LRAS
SRAS
SRAS
SRAS
AD
AD
AD
Y
Y
LRAS
Y
LRAS
P
Y
Y
LRAS
P
Y
LRAS
SRAS
SRAS
SRAS
AD
AD
AD
Y
Y
Y
Y
Y
11
This macroeconomic model allows us to examine how the aggregate
price level and quantity of aggregate output are determined in the
short run. It also provides a way to contrast how the economy
behaves in the long run and how it behaves in the short run.
P
LRAS
Long Run
SRAS
Short run
AD
Y
Chapter Nine
Y
12
Aggregate demand (AD) is the relationship between the quantity of
output demanded and the aggregate price level. It tells us the quantity
of goods and services people want to buy at any given level of prices.
Recall the Quantity Theory of Money (MV=PY), where M is the money
supply, V is the velocity of money, P is the price level, and Y is the
amount of output. It makes the not quite realistic, but very convenient
assumption that velocity is constant over time. Also, when
interpreting this equation, recall that the quantity equation can be
rewritten in terms of the supply and demand for real money balances:
M/P = (M/P)d = kY, where k = 1/V is a parameter determining how
much money people want to hold for every dollar of income. This
equation states that supply of money balances M/P is equal to the
demand and that demand is proportional to output.
The assumption of constant velocity is equivalent to the assumption of
a constant demand for real money balances per unit of output.
Chapter Nine
13
Price level
The Aggregate Demand (AD) curve shows the negative relationship
between the price level P and quantity of goods and services demanded
Y. It is drawn for a given value of the money supply M. The aggregate
demand curve slopes downward: the higher the price level P, the lower
the level of real balances M/P, and therefore the lower the quantity of
goods and services demanded Y.
AD
Output (Y)
Chapter Nine
As the price level decreases, we’d
move down along the AD curve.
Any changes in M or V would shift
the AD curve.
Remember that the demand for real
output varies inversely with the price
level.
Y = MV/P
14
Think about the supply and demand for real money balances.
If output is higher, people engage in more transactions and need
higher real balances M/P. For a fixed money supply M, higher
real balances imply a lower price level. Conversely, if the price
level is lower, real money balances are higher; the higher level
of real balances allows a greater volume of transactions,
which means a greater quantity of output is demanded.
Chapter Nine
15
The aggregate demand curve is drawn for a fixed value of the
money supply. In other words, it tells us the possible combinations
of P and Y for a given value of M. If the Fed changes the money
supply, then the possible combinations of P and Y change,
which means the aggregate demand curve shifts.
Let’s see how.
Chapter Nine
16
Price level
A decrease in the money supply M
reduces the nominal value of output
PY. For any given price level P,
output Y is lower. Thus, a decrease
in the money supply shifts the AD
curve inward from AD to AD'.
AD
AD'
Output (Y)
Chapter Nine
17
Price level
An increase in the money supply M
raises the nominal value of output
PY. For any given price level P,
output Y is higher. Thus, an increase
in the money supply shifts the AD
curve outward from AD to AD'.
AD
AD'
Output (Y)
Chapter Nine
18
Aggregate supply (AS) is the relationship
between the quantity of goods and services
supplied and the price level. Because the
firms that supply goods and services have
flexible prices in the long run but sticky
prices in the short run, the aggregate supply
relationship depends on the time horizon.
There are two different aggregate supply curves: the long-run aggregate
supply curve (LRAS) and the short-run aggregate supply curve (SRAS).
We also must discuss how the economy makes the transition from the
short run to the long run.
But, first, let’s build the long-run aggregate supply curve (LRAS).
Chapter Nine
19
Because the classical model describes how the economy behaves in the
long run, we can derive the long-run aggregate supply curve from the
classical model.
Recall the amount of output produced depends on the fixed amounts of
capital and labor and on the available technology.
To show this, we write Y = F(K, L) = Y
According the classical model, output does not depend on the price
level. Let’s think about this considering the market clearing process in
the labor market, the “L” component of the production function.
Chapter Nine
20
Let’s begin at full employment, n*, with a wage of W/P0.
Now let’s see how workers will respond when there
is a sudden increase in the price level.
At this new lower real wage,
workers will cut back on hours worked.
Real wage,
ns
W/P
(Employees)
But, at the same
time, employers
increase their demand
for workers.
W/P0
W/2P0
(Employers)
nd
Chapter Nine
n
n * n
Hours worked
What will happen next?
21
So, right now the labor market is in “disequilibrium” where the quantity
demanded exceeds the quantity supplied.
We’re now going to see how “flexible wages” will allow the labor
market to come back to equilibrium, at full employment, n*.
To hire more workers, the employer must raise the real wage to 2W.
As a result of 2W,
more workers are
(Employees)
hired, and the labor market
can move...
ns
W/P
2W/2P0
W/2P0
(Employers)
nd
n
Chapter Nine
n* n
Hours worked
22
The mechanism we just went through will enable us
to build our long run aggregate supply curve.
P
The vertical line suggests that
changes in the price level
will have no lasting impact on
full employment.
Y
Chapter Nine
Y=F (K, L)
Y
23
The vertical-aggregate supply curve satisfies the classical dichotomy,
because it implies that the level of output is independent of the money
supply. This long-run level of output, Y, is called the full-employment or
natural level of output. It is the level of output at which the economy’s
resources are fully employed, or more realistically, at which
unemployment is at its natural rate.
P
A reduction in the money
supply shifts the aggregate
demand curve downward
from AD to AD'. Since the AS
curve is vertical in the long
run, the reduction in AD
affects the price level, but not
the level of output.
A
B
Chapter Nine
Y
Y
24
Remember that the the vertical LRAS curve assumed that changes in the
price level left no lasting impact on Y (because of the market-clearing
process)--that will be the model for examining the long term. But we
need a theory for the short run, defined as the interval of time during
which markets are not fully cleared.
LRAS
A simple, but useful first approach is
P
to assume short-run price rigidity
C
meaning that the aggregate supply
B
curve is flat. As AD shifts to AD we
P0
SRAS
A
AD slide in an east-west direction to point
B on the short run aggregate supply
AD
curve (SRAS).
Then, in the long run, we move from
Y
Y
Y = F (K,L)
B to C (move up and along AD).
Chapter Nine
25
P
LRAS
SRAS
AD
Y
Y
Y = F (K,L)
In the long run, the economy finds itself at the intersection of the
long-run aggregate supply curve and aggregate demand curve. Because
prices have adjusted to this level, the SRAS crosses this point as well.
Chapter Nine
26
LRAS
P
B
A
C
SRAS
AD
AD'
Y
Y
The economy begins in long-run equilibrium at point A. Then, a
reduction in aggregate demand, perhaps caused by a decrease in the
money supply M, moves the economy from point A to point B, where
output is below its natural level. As prices fall, the economy recovers
from the recession, moving from point B to point C.
Chapter Nine
27
Exogenous changes in aggregate supply or aggregate demand are
called shocks. A shock that affects aggregate supply is called a
supply shock. A shock that affects aggregate demand is called
a demand shock. These shocks that disrupt the economy push output
and unemployment away from their natural levels.
A goal of the aggregate demand/aggregate supply model is to help
explain how shocks cause economic fluctuations. Economists use
the term stabilization policy to refer to the policy actions taken to
reduce the severity of short-run economic fluctuations. Stabilization
policy seeks to dampen the business cycle by keeping output and
employment as close to their natural rate as possible. The model in
this chapter is a simpler version of the one we’ll see in coming
chapters.
Chapter Nine
28
P
LRAS
C
B
A
SRAS
AD'
AD
Y
Y
The economy begins in long-run equilibrium at point A. An increase
in aggregate demand, due to an increase in the velocity of money,
moves the economy from point A to point B, where output is above
its natural level. As prices rise, output gradually returns to its natural
rate, and the economy moves from point B to point C.
Chapter Nine
29
P
LRAS
B
A
SRAS'
SRAS
AD
Y
Y
An adverse supply shock pushes up costs and prices. If AD is held
constant, the economy moves from point A to point B, leading to
stagflation—a combination of increasing prices and declining level
of output. Eventually, as prices fall, the economy returns to the
natural rate at point A.
Chapter Nine
30
P
LRAS
B
A
Y
SRAS'
SRAS
AD'
AD
Y
In response to an adverse supply shock, the Fed can increase aggregate
demand to prevent a reduction in output. The economy moves from
point A to point B. The cost of this policy is a permanently higher
level of prices.
Chapter Nine
31
Aggregate demand
Aggregate supply
Shocks
Demand shocks
Supply shocks
Stabilization policy
Chapter Nine
32