Transcript Chapter 9: Introduction to Economic Fluctuations

Chapter 9:
Introduction to Economic
Fluctuations
Business Cycle
Changes in the level of economic activity. Real
GDP has grown at an average rate of 3% per year
in 1960-95
But, growth has not been smooth:
– Recession: 1974-75, 1981-82, 1990-91
– Boom: 1964-69, 1983-84, 1993-95
Time Horizon in Macroeconomics
Long run: a time period in which prices are flexible
and can respond to changes in demand and
supply. Prices respond to policy changes.
Short-run: a time period in which prices are
“sticky” at some predetermined level. Prices do
not respond to policy changes.
Aggregate Demand
The relationship between the quantity of output
demanded and the price level
Money market equilibrium
– Money demand for transaction: (M/P) = kY
– Money supply = M/P
– Equilibrium: M/P = kY where k is a constant
Aggregate Demand Line
Price level
An increase in the price level (P) reduces the real
money balances (M/P), which lowers the quantity
demanded for goods and services.
AD
Output, Income
Shift in Aggregate Demand
An increase in the money supply (M) makes the real
money balances (M/P) to go up, which increases the level
of the AD (this is a shift to the right)
An decrease in the money supply (M) reduces lower the
real money balances (M/P), which decreases the level of
the AD (this is a shift to the left)
Shift in Aggregate Demand
Price level
Increase
AD2
Decrease
AD1
AD3
Output, Income
Aggregate Supply
The relationship between the quantity of output
supplied and the price level
Long-run AS is a vertical line because of complete
price flexibility assertion
Short-run AS is a horizontal line because of price
inflexibility assertion
Aggregate Supply
Price level
Long-run AS
Price level
Short-run AS
P
Y
Output, Income
Output, Income
Shift in Aggregate Demand
Price level
In the short-run, a higher AD results in
a greater output at a constant price level.
SRAS
AD2
AD1
Y1 Y2
Output, Income
Shift in Aggregate Demand
In the long-run, a higher AD results in
a higher price level at a constant output.
Price level
LRAS
P2
P1
AD2
AD1
Y
Output, Income
Aggregate Equilibrium
Price level
LRAS
SRAS
P
AD
Y
Output, Income
Effect of Stabilization Policy
An increase in the money supply stimulates the
investment demand, causing AD to increase
Short-run effect: An increase in the level of output (point
A moves to point B)
Long-run effect: The rise in income increases the demand
for goods, resulting in higher prices. As prices rise, output
falls to its natural level (point B moves to point C)
Effect of Stabilization Policy
Results of expansionary policy:
Short-run: output growth
Long-run: higher price level
Price level
LRAS
C
P
A
B
SRAS
AD2
AD1
Y
Output, Income
Effects of a Supply Shock
An increase in the production cost, reduces the short-run
AS
Short-run effect: A decrease in the level of output and a
higher price level (point A moves to point B)
Long-run effect: The decline in income decreases the
demand for goods, resulting in lower prices. As prices fall,
output rises to its natural level (point B moves back to A)
Effects of a Supply Shock
Results of supply shock:
Short-run: output decline and price increase
Long-run: higher price level
Price level
LRAS
B
P
SRAS2
A
SRAS1
AD1
Y
Output, Income
Accommodating Supply Shock
The offset the short-run output decline, the central
bank can increase the money supply to shift the
AD up
The long-run effect is a permanent price increase
Accommodating Supply Shock
Price level
LRAS
C
SRAS2
A
SRAS1
AD2
AD1
Y
Output, Income