macro Roadmap to this Lecture Time horizons Introduction to Economic Fluctuations In Classical Macroeconomic Theory, When prices are sticky

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1 Roadmap to this Lecture macro Introduction to Economic Fluctuations We abandon the view that production is determined by technology and full employment of production factors (i.e., there can be unemployment and capital underutilization) Short-run frictions prevent full factor utilization in the short-run and distort optimal economic outcomes When this happens, what can we do? Monetary olicy Fiscal olicy The D/S model is the basic tool to think about policy slide 1 ercent change from four quarters earlier Real GD Growth in the U.S., eak verage growth rate = 3.4% Trough Time horizons Long run: rices are flexible, respond to changes in supply or demand Short run: many prices are sticky at some predetermined level (or there are other frictions, e.g. information) The economy behaves much differently when prices are sticky. slide 2 slide 3 In Classical Macroeconomic Theory, 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. 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. slide 4 slide 5 1

2 The model of aggregate demand and supply ggregate demand 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 The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. For now, we derive the D/S model with a simple theory of aggregate demand based on the Quantity Theory of Money. Later we will develop the theory of aggregate demand in more detail. slide 6 slide 7 The Quantity Equation as ggregate Demand Recall the quantity equation MV = We now assume that is flexible (rather than solely determined by technology and available factors). For given values of M and V, QTM implies an inverse relationship between and : The downward-sloping D curve n increase in the price level causes a fall in real money balances (M/ ), causing a decrease in the demand for goods & services. D slide 8 slide 9 n increase in the money supply shifts the D curve to the right. Shifting the D curve Using Total Differentiation to Make the Same oint Recall M V = (QTM) The slope of the aggregate demand curve is determined by how prices change when income changes by one unit, everything else constant Totally differentiating QTM: M dv + V dm = d + d Notice, dv = dm = 0 Hence: d/d = -/ < 0 slide 10 slide 11 2

3 ggregate Supply in the Long Run In the long run, output is determined by factor supplies and technology = F ( K, L) 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. ggregate Supply in the Long Run Recall from chapter 3: In the long run, output is determined by factor supplies and technology = F ( K, L) Full-employment output does not depend on the price level, so the long run aggregate supply () curve is vertical: slide 12 slide 13 The long-run aggregate supply curve Long-run effects of an increase in M The curve is vertical at the full-employment level of output. In the long run, this increases the price level 2 1 n increase in M shifts the D curve to the right. but leaves output the same. slide 14 slide 15 ggregate Supply in the Short Run The short run aggregate supply curve In the real world, many prices are sticky in the short run. For now, assume that all prices are stuck at a predetermined level in the short run and that firms are willing to sell as much at that price level as their customers are willing to buy (why is this a sensible exercise?) Therefore, the short-run aggregate supply (SRS) curve is horizontal: The SRS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. SRS slide 16 slide 17 3

4 Short-run run effects of an increase in M From the short run to the long run In the short run when prices are sticky, an increase in aggregate demand Over time, prices gradually become unstuck. When they do, will they rise or fall? In the short-run equilibrium, if then over time, the price level will causes output to rise. 1 2 SRS > < = rise fall remain constant This adjustment of prices is what moves the economy to its long-run equilibrium. slide 18 slide 19 The SR & LR effects of M > 0 How shocking!!! = initial equilibrium = new shortrun eq m after Fed increases M C = long-run equilibrium 2 C 2 SRS shocks: exogenous changes in aggregate supply or demand Shocks temporarily push the economy away from full-employment. n 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: slide 20 slide 21 The effects of a negative demand shock Supply shocks The shock shifts D left, causing output and employment to fall in the short run Over time, prices fall and the economy moves down its demand curve toward fullemployment. 2 2 C SRS supply shock alters production costs, affects the prices that firms charge. (also called price shocks) Examples of adverse supply shocks: ad 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.) slide 22 slide 23 4

5 CSE STUD: Early 1970s: OEC coordinates a reduction in the supply of oil. Oil prices rose 11% in % in % in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices (and each unit of GD required much more oil to be produced. Now the economy is more service oriented a massage requires little oil). CSE STUD: The oil price shock shifts SRS up, causing output and employment to fall. In absence of further price shocks, prices will fall over time and economy moves back toward full employment D SRS 2 SRS 1 slide 24 slide 25 CSE STUD: redicted effects of the oil price shock: inflation output unemployment and then a gradual recovery % 4% Change in oil prices (left scale) Inflation rate-ci (right scale) Unemployment rate (right scale) 8% 6% CSE STUD: Late 1970s: s economy was recovering, oil prices shot up again, causing another huge supply shock!!! % 12% 8% 6% 4% Change in oil prices (left scale) Inflation rate-ci (right scale) Unemployment rate (right scale) slide 26 slide 27 CSE STUD: 1980s: favorable supply shock-- a significant fall in oil prices. s the model would predict, inflation and unemployment fell: The 1980s oil shocks % 6% - 4% % Change in oil prices (left scale) Inflation rate-ci (right scale) Unemployment rate (right scale) Stabilization policy definition: policy actions aimed at reducing the severity of short-run economic fluctuations. Example: Using monetary policy to combat the effects of adverse supply shocks: slide 28 slide 29 5

6 Stabilizing output with monetary policy Stabilizing output with monetary policy The adverse supply shock moves the economy to point. 2 SRS 2 ut the Fed accommodates the shock by raising agg. demand. 2 C SRS SRS 1 results: is permanently higher, but remains at its fullemployment level. 1 2 slide 30 slide 31 6