macro business cycle models. chapter objectives difference between short run & long run ...

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ro

Business Cycle Models

Chapter objectivesChapter objectives

difference between short run & long run

introduction to aggregate demand

aggregate supply in the short run & long run

see how model of aggregate supply and demand can be used to analyze short-run and long-run effects of “shocks”

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1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Per

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arte

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erReal GDP Growth in the U.S., Real GDP Growth in the U.S., 1960-20041960-2004

Average growth rate = 3.4%

Time horizonsTime horizons

Long run: Prices are flexible, respond to changes in supply or demand

Short run:many prices are “sticky” at some predetermined level

The economy behaves much differently when prices are sticky.

In Classical Macroeconomic TheoryIn 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 stickyWhen 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.

AD/AS ModelAD/AS Model

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

Aggregate demandAggregate demand

The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.

For this chapter’s intro to the AD/AS model, we use a simple theory of aggregate demand based on the Quantity Theory of Money.

Chapters 10-11 develop the theory of aggregate demand in more detail.

The Quantity Equation as ADThe Quantity Equation as AD

M V = P Y

For given values of M and V, these equations imply an inverse relationship between P and Y:

The downward-sloping The downward-sloping ADAD curve curve

An increase in the price level causes a fall in real money balances (M/P ),

causing a decrease in the demand for goods & services.

Y

P

AD

Shifting the Shifting the ADAD curve curve

An increase in the money supply shifts the AD curve to the right.

Y

P

AD1

AD2

Aggregate Supply in the Long RunAggregate Supply in the Long Run

In the long run, output is determined by

factor supplies and technology, ( )Y 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.

Y

“Full employment” means that unemployment equals its natural

rate.

The long-run aggregate supply curveThe long-run aggregate supply curve

Y

P LRAS

Y

The LRAS curve is vertical at the full-employment level of output.

Long-run effects of an increase in Long-run effects of an increase in MM

Y

P

AD1

AD2

LRAS

Y

An increase in M shifts the AD curve to the right.

P1

P2In the long run, this increases the price level…

…but leaves output the same.

Aggregate Supply in the Short RunAggregate Supply in the Short Run

In the real world, many prices are sticky in the short run.

For now (and throughout Chapters 9-11), we 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.

Therefore, the short-run aggregate supply (SRAS) curve is horizontal:

The short run aggregate supply curveThe short run aggregate supply curve

Y

P

PSRAS

The SRAS curve is horizontal:

The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

Short-run effects of an increase in Short-run effects of an increase in MM

Y

P

AD1

AD2

…an increase in aggregate demand…

In the short run when prices are sticky,…

…causes output to rise.

PSRAS

Y2Y1

From the short run to the long runFrom the short run to the long run

Over time, prices gradually become “unstuck.” When they do, will they rise or fall?

Y Y

Y Y

Y Y

rise

fall

remain constant

In the short-run equilibrium, if

then over time, the price level

will

This adjustment of prices is what moves the This adjustment of prices is what moves the economy to its long-run equilibrium.economy to its long-run equilibrium.

The SR & LR effects of The SR & LR effects of MM > 0 > 0

Y

P

AD1

AD2

LRAS

Y

PSRAS

P2

Y2

A = initial equilibrium

AB

CB = new short-

run eq’m after Fed increases M

C = long-run equilibrium

How shocking!!!How shocking!!!

shocks: exogenous changes in aggregate supply or demand

Shocks temporarily push the economy away from full-employment.

An 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:

LRAS

AD2

PSRAS

The effects of a negative demand shockThe effects of a negative demand shock

Y

P

AD1

Y

P2

Y2

The shock shifts AD left, causing output and employment to fall in the short run

AB

COver time, prices fall and the economy moves down its demand curve toward full-employment.

Supply shocksSupply shocks

A supply shock alters production costs, affects the prices that firms charge. (also called price shocks)

Examples of adverse supply shocks: Bad 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.)

CASE STUDY: CASE STUDY: The 1970s oil shocksThe 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in the supply of oil.

Oil prices rose11% in 1973 68% in 1974 16% in 1975

Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

1P SRAS1

Y

P

AD

LRAS

YY2

The oil price shock shifts SRAS up, causing output and employment to fall.

A

BIn absence of further price shocks, prices will fall over time and economy moves back toward full employment.

2P SRAS2


A


Predicted effects of the oil price shock:• inflation • output • unemployment

…and then a gradual recovery. 0%

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Change in oil prices (left scale)

Inflation rate-CPI (right scale)

Unemployment rate (right scale)


Late 1970s:

As economy was recovering, oil prices shot up again, causing another huge supply shock!!! 0%

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1980s: A favorable supply shock--a significant fall in oil prices.

As the model would predict, inflation and unemployment fell:

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Stabilization policyStabilization policy

def: policy actions aimed at reducing the severity of short-run economic fluctuations.

Example: Using monetary policy to combat the effects of adverse supply shocks:

Stabilizing output with Stabilizing output with monetary policymonetary policy

1P SRAS1

Y

P

AD1

B2P SRAS2

A

Y2

LRAS

Y

The adverse supply shock moves the economy to point B.

Stabilizing output with Stabilizing output with monetary policymonetary policy

1P

Y

P

AD1

B2P SRAS2

A

C

Y2

LRAS

Y

AD2

But the Fed accommodates the shock by raising agg. demand.

results: P is permanently higher, but Y remains at its full-employment level.

Chapter summaryChapter summary

1. Long run: prices are flexible, output and employment are always at their natural rates, and the classical theory applies.

Short run: prices are sticky, shocks can push output and employment away from their natural rates.

2. Aggregate demand and supply: a framework to analyze economic fluctuations


3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical, because output depends on technology and factor supplies, but not prices.

5. The short-run aggregate supply curve is horizontal, because prices are sticky at predetermined levels.


6. Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.

7. The Fed can attempt to stabilize the economy with monetary policy.

Estimates of fiscal policy multipliersEstimates of fiscal policy multipliers

from the DRI macroeconometric model

Assumption about monetary policy

Estimated value of

Y / G

Fed holds nominal interest rate constant

Fed holds money supply constant

1.93

0.60

Estimated value of

Y / T

1.19

0.26

CASE STUDY: CASE STUDY:

The U.S. recession of 2001The U.S. recession of 2001 During 2001,

– 2.1 million people lost their jobs, as unemployment rose from 3.9% to 5.8%.

– GDP growth slowed to 0.8% (compared to 3.9% average annual growth during 1994-2000).


The U.S. recession of 2001The U.S. recession of 2001

Causes: 1) Stock market decline C

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The U.S. recession of 2001The U.S. recession of 2001 Causes: 2) 9/11

– increased uncertainty– fall in consumer & business

confidence– result: lower spending, IS curve

shifted left

Causes: 3) Corporate accounting scandals– Enron, WorldCom, etc. – reduced stock prices, discouraged

investment


The U.S. recession of 2001The U.S. recession of 2001 Fiscal policy response: shifted IS

curve right– tax cuts in 2001 and 2003– spending increases

•airline industry bailout•NYC reconstruction •Afghanistan war


The U.S. recession of 2001The U.S. recession of 2001 Monetary policy response: shifted LM curve right

Three-month T-Bill Rate

Three-month T-Bill Rate

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What is the Fed’s policy instrument?What is the Fed’s policy instrument?

The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.

In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans.

The Fed changes the money supply and shifts the LM curve to achieve its target.

Other short-term rates typically move with the federal funds rate.

What is the Fed’s policy instrument?What is the Fed’s policy instrument?

Why does the Fed target interest rates instead of the money supply?

1) They are easier to measure than the money supply.

2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (Problem Set #16.)

The Great DepressionThe Great Depression

Unemployment (right scale)

Real GNP(left scale)

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THE SPENDING HYPOTHESIS: THE SPENDING HYPOTHESIS: Shocks to the Shocks to the ISIS curve curve

asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.

evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

THE SPENDING HYPOTHESIS: THE SPENDING HYPOTHESIS: Reasons for the Reasons for the ISIS shift shift

Stock market crash exogenous C – Oct-Dec 1929: S&P 500 fell 17%– Oct 1929-Dec 1933: S&P 500 fell 71%

Drop in investment– “correction” after overbuilding in the 1920s– widespread bank failures made it harder to obtain

financing for investment

Contractionary fiscal policy– Politicians raised tax rates and cut spending to

combat increasing deficits.

THE MONEY HYPOTHESIS: THE MONEY HYPOTHESIS: A shock to the A shock to the LMLM curve curve

asserts that the Depression was largely due to huge fall in the money supply.

evidence: M1 fell 25% during 1929-33.

But, two problems with this hypothesis:– P fell even more, so M/P actually rose

slightly during 1929-31. – nominal interest rates fell, which is the

opposite of what a leftward LM shift would cause.

THE MONEY HYPOTHESIS AGAIN: THE MONEY HYPOTHESIS AGAIN: The effects of falling pricesThe effects of falling prices

asserts that the severity of the Depression was due to a huge deflation:

P fell 25% during 1929-33.

This deflation was probably caused by the fall in M, so perhaps money played an important role after all.

In what ways does a deflation affect the economy?

THE MONEY HYPOTHESIS AGAIN: THE MONEY HYPOTHESIS AGAIN: The effects of falling pricesThe effects of falling prices

The destabilizing effects of expected deflation:

e

r for each value of i I because I = I (r )planned expenditure & agg. demand income & output

Why another Depression is unlikelyWhy another Depression is unlikely

Policymakers (or their advisors) now know much more about macroeconomics:– The Fed knows better than to let M fall

so much, especially during a contraction.– Fiscal policymakers know better than to raise

taxes or cut spending during a contraction.

Federal deposit insurance makes widespread bank failures very unlikely.

Automatic stabilizers make fiscal policy expansionary during an economic downturn.

macro business cycle models. chapter objectives difference between short run & long run ...

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