Introduction to Economic Fluctuations

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CHAPTER 9 Introduction to Economic Fluctuations
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A recent recession began in late 2007
From the 4th quarter of 2007 to the 3rd
quarter of 2008, the economys
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.
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The Business Cycle
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 well
seek to understand how the economy behaves in the
short run.
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GDP and Its Componants
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.
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In recessions, unemployment rises. This negative
(when one rises, the other falls) relationship
between unemployment and GDP is called Okuns
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.
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Leading Economic Indicators
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.
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Index of Leading Economic Indicators

• Average workweek of production workers in
  manufacturing
• Average initial weekly claims for unemployment
  insurance
• New orders for consumer goods and materials
  adjusted for inflation
• New orders, nondefense capital goods
• Vendor performance
• New building permits issued
• Index of stock prices
• Money-supply (M2) adjusted for inflation
• Interest rate spread the yield spread between
  10-year Treasury
• notes and 3-month treasury bills
• 10) Index of consumer expectations

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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.
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Time Horizons in Macroeconomics
Classical macroeconomic theory applies to the
long run but not to the short runWHY? 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. Lets see this in
action.
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Recall from Chapter 4, the theoretical
separation of real and nominal variables is
called
The Classical Dichotomy
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The Model of Aggregate Supply and Aggregate
Demand
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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.
Long Run
Short run
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Aggregate Demand
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 (MVPY), 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.
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The Aggregate Demand Curve
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.
As the price level decreases, wed move down
along the AD curve.
Price level
Any changes in M or V would shift the AD curve.
Remember that the demand for real output varies
inversely with the price level.
AD
?Y MV/?P
Output (Y)
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Why the aggregate demand curve slopes downward
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.
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More about the Aggregate Demand Curve
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. Lets see how.
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Shifts in Aggregate Demand
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Shifts in Aggregate Demand
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Aggregate Supply
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, lets build the long-run
aggregate supply curve (LRAS).
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The Long Run The Vertical-Aggregate Supply Curve
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Market Clearing in the Labor Market
Lets begin at full employment, n, with a wage
of W/P0.
Now lets 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, W/P
ns
(Employees)
But, at the same time, employers increase their
demand for workers.
W/2P0
(Employers)
nd
What will happen next?
Hours worked
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So, right now the labor market is in
disequilibrium where the quantity demanded
exceeds the quantity supplied.
Were 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 hired, and
the labor market can move...
W/P
ns
(Employees)
W/2P0
(Employers)
nd

n
Hours worked
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The mechanism we just went through will enable
us to build our long run aggregate supply curve.
LRAS
P
The vertical line suggests that changes in the
price level will have no lasting impact on full
employment.
Y
Y
YF (K, L)
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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
economys resources are fully employed, or more
realistically, at which unemployment is at its
natural rate.
LRAS
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
AD
B
AD'
Y
Y
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The Short-Run The Horizontal Aggregate Supply
Curve
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 to assume
short-run price rigidity meaning that the
aggregate supply curve is flat. As AD shifts to
AD? we slide in an east-west direction to point B
on the short run aggregate supply curve
(SRAS). Then, in the long run, we move from B to
C (move up and along AD?).
P
C
B
P0
SRAS
A
AD?
AD
Y
Y
Y F (K,L)
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The Long-run Equilibrium
LRAS
P
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.
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A Reduction in Aggregate Demand
LRAS
P
SRAS
A
B
AD
C
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.
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Stabilization Policy
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
well see in coming chapters.
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Shocks to Aggregate Demand
LRAS
P
C
SRAS
B
A
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.
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Shocks to Aggregate Supply
LRAS
P
B
SRAS'
SRAS
A
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 stagflationa combination of increasing prices
and declining level of output. Eventually, as
prices fall, the economy returns to the natural
rate at point A.
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Accommodating an Adverse Supply Shock
LRAS
P
B
SRAS'
SRAS
A
AD'
AD
Y
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.
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Key Concepts of Chapter 9
Aggregate demand Aggregate
supply Shocks Demand shocks Supply
shocks Stabilization policy