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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.

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Chapter 9: Introduction to Economic Fluctuations

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  1. Chapter 9:Introduction to Economic Fluctuations

  2. 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

  3. 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. Time Horizon in Macroeconomics

  4. 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

  5. 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

  6. 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)

  7. Shift in Aggregate Demand Price level Increase AD2 Decrease AD1 AD3 Output, Income

  8. 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

  9. Aggregate Supply Price level Price level Long-run AS Short-run AS P Y Output, Income Output, Income

  10. Shift in Aggregate Demand In the short-run, a higher AD results in a greater output at a constant price level. Price level SRAS AD2 AD1 Y2 Y1 Output, Income

  11. 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

  12. Aggregate Equilibrium Price level LRAS SRAS P AD Y Output, Income

  13. 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)

  14. Effect of Stabilization Policy Results of expansionary policy: Short-run: output growth Long-run: higher price level Price level LRAS C A B SRAS P AD2 AD1 Y Output, Income

  15. 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)

  16. 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 SRAS2 A SRAS1 P AD1 Y Output, Income

  17. 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

  18. Accommodating Supply Shock Price level LRAS C SRAS2 A SRAS1 AD2 AD1 Y Output, Income

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