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Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10)

Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10) Li Gan Department of Economics Texas A&M University We have just come out of a severe recession – but risk to have another one. Historically, GDP fluctuates. Shaded areas are recessions GDP components

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Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10)

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  1. Lecture 7 Short Run Economic Fluctuations and Business Cycles (Part I, Chapter 9 and 10) Li Gan Department of Economics Texas A&M University

  2. We have just come out of a severe recession – but risk to have another one.

  3. Historically, GDP fluctuates. Shaded areas are recessions

  4. GDP components • GDP = consumption + investment + government purchase + net exports • Which components fluctuates the most during the business cycles?

  5. Growth in consumption and investment

  6. Consumption

  7. Investment

  8. Government consumption

  9. Net export

  10. Investment • Since investment varies the most during the business cycles, it will be a key variable in our analysis.

  11. Unemployment rate • Unemployment rate also fluctuates substantially. • http://www.google.com/publicdata?ds=usunemployment&met=unemployment_rate&tdim=true&dl=en&hl=en&q=unemployment+rate • Looks like we have emerged from the worst.

  12. Unemployment rates and Okun’s law

  13. Okun’s law • Percentage change in Real GDP = 3.5% - 2 x change in the unemployment rate • Quite intuitive: a higher unemployment rate indicates a lower number of people working  Lower output.

  14. Leading economic indicators • Average workweek of production workers in manufacturing • Businesses often adjust their work hours before they adjust number of workers – because of transaction costs. • Average initial weekly claims for unemployment insurance • Quick indicators of labor market situations. • New orders for consumer goods and materials, adjusted for inflation • New consumer goods • New orders, nondefense capital goods • New investment • Vendor performance • A measure of number of companies receiving slower deliveries from suppliers. A lower performance indicates a future increase in activity.

  15. Leading economic indicators 6. New building permits issued 7. Index of stock prices • Expectations about the future. 8. Money supply (M2), adjusted for inflation • More money supply predicts increase in spending

  16. Leading economic indicators 9.Interest rate spread: the yield spread between 10-year treasury notes and 3-month treasury notes. • Typically, interest rate for long-term bond is higher than interest rate for short-term bond.

  17. Interest rate spread • Interest rates usually decline during a recession. • If investors anticipate a recession in the near future, they will sell their short-term bonds and buy longer-term bonds to carry them through the recession.

  18. Interest rate spread • Price of short-term bonds will be lower yields (interest rates) will be higher. • Price of long-term bonds will be higher  yields (interest rates) will be lower. • If these two effects are sufficiently strong, the interest rate spread can invert, or become negative.

  19. Short and long-term interest rates

  20. Short run and long run • The key difference between the short run and the long run is if prices are “sticky”. • Suppose that Fed suddenly reduces the money supply by 5%. In the long run, the prices would be down by 5% while output, employment, and other real variables remain the same. • In the short run, however, many prices do not respond to changes in monetary policy.

  21. Price stickiness in the short run • Why prices do not change in the short run: • Mankiw’s Menu Cost theory • Suppose it is optimal for firms to increase price by 1%. • Mankiw argues that the gains of increasing prices is proportional to the square of 1% (very very small), smaller than even printing a new set of “menus”. • Therefore, firms do not change prices in the short run.

  22. Price stickiness in the short run • However, everybody agrees that firms would change prices in the long run. • Therefore, the difference between a long-run and a short-run is whether prices may change or not.

  23. Aggregate demand • Quantity theory of money: MV = PY • Rewrite this: M/P = kY, where k = 1/V • At any given M, one must have:

  24. Aggregate demand function

  25. Aggregate supply curve • Two major schools of thoughts: • Neoclassical: • Chicago, Stanford, Minnesota, etc. • Keynesian • Harvard, Berkeley, MIT, Princeton, etc. • They differ by how they view the aggregate supply curve.

  26. Neoclassical macroeconomics: prices are flexible aggregate supply Price P Neoclassical World output Income Y

  27. A shift in aggregate demand: price changes but output remains the same aggregate supply Price P Neoclassical World New price Old price Aggregate Demand output Income Y

  28. Key points of neoclassical economics • Prices are flexible to adjust. • Aggregate demand shocks would only affect prices not the real output. • Economic fluctuations are mostly due to shocks on aggregate supply • Shocks such as technology innovation, etc. would affect aggregate supply and hence aggregate output.

  29. Key implications • Government plays very little role during the business cycles. • Very close to Republicans’ point of view.

  30. Key economists in this camp Robert Lucas, Jr 1995 Nobel Edward Prescott 2004 Nobel Finn Kydland 2004 Nobel

  31. Keynesian economics: prices are sticky in the short run Keynesian World

  32. A shift in aggregate demand price remains the same, output increases Price P Keynesian World Short run AS Aggregate Demand Old output Income Y New output

  33. Key points of Keynesian economics • Prices are sticky in the short run but flexible in the long run. • Shifts in aggregate demand curve would affect short run output. • Economic fluctuations and business cycles are mostly due to shocks to aggregate demand. • Shocks such as a drop in stock prices reduces future expectations.

  34. Key implications: • Government is very important in “managing economy.” • When economy is doing poorly, government may try to shift aggregate demand curve to the right. • Very close to Democrats’ point of view.

  35. Key economists Ben Bernanke Current Fed Chairman John Maynard Keynes 1983-1946

  36. Keynesian: Long run and short run Price P Long run AS Short run AS Aggregate Demand Income Y

  37. A money supply increase: short run, moves along the short run AS Price P Same price, higher output Aggregate Demand Short run AS Long run AS New output Income Y A money supply increase

  38. A money supply increase: long run, prices adjusted and total output backs to the original value Price P Move along the AD curve Aggregate Demand Short run AS Long run AS Income Y Higher price, same output A money supply increase

  39. A reduction in money supply in the short run and in the long run:

  40. Examples of government intervention • A negative supply by Hurricane Katrina, or by 911 Terrorist Attack, destroy a large amount of capital stock. • A demand shock caused by subprime mortgage crisis, a large drop in stock market.

  41. A negative shock in supply examples: 911 terrorist attack, Hurricane Katrina A sudden and large increase in oil price Price P AD Income Y new output old output

  42. Keynesian stablization policy: Fed raises money supply Price P New equilibrium New AD AD Income Y Fed raises money supply AD shifts right A higher short run output

  43. Stablization policy: raises (too little) money supply and/or government spending Price P New equilibrium New AD AD Raises money supply or government spending AD shifts right Income Y A higher short run output

  44. Stablization policy: Raises (too much) money supply and government spending Price P New equilibrium New AD AD Income Y Fed raises money supply AD shifts right A higher short run output

  45. Stablization policy • An negative aggregate shock: • Short run aggregate supply curves shifts up. • A lower short run output • Fed raises money supply • Aggregate demand shifts right. • Short run output is higher. • Higher long run prices.

  46. A negative shock in demand shifts AD curve left examples: subprime mortgage crisis, crash of stock market Price P AD Income Y new output old output

  47. Stablization policy: raise (too little) the money supply and/or government spending to shift AD right Price P AD Income Y

  48. Stablization policy: raise (too much) the money supply and/or government spending to shift AD right Price P AD Income Y

  49. Why aggregate demand curve shifts • The key public policy is to shift the aggregate demand curve. • We want to understand why changes in government spending or money supply may shift aggregate demand curve.

  50. The Keynesian cross • The GDP equality: E = C + I + G = C(Y-T) + I + G = a + b(Y-T) + I + G • Expenditure = Income

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