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Instructor Sandeep Basnyat Sandeep_basnyat@yahoo 9841 892281

Macroeconomics & The Global Economy Ace Institute of Management Chapter 9: Economic Fluctuation (Business Cycle Theory). Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281. Introduction. Continual ups and downs in the rate of growth of national income

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Instructor Sandeep Basnyat Sandeep_basnyat@yahoo 9841 892281

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  1. Macroeconomics & The Global Economy Ace Institute of ManagementChapter 9: Economic Fluctuation (Business Cycle Theory) Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

  2. Introduction • Continual ups and downs in the rate of growth of national income • Business cycle is the alternating periods of expanding and contracting economic activity.

  3. Average growth rate Consumption growth rate Real GDP growth rate Growth rates of real GDP, consumption Percent change from 4 quarters earlier

  4. Real GDP growth rate Investment growth rate Consumption growth rate Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier

  5. Unemployment Percent of labor force

  6. Phases of Business Cycle • There are four phases of business cycle • Prosperity or Boom • Recession • Depression or Slump • Recovery or Revival Output Recession Revival Prosperity Depression Periods

  7. Why does this happen? What are its implications to an economy? • Different behavior of Price in short and long run • Demand and supply shocks

  8. Behaviour of Price • Short runMany prices are “sticky” at a predetermined level. • Long runPrices are flexible, respond to changes in supply or demand. The economy behaves much differently when prices are sticky than flexible.

  9. Aggregate demand • The aggregate demand curve shows the relationship between the price level and the quantity of output demanded. • Also. from quantity equation MV = PY • If M and V are constant then, this equation implies an inverse relationship between P and Y causing downward sloping AD curve

  10. P AD Y The downward-sloping AD curve

  11. P AD2 AD1 Y Shifting the AD curve An increase in the money supply shifts the AD curve to the right.

  12. P SRAS Y The short-run aggregate supply curve The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand.

  13. P LRAS Y The long-run aggregate supply curve Increase in price is followed by increase in cost and suppliers do not have incentives to increase supply has enough time to respond to fixed K,L: does not depend on P, so LRAS is vertical.

  14. P LRAS SRAS AD Y The Aggregate Demand and supply curves

  15. P In the short run when prices are sticky,… …causes output to rise. SRAS Y2 AD2 AD1 Y From short run to Long run …an increase in aggregate demand… Y1

  16. P LRAS B = new short-run eq’m after Central Bank increases M C = long-run equilibrium SRAS Y2 AD2 AD1 Y Short-run effects of an increase in M A = initial equilibrium C B A

  17. P LRAS P2 Net Effect Short run and long run effects of price cause business cycle AD2 AD1 Y Long-run effects of an increase in M P1

  18. How shocking!!! • shocks: exogenous changes in agg. supply or demand • Shocks temporarily push the economy away from full employment. CHAPTER 9Introduction to Economic Fluctuations

  19. LRAS P P2 Over time, prices fall and the economy moves down its demand curve toward full-employment. SRAS Y2 AD2 AD1 Y The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. A B C CHAPTER 9Introduction to Economic Fluctuations

  20. Supply 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. CHAPTER 9Introduction to Economic Fluctuations

  21. CASE STUDY: The 1970s oil shocks • Early 1970s: OPEC coordinates a reduction in the supply of oil. • Oil prices rose 11% in 1973 68% in 1974 16% in 1975 • Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. CHAPTER 9Introduction to Economic Fluctuations

  22. P LRAS In absence of further price shocks, prices will fall over time and economy moves back toward full employment. SRAS1 SRAS2 Y2 AD Y CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. B A A CHAPTER 9Introduction to Economic Fluctuations

  23. Thank You

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