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The Macroeconomy in the Short-Run

The Macroeconomy in the Short-Run. Introduction to Economic Fluctuations. Introduction to Economic Fluctuations. Business Cycle: Short-run fluctuations in output and employment Recessions: periods of falling incomes and rising unemployment

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The Macroeconomy in the Short-Run

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  1. The Macroeconomy in the Short-Run Introduction to Economic Fluctuations Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  2. Introduction to Economic Fluctuations • Business Cycle: Short-run fluctuations in output and employment • Recessions: periods of falling incomes and rising unemployment • Booms: periods of rising incomes and falling unemployment • In previous topic we developed models to identify the long-run determinants of national income, unemployment and inflation • But we didn’t examine why these variables fluctuate from year to year • Here we develop a model to explain these short-run fluctuations Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  3. Time Horizons in Macroeconomics • Key difference between the short-run and long-run is the behaviour 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 • Therefore, economic policies have different effects over different time horizons Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  4. Time Horizons in Macroeconomics • Example: • Central Bank decreases money supply by 5% • According to the quantity theory (classical model): a 5% decrease in money supply, decreases all prices by 5%, while all real variables stay the same (classical dichotomy). This describes the economy in the long run: change in money supply does not cause fluctuations in output or employment Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  5. Time Horizons in Macroeconomics • Example (cont’d): • In short-run: many prices do not respond to changes in money supply • A reduction in money supply does not immediately cause firms to change their prices and lower their wages • Instead prices are sticky • Failure of prices to adjust immediately means output and employment adjust Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  6. Time Horizons in Macroeconomics • During the time horizon over which prices are sticky, the classical dichotomy does not hold: nominal variables can affect real variables Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  7. Model of Aggregate Demand and Aggregate Supply • Use the model of aggregate supply and aggregate demand: • ‘economy-size’ version of the demand and supply model for a single good although more sophisticated (see this later in lectures) Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  8. Aggregate Demand • Aggregate Demand (AD): relationship between the quantity of output demanded and the aggregate price level • Tells us the quantity of goods and services people want to buy at any given level of prices • AD: chapters 10 & 11 develop the theory of AD in detail. Here, as an introduction, we will use the quantity theory of money to provide a simple but incomplete derivation of AD curve Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  9. Aggregate Demand • Quantity equation and AD: • Quantity theory says: MV = PY • Quantity equation can be rewritten in terms of supply and demand for real money balances: • M/P = (M/P)d = kY, where k = 1/V • For fixed money supply (M) and velocity (V), the quantity equation shows a negative relationship between the price level (P) and output (Y) Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  10. Aggregate Demand • Downward sloping AD curve • The combinations of P and Y that satisfy the quantity equation holding M and V constant • Explanation for downward sloping AD curve: if output is higher, people engage in more transactions and need higher real money balances M/P. For M fixed, higher money balances implies a lower price level, P. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  11. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  12. Aggregate Demand • Shifts in AD: • AD curve is drawn for a fixed value of money supply – tells us the possible combinations of P and Y for a give value of M • If the central bank changes M, then the AD curve shifts • E.g. Central bank reduces money supply. Quantity equation: MV = PY Reduction in M leads to a reduction in PY Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  13. Aggregate Demand • Shifts in AD (cont’d): • For any given level of output, the price level is lower and for any given price level, output is lower (see figure a). Decrease in M, causes AD curve to shift to the left. • If central bank increase money supply, M leads to an increase in PY. For any given level of output, the price level is higher and for any given price level, output is higher (see figure b). Increase in M causes AD curve to shift to the right. • A change in velocity may also affect AD curve Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  14. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  15. Aggregate Supply • Aggregate Supply (AS) is the relationship between quantity of goods and services supplied and the price level • AD and AS together determine the economy’s price level and quantity of output • Firms that supply goods and services have flexible prices in the long run and sticky prices in the short run • LRAS: Long run AS curve • SRAS: Short run AS curve Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  16. Long Run AS Curve • Classical model: deals with the long run • Use this to derive the LRAS curve • Amount of output (Y) depends on the factors of production and the production function • Factors of production are fixed (K, L) • Y = F(K, L) • Y Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  17. Long Run AS Curve • According to classical model: output does not depend on the price level • Output is fixed • Therefore, a vertical AS curve (see graph) • Intersection of AD with the vertical AS curve gives the price level • If AS is vertical: changes in AD affect prices and not output Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  18. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  19. Long Run AS Curve • If money supply falls: AD curve shifts downward • Economy moves from equilibrium point A to equilibrium point B • And prices fall (see graph) • Vertical AS curve satisfies the classical dichotomy i.e. level of output is independent of money supply • At Y: unemployment is at its natural rate. It’s called full-employment or natural level of output Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  20. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  21. Short Run AS Curve • In short-run some prices are sticky • Because the price level is fixed: a horizontal AS curve (see graph) • Price level fixed: e.g. suppose all firms have issued price catalogs and it’s expensive for them to issue new ones. Prices are stuck Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  22. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  23. Short-Run AS Curve • Short-run equilibrium of the economy: the intersection of the AD curve and the short-run AS curve (see graph) • Changes in AD do affect the level of output • E.g. if the central bank reduces money supply • AD curve shifts to the left • Economy moves from intersection point A to B • Decline in output • Fixed price level Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  24. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  25. Short Run AS curve • A fall in aggregate demand reduces output in the short run because prices do not fall instantly • After fall in demand firms are stuck with high prices, firms sell less of the product, so production falls and workers are laid off • There is a recession in the economy Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  26. From the Short Run to the Long Run Summary • Over long periods of time: • prices are flexible • AS curve is vertical • Changes in aggregate demand affect prices not output • Over short periods of time: • Prices are sticky • AS curve is flat • Changes in aggregate demand affect the economy’s output Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  27. From the Short Run to the Long Run Transition from short run to long run: • See graph: three curves – AD curve, long-run AS curve and short run AS curve • Long run equilibrium = where long-run AS curve crosses AD curve • Prices have adjusted to reach this equilibrium • Therefore, when economy is in long-run equilibrium, short-run AS curve crosses this point as well Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  28. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  29. From the Short-Run to the Long-Run • Suppose the central bank decreases money supply: • AD curve shifts to the left • In short-run: prices are sticky, economy moves from point A to point B • At point B: output and employment falls below natural levels and economy is in recession • Over time: wages and prices will fall in response to change in demand • There is a gradual movement in the economy to point C = the new long-run equilibrium Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  30. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  31. From the Short-run to the Long-run At point C: • output and unemployment are back to their natural levels • Prices are lower A shift in AD affects output in the short run, but his dissipates over time as firms adjust prices Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  32. Stabilisation Policy • Fluctuations in the economy come from • Changes in AS or AD • Exogenous changes: called shocks • Demand shock: shifts the AD curve • Supply shock: shifts the AS curve • Stabilisation policy = actions reduce severity of short run economic fluctuations Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  33. Shocks to AD • Example of a demand shock: introduction of credit cards: • Reduce quantity of money people hold • Reduction in quantity of money demanded • Velocity of money increases (money moves from hand to hand quicker) • If money supply is held constant, nominal spending rises and AD curve shifts outward • Economy moves from A to B Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  34. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  35. Shocks to AD • Cont’d: • Over time high AD pulls up wages and prices • As price rises, output demand falls • Economy moves to C • But the Central Bank could offset the increase in velocity by reducing money supply thereby eliminating the demand shock Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  36. Shocks to AS • Supply shocks: alters the cost of producing goods and services e.g. oil prices • Raising the world price of oil = adverse supply shock • Adverse supply shock: shifts the short run supply curve upwards • If AD is held constant economy moves from A to B (see graph) Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  37. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  38. Shocks to AS • At point B: price level rises, output falls • Central bank has two options: • Hold AD constant, lower output and employment. Eventually prices will fall and economy back to point A but will have gone through a recession • Expand AD to coincide with the AS shock: so economy immediately goes from point A to C but the price level is permanently higher Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  39. Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

  40. Summary: AD and AS model • Framework for studying economic fluctuations: AD and AS model • Prices are sticky in the short run and flexible in the long run • In this chapter, AD was derived very simply using the quantity theory of money but this derivation is incomplete for fully understanding AD • Next few chapters derives the AD curve in a complete fashion Source: Mankiw (2000) Macroeconomics, Fourth edition Chapter 9, Fifth edition Chapter 9

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