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IS-LM/AD-AS

IS-LM/AD-AS. Demand and Supply Shocks: Exploring Business Cycles. Learning Objectives. To understand the difference between demand shocks and supply shocks. To understand how demand shocks and supply shocks cause business cycles.

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IS-LM/AD-AS

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  1. IS-LM/AD-AS Demand and Supply Shocks: Exploring Business Cycles

  2. Learning Objectives • To understand the difference between demand shocks and supply shocks. • To understand how demand shocks and supply shocks cause business cycles. • To consider the efficacy of government policy designed to stabilize the economy.

  3. Business Cycles • Causes: • Fluctuations in aggregate demand • Collapse of confidence of investors • Inappropriate monetary policy • Inappropriate fiscal policy • Fluctuations in aggregate supply • Change in the availability of a crucial natural resource • Technology

  4. Demand Shocks • If most shocks experienced by an economy are demand shocks, the relationship between GDP growth and inflation will be direct or as GDP increases, so does inflation. • Therefore, a plot of GDP growth points and their associated inflation levels would follow an upward-sloping aggregate supply curve. • Prices are procyclical.

  5. Demand Shocks P p 10 0 -10 -20 -30 LRAS SRAS C A AD3 B AD1 AD2 /\Y/Y Y* Y 0 -20 -10 0 10 20 A B B Macroeconomics, Farmer, p. 270

  6. Demand Shocks: 1921-1939 • Panel A • When aggregate demand shifts to the right, output and the price level increase. • When aggregate demand shifts to the left, output and the price level decrease. • Panel B • Note that the pattern of observations follow an upward slope as expected.

  7. Demand Shocks • Great Depression • Economists argue that the depression was caused by a left-ward shift of the aggregate demand curve from AD1 to AD2. • As the price level fell, real wages increased, causing a rise in unemployment above the natural rate. • Nominal wages did fall during the depression, but they fell more slowly than the price level.

  8. Demand Shocks • World War II • During WWII, the aggregate demand curve shifted from AD1 to AD3. • As the price level rose, real wages decreased, causing a fall in unemployment below the natural rate. • Nominal wages were controlled by wage and price controls during much of WWII.

  9. Supply Shocks • If most shocks experienced by an economy are supply shocks, the relationship between GDP growth and inflation will be inverse or as GDP increases, inflation decreases. • Therefore, a plot of GDP growth points and their associated inflation levels would follow a downward-sloping aggregate demand curve. • Prices are counter-cyclical.

  10. Supply Shocks P p LRAS 10 0 -10 -20 -30 SRAS2 SRAS1 SRAS3 D A E AD /\Y/Y 0 Y* Y -20 -10 0 10 20 D C Macroeconomics, Farmer, p. 270

  11. Supply Shocks: 1970-1989 • Panel C • When aggregate supply shifts to the right, output increases and the price level decreases. • When aggregate supply shifts to the left, output decreases and the price level increases. • Panel D • Note that the pattern of observations follow a downward slope as expected.

  12. Supply Shocks • Oil Shocks • During the 1970s and in 1990, the short-run aggregate supply curve shifted from AS1 to AS2. • Oil price increases cause domestic technology to produce less output for a given input of labor and capital because many technologies rely heavily on oil products. Costs and prices rise. • Inflation increased and output decreased.

  13. Supply Shocks • Technology Shocks • During the late 1990s, the short-run aggregate supply curve shifted from AS1 to AS3. • Improvements in technology increased labor productivity and shifted aggregate supply to the right. • Inflation decreased and output increased.

  14. Macroeconomic Stabilization • Does economic stabilization work? • The government must first recognize that there is a recession. Data available are often incomplete. • Once the problem is recognized, the government may use either fiscal policy or monetary policy. • Fiscal policy can take a year or more to get through Congress. • Monetary policy can be implemented more quickly, but there is a long and unpredictable lag between implementation and impact.

  15. Macroeconomic Stabilization • Does economic stabilization work? • Expectations are not exogenous, but rather change as the economic environment changes. • If people take actions to protect their own economic welfare that counter government policies, those policies will be less effective.

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