Chapter 10 - Introduction to macroeconomic fluctuations Flashcards
When is it a recession?
Old rule of thumb – a period of at least two consecutive quarters of declining GDP i.e. negative growth rate
What are the most volatile components of GDP?
Growth in consumption and investment decline when there is a recession. Investment is far more volatile than consumption over the business cycle
What is the average GDP growth?
3-3.5%
What are cyclical fluctuations?
When actual GDP differs from structural GDP
Structural GDP cannot be observed but can be estimated by use of an economic model: Y=F(K ̅,(EL) ̅)
Output gap=(GDP-Structural GDP)/(Structural GDP)
What is Okun’s law?
Short run: Negative relationship between unemployment and GDP – when real GDP declines, unemployment increases
In the long run: GDP determined by growth of technology and capital accumulation, Okun’s law does not apply
Short-run movements in GDP are highly correlated with the utilisation of the economy’s labour force
What is classical economic theory?
Chapters 3-9
Output is determined by supply side – supplies of capital, labour, technology
Changes in demand for goods and services (C;I;G) only affect prices, not quantities
Complete price flexibility is a crucial assumption
Classical theory applies in the long run
How does the short-run and the long-run differ?
Behaviour of prices, i.e. sticky in the short run and flexible in the long (respond to supply and demand)
Hence, output and employment also depend on demand for goods and services which is affected by fiscal policy (G and T), monetary policy (M), other factors like exogenous changes in C or I
Suppose CB reduces money supply, what happens in the short and long run respectively?
In the long run – money supply affects nominal variables but not real variables (remember classical dichotomy and monetary neutrality)
Thus, in the long run – 5% reduction in M lowers all prices by 5%, while output, employment and other real variables remain the same. Changes in M do not cause fluctuations in output and employment
In the short run – many prices do not respond to changes in monetary policy
The failure of prices to adjust quickly and completely means that, in the short run, real variables such as output and employment must do some of the adjusting instead – classical dichotomy no longer holds
How does the economy work differently when prices are sticky?
Output also depends on the economy’s demand for goods and services
As monetary and fiscal policy can influence demand, and demand can influence economy’s output, price stickiness provides a rationale for why these policies may be useful to stabilise economy in the short run
What is aggregate demand?
The relationship between the quantity of output demanded and the aggregate price level
The aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices
The aggregate demand curve is drawn for a fixed value of M, tells us the possible combinations of P and Y for a given value of M
Why does the aggregate demand curve slope downward?
M and V determine the nominal value of output PY
Once PY is fixed, if P goes up, Y must go down
If output is higher, people engage in more transactions and need higher real balances M/P
For a fixed M, higher M/P implies lower P
Another explanation – as we have assumed V is fixed, M determines the euro value of all transactions in the economy, if P rises, each transaction requires more euros i.e. the number of transactions and thus quantity of goods and services purchased must fall
What happens to the aggregate demand curve if the CB reduces money supply?
MV = PY, tells us that reduction in M leads to proportionate reduction in PY
i.e. for any given P, Y is lower and for any given Y, P is lower
opposite if CB increases M
What is aggregate supply?
The relationship between the quantity of goods and services supplied and the price level
Two different supply curves, depending on the time horizon – LRAS and SRAS
What is the aggregate supply curve in the long run? And what determines the price level?
Y=F(K ̅,L ̅ )=Y ̅
Output produced depends on the fixed amounts of capital and labour and on the available technology
What is the natural level of unemployment?
The average rate of unemployment around which the economy fluctuates (i.e., it applies to the long run). In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual unemployment rate falls below the natural rate. Depends on structural conditions such as unemployment benefits, regulations of hiring and firing, active labour market policies, skills in the population and population composition.
What is Y ̅?
The full-employment or natural level of output, the level of output at which the economy’s resources are fully employed. “Full employment” means that unemployment equals its natural rate.
What happens if the real wage is stuck above the equilibrium?
There are not enough jobs to go around
Firms must ration the scarce jobs among workers
Structural unemployment – the unemployment resulting from real wage rigidity and job rationing
What is the aggregate supply curve in the long run ?
Vertical aggregate supply curve (output does not depend on price level)
Full-employment level of output
In the long run, the intersection of the aggregate demand curve with this aggregate supply curve determines the price level
If aggregate supply curve is vertical, changes in aggregate demand affect prices, but not output
Satisfies classical dichotomy as it implies the level of output is independent of M
What happens to the long-run aggregate supply curve if there is an increase in M?
An increase in M shifts the AD curve to the right. In the long run this increases the price level but leaves output the same.
What is the aggregate supply curve in the short run?
Assume all prices stuck at predetermined levels
At these prices, firms are willing to sell as much as their customers are willing to buy, and they hire just enough labour to produce amount demanded
The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this horizontal short-run aggregate supply curve
Changes in aggregate demand do affect level of output
What happens in the short-run aggregate supply curve if CB reduces M?
Aggregate demand curve shifts inward
Decline in output at fixed price level
A fall in aggregate demand reduces output in the short run because prices do not adjust instantly
Firms stuck with too high prices – with low demand and high prices firm sell less, hence they reduce production and lay off workers
What happens in the short-run if there is an increase in M?
When prices are sticky, an increase in aggregate demand causes output to rise.
What happens in the short vs. the long run if CB reduces M and the aggregate demand curve shifts inward?
In the short run, output and employment fall below their natural levels and the economy is in a recession
Over time, in response to the low demand, wages and prices fall
The gradual reduction in the price level moves the economy downward along the aggregate demand curve
In the new long-run equilibrium, output and employment are back to their natural levels, but prices are lower than in the old long-run equilibrium
Is it in the short or the long run that aggregate demand affects output?
Over long periods of time, prices are flexible, the aggregate supply curve is vertical and changes in aggregate demand affect the price level but not output. Over short periods of time, prices are sticky, the aggregate supply curve is flat and changes in aggregate demand do affect the economy’s output
What are shocks to the economy?
Exogenous evens that shift aggregate demand or aggregate supply curve – shocks to the economy
These shocks disrupt the economy by pushing output and employment away from their natural levels
What are stabilization policies?
Policy actions aimed at reducing the severity of short-run economic fluctuations
Dampens business cycle by keeping output and employment as close to their natural levels as possible
What happens to aggregate demand and the economy if there is a reduction in the quantity if money people choose to hold? And what can the CB do?
Reduction in money demand is equivalent to an increase in V
When each person holds less money, money demand parameter falls, i.e. V (1/k) increases
If M is constant, the increase in V causes nominal spending to rise and the aggregate demand curve to shift outward
In the short run, the increase in demand raises the output of the economy – i.e. a boom
Over time, high level of aggregate demand pulls up wages and prices, as the price level increases, the quantity of output demanded declines, the economy gradually approaches natural level
To dampen boom and keep output closer to natural level, the CB can reduce M to offset increase in V, which would stabilize aggregate demand
What is a supply shock?
A shock to the economy that alters the cost of producing goods and services, and, as a result, the prices that firms charge
Direct impact on price level – sometimes called price shocks
Adverse supply shock – push costs and prices upward
Favourable supply shock – reduces costs and prices
How does an adverse supply shock affect the economy and what can policy makers do?
Short-run aggregate supply curve shifts upward
If aggregate demand is held constant, the price level rises, and the amount of output falls below natural level
Stagflation – falling output (stagnation) and inflation
Two options:
(1) hold aggregate demand constant, output and employment lower than natural level, eventually, prices will fall to restore full employment at the old price level, but the cost of this adjustment is painful recession
(2) expand aggregate demand to bring economy towards natural level of output more quickly
CB accommodates supply shock. The drawback is that the price level is permanently higher
There is no way to adjust aggregate demand to maintain full employment and keep price level stable
