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Business-Finance

Published on April 9, 2008

Author: Heather

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Short Run Economic Fluctuation:  Short Run Economic Fluctuation Aggregate Demand And Aggregate Supply Short-Run Economic Fluctuation :  Short-Run Economic Fluctuation Economic activity fluctuates from year to year. In most years production of goods and services rises. On average, production in the U.S. economy has grown by about 3 percent per year over the past 50 years. In some years normal growth does not occur. Fluctuations in U.S. Real GDP, 1920-1999:  Fluctuations in U.S. Real GDP, 1920-1999 Short-Run Economic Fluctuation:  Short-Run Economic Fluctuation Recession (Contraction) A period of declining real incomes, and rising unemployment. Two quarters of shrinking GDP (negative growth). http://www.nber.org/cycles/main.html A depression is a severe recession. Recovery (Expansion) A period of economy growing at a rate significantly above normal. A boom is a particularly strong and protracted expansion. Short-Run Economic Fluctuation:  Short-Run Economic Fluctuation Three features of economic fluctuations: Irregularity and Unpredictability Co-movement of most macroeconomic quantities As output falls, unemployment rises Short-Run Economic Fluctuation:  Short-Run Economic Fluctuation Irregularity and unpredictability Cycles with no patterns Almost impossible to predict Length and severity varies over time A Look At Short-Run Economic Fluctuations:  A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars Real GDP (a) Real GDP $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000 Short-Run Economic Fluctuation:  Short-Run Economic Fluctuation Co-movement Real GDP Personal income Corporate profits Consumer spending Industrial production Retail, auto and home sales, etc. Inflation They fluctuate by different amount. A Look At Short-Run Economic Fluctuations:  A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars (b) Investment Spending $1,800 1,600 1,400 1,200 1,000 800 600 400 200 1965 1970 1975 1980 1985 1990 1995 2000 Investment spending Copyright © 2004 South-Western U.S. Inflation, 1960-1999:  U.S. Inflation, 1960-1999 Short-Run Economic Fluctuation:  Short-Run Economic Fluctuation As output falls, unemployment rises When firms choose to produce a smaller amount of goods and services, they lay off workers. Output depends on an economy’s utilization of its labor force. Okun’s Law A Look At Short-Run Economic Fluctuations:  A Look At Short-Run Economic Fluctuations Percent of Labor Force (c) Unemployment Rate 0 2 4 6 8 10 12 1965 1970 1975 1980 1985 1990 1995 2000 Unemployment rate Copyright © 2004 South-Western Why There Is Short-Run Fluctuation:  Why There Is Short-Run Fluctuation In the long run Classical dichotomy holds Monetary neutrality holds Money supply affect prices and other nominal variables but not real GDP, unemployment, and other real variables. In the short run Classical dichotomy doesn’t hold Monetary neutrality fails Money supply affect prices and other nominal variables as well as real GDP, unemployment, and other real variables. The Basic Model of Economic Fluctuation:  The Basic Model of Economic Fluctuation Demand and Supply analysis of commodity: Price Quantity Aggregate Demand and Aggregate Supply analysis: Price level (GDP deflator or CPI) Total output (real GDP) AD-AS Model:  AD-AS Model Aggregate Demand curve Shows the quantity of goods and services that households, firms, and the government want to buy at each price level. Aggregate Supply curve Shows the quantity of goods and services that firms choose to produce and sell at each price level. Aggregate Demand and Aggregate Supply...:  Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Copyright © 2004 South-Western Derivation of AD Curve:  Derivation of AD Curve Why it is downward sloping? Lowering price level increase quantity of aggregate demand Recall Y = C + I + G + NX Suppose G is fixed by policy regardless of price level. Three possible channels: C I NX Derivation of AD Curve:  Derivation of AD Curve The Price Level and Consumption: The Wealth Effect A decrease in the price level makes consumers feel more wealthy, in turn encourages them to spend more. An increase in consumer spending larger quantities of goods and services demanded. Derivation of AD Curve:  Derivation of AD Curve The Price Level and Investment: The Interest Rate Effect A lower price level induces households to hold less money in cash by saving more in bank to earn interest An increase in supply of loanable funds reduces the interest rate, which encourages borrowing by firms to spend on investment goods. An increase in investment spending a larger quantity of goods and services demanded. Derivation of AD Curve:  Derivation of AD Curve The Price Level and Net Exports: The Exchange-Rate Effect A fall in the U.S. price level causes U.S. interest rates to fall. American investors seek higher returns by investing abroad to acquire assets in foreign countries. An increase in dollar supply in exchange market lowers the real exchange rate of dollar. The real exchange rate depreciates, U.S. goods become relatively cheaper than foreign goods. Export rises, import declines, net exports increase. The Aggregate-Demand Curve...:  The Aggregate-Demand Curve... Quantity of Output Price Level 0 Shifts of AD Curve:  Shifts of AD Curve Changes in real output or aggregate demand for each given price level,. What might change C, I, G, and NX for reasons other than a change in the price level? Shifts of AD Curve:  Shifts of AD Curve Consumption Events that might cause consumers to spend more. Tax cut Stock market boom Baby boom AD curve shifts to the right Shifts of AD Curve:  Shifts of AD Curve Investment Events that make firms invest more at a given price level A new cost-cutting technology is introduced Optimistic about future business An investment tax credit Lower interest rate due to an increase in money supply AD curve shifts to the right Shifts of AD Curve:  Shifts of AD Curve Government purchases An increase in government purchases of goods and services. More spending on new weapons More interstate highway construction AD curve shifts to the right Shifts of AD Curve:  Shifts of AD Curve Net exports Events that raise net exports (increase export, decrease import, or both) at any given price level. Booms in Europe A sharp appreciation of Chinese Yuan against Dollar AD curve shifts to the right Shifts in the Aggregate Demand Curve:  Shifts in the Aggregate Demand Curve 0 P1 Y1 Derivation of AS Curve:  Derivation of AS Curve Aggregate Supply Curve The relationship b/w the price level and the quantity of goods and services supplied, depending on the time horizon being examined. Long run AS curve Vertical Short run AS curve Upward sloping Long-Run AS Curve:  Long-Run AS Curve Recall: In the long run, classical dichotomy holds. Y = A F( L, K, H, N) The price level does not affect these variables in the long run The long-run AS curve is vertical at Y* Y* is the natural rate of output, potential output, or full-employment output. The Long-Run Aggregate-Supply Curve:  The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 The Shifts of Long Run AS Curve:  The Shifts of Long Run AS Curve Any changes in the economy that alters the natural rate of output, Y*, shifts the long-run aggregate-supply curve. Y = A F( L, K, H, N) Immigration, demographic changes Physical and human capital changes New mineral deposit, weather Invention of computers, open-up to international trade. The Shifts of Long Run AS Curve An Example:  The Shifts of Long Run AS Curve An Example In the long run: Technological progress shifts long-run AS curve to the right The Fed increases the money supply over time, which raise aggregate demand. Result: growth in output and increase in price level Long-Run Growth and Inflation:  Long-Run Growth and Inflation Quantity of Output Price Level 0 Short Run AS curve:  Short Run AS curve Short-run fluctuations in output and price level are deviations from the continuing long-run trends. In the Short Run An increase in the overall level of prices raise the quantity of goods and services supplied. A decrease in the overall level of prices reduce the quantity of goods and services supplied. The Short-Run Aggregate-Supply Curve:  The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Copyright © 2004 South-Western Derivation of Short-Run AS Curve:  Derivation of Short-Run AS Curve Sticky-Wage Theory Nominal wage is often slow to adjust b/w firms and workers. A sudden decrease in price level Firm pays higher real wage than it expected. Firm cannot renegotiate immediately with workers for a lower wage, firm’s cost is rising. Firm hires less labor and produce smaller quantity of goods and services Derivation of Short-Run AS Curve:  Derivation of Short-Run AS Curve Sticky-Price Theory The prices of some goods and services are also slow to respond to changes in the economy, called menu costs. A sudden decrease in price level Firm cannot adjust its price immediately, suffers sales losses. Firm cut its production of goods and services. Derivation of Short-Run AS Curve:  Derivation of Short-Run AS Curve The Misperception Theory Changes in the overall price level can temporarily mislead suppliers about the market conditions. A sudden decline of price level. Suppliers mistakenly believe the price of their product falls. Supplying the products is less profitable. Firms decrease the quantity that they supply Same story for workers see a sudden decline in nominal wage. Derivation of Short-Run AS Curve:  Derivation of Short-Run AS Curve Note: Each of these suggest that output deviates from its natural rate when the price level deviate from the price level people expected. Y = Y* + α ( P – Pe ) People will adjust Pe in the long run to be consistent with P, thus output will return to its natural level, which gives the long run vertical AS curve. The Long-Run Equilibrium:  The Long-Run Equilibrium Quantity of Output Price Level 0 Copyright © 2004 South-Western The Shifts of Short Run AS Curve:  The Shifts of Short Run AS Curve Events that shift the long-run AS curve will shift the short-run AS curve as well L, K, H, N, and A Expectations of the price level ( Pe ) shifts the short-run AS curve, though they don’t affect long-run AS curve. Higher expected price level → SAS shifts to the left Lower expected price level → SAS shifts to the right Two Causes of Economic Fluctuations:  Two Causes of Economic Fluctuations Shifts in AD curve, an example Pessimism causes household spending and investment decline AD shifts to the left In short run, price level and output both fall, a recession. Two policy options: Government intervention Leave it alone Two Causes of Economic Fluctuations:  Two Causes of Economic Fluctuations If government intervenes AD curve shifts back If government does nothing People correct misperception, expected price falls. Short-run AS curve shifts to the right In the long-run, the decrease in AD solely decreases equilibrium price level. The long-run effect of a change in AD is a nominal change (price level) but not a real change (output unchanged) A Contraction in Aggregate Demand:  A Contraction in Aggregate Demand Quantity of Output Price Level 0 Long-run aggregate supply Two Causes of Economic Fluctuations:  Two Causes of Economic Fluctuations More examples of AD driven fluctuations: The Great Depression The World War II boom The recession of 2001 Burst of dot.com bubbles Terrorist attack with increasing uncertainty Corporate accounting scandals Two Causes of Economic Fluctuations:  Two Causes of Economic Fluctuations Shift in short-run AS curve, an example Firms experience a sudden increase in oil price, thus cost of production increases. SAS shifts to the left Output falls below the natural rate of employment. Unemployment rises. The price level rises. Stagflation: a period of falling output and rising prices An Adverse Shift in Aggregate Supply:  An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Long-run aggregate supply Copyright © 2004 South-Western Two Causes of Economic Fluctuations:  Two Causes of Economic Fluctuations Policy options: Shift in AD curve Permanently higher inflation End of recession Do nothing Price expectation adjusts SAS shifts back to right Accommodating an Adverse Shift in Aggregate Supply:  Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply Aggregate demand, AD Copyright © 2004 South-Western

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