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Introduction to Economic Fluctuations

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					Introduction to Economic
      Fluctuations
Chapter 11 of Macroeconomics, 7th
  edition, by N. Gregory Mankiw
        ECO62 Udayan Roy
        Short-Run Fluctuations
• We have discussed the behavior of an
  economy in the long run
• In the short run, the economy fluctuates
  around its long-run path
• We need to understand why these
  fluctuations happen …
• … and what can be done to stabilize the
  economy—as far as possible—when
  fluctuations occur
BUSINESS-CYCLE FACTS
  Some facts about the business cycle
• GDP growth averages 3 to 3.5 percent per year in
  the US over the long run
• But there are large fluctuations in the short run.
• Consumption and investment fluctuate with GDP,
  but consumption tends to be less volatile and
  investment more volatile than GDP.
• Unemployment rises during recessions and falls
  during expansions.
  – Okun’s Law: there is a reliable negative relationship
    between the GDP growth rate and changes in the
    unemployment rate.
                 Growth rates of real GDP, consumption
Percent     10                            Real GDP
 change                                   growth rate
  from 4    8
quarters                                                 Consumption
  earlier                                                 growth rate
            6


Average     4
 growth
    rate    2


            0


            -2


            -4
              1970   1975   1980   1985    1990   1995   2000   2005    2010
            Growth rates of real GDP, consumption, investment
Percent                                     Investment
 change      40                             growth rate
  from 4
quarters     30
  earlier
             20
                                            Real GDP
             10                             growth rate

              0
                                                    Consumption
             -10                                     growth rate

             -20


             -30
                1970   1975   1980   1985    1990   1995   2000   2005   2010
                          Unemployment
Percent    12
of labor
   force   10


           8


           6


           4


           2


           0
            1970   1975   1980   1985   1990   1995   2000   2005   2010
                                   Okun’s Law
Percentage
          10
                                                            Y
 change in                          1966
                                                                3  2 u
                       1951                                 Y
  real GDP 8
                    1984
           6
                                                      2003
           4
                                                            1971
                            1987
           2                                                       2008

           0                                                              1975
                                        2001
          -2                                         1991      1982

          -4
               -3          -2      -1          0        1           2     3      4
                                                   Change in unemployment rate
 Index of Leading Economic Indicators
• Published monthly by the Conference Board.
• Aims to forecast changes in economic activity
  6-9 months into the future.
• Used in planning by businesses and
  government, even though ILEI is not a perfect
  predictor.
          Components of the ILEI
• Average workweek in manufacturing
• Initial weekly claims for unemployment insurance
• New orders for consumer goods and materials, adjusted for
  inflation
• New orders, nondefense capital goods, adjusted for inflation
• Index of supplier deliveries (vendor performance)
• New building permits issued
• Index of stock prices
• Money supply (M2), adjusted for inflation
• Yield spread (10-year minus 3-month) on Treasuries
• Index of consumer expectations
                      Index of Leading Economic Indicators
                120

                110

                100
   2004 = 100




                 90

                 80

                 70

                 60

                 50

                 40

Source: 30
Conference 1970         1975   1980   1985   1990   1995   2000   2005   2010
Board
SHORT-RUN PRICE STICKINESS IS THE
ROOT CAUSE OF FLUCTUATIONS
Time horizons in macroeconomics
• Long run
  Prices are flexible, respond to changes in
  supply or demand.
• Short run
  Many prices are “sticky” at a predetermined
  level.
           The economy behaves very
       differently when prices are sticky.
    Recap of classical macro theory
                       (Chaps. 3-8)

• Output is determined by the supply side:
  – supplies of capital, labor
  – Technology
  – Y = F(K, L)
• Changes in demand for goods and services
  (C, I, G) only affect prices (r), not output.
• Assumes complete flexibility of overall price
  level (P).
• Applies to the long run.
        When prices are sticky…
… output and employment also depend on
  demand,
And demand is affected by:
  – fiscal policy (G and T)
  – monetary policy (M)
  – other factors, like exogenous changes in
    C or I
      The role of price stickiness
• When P is flexible, recessions would not occur
  – Under price and wage flexibility, if any recession
    did occur it would quickly be over …
  – … because unemployed workers would accept
    lower and lower wages, prices would drop, and
    customers would flock to the malls, thereby
    ending the recession
• To explain why recessions do in fact occur, we
  therefore need to assume that prices are
  sticky or rigid
             “Price Stickiness”
• Price stickiness does not necessarily mean
  that the overall level of prices (P) is constant
• All that price stickiness means is that P has
  stopped responding to the economic factors
  that you would expect to affect P
• P may be increasing or decreasing, but in that
  case it would be doing so purely on
  momentum, and not because of some
  economic cause
           The role of shocks
• Price stickiness helps us explain why an
  economy that has fallen into a recession may
  continue in a recession
• But price stickiness does not explain why the
  economy got into trouble in the first place
• For that we need shocks that can explain why
  businesses may suddenly see there customers
  stop buying
                The role of shocks
•   Consumption function: Co + Cy(Y – T)
•   Investment function: Io + Irr
•   Net exports function: NXo + NXεε
•   Fiscal policy (G and T)
•   Monetary policy (M)
•   Business costs (for example, costlier imported oil)

• These shocks can throw an economy off its long-run
  path
• Price stickiness then impedes a quick bounce back to
  the long-run path
STABILIZATION POLICY
      Fiscal and Monetary Policy
• We have seen that, in the long run, changes in G
  and T have no effect on Y
• In the short run, G and T can affect Y
• We have seen that, in the long run, changes in M
  affect only P and have no effect on Y
  – Recall “classical dichotomy” and “monetary
    neutrality” from chapter 4
• In the short run, M cannot affect P, which is
  sticky, but it can affect Y
• Therefore, G, T and M can be used to stabilize Y
  and other economic variables
CASE STUDY: SHOCKS TO BUSINESS
COSTS
                  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.
               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.
                          CASE STUDY:
                      The 1970s oil shocks
                        70%
                                                                        12%
Predicted effects       60%
of the oil shock:       50%                                             10%
 • inflation           40%
 • output              30%
                                                                        8%
 • unemployment        20%
                                                                        6%
…and then a gradual     10%
recovery.
                         0%                                              4%
                           1973   1974       1975        1976         1977

                                  Change in oil prices (left scale)
                                  Inflation rate-CPI (right scale)
                                  Unemployment rate (right scale)
                         CASE STUDY:
                     The 1970s oil shocks
                       60%                                             14%

Late 1970s:            50%
                                                                       12%
 As economy
                       40%
was recovering,                                                        10%
oil prices shot up     30%
again, causing                                                         8%
                       20%
another huge                                                           6%
supply shock!!!        10%

                        0%                                             4%
                         1977   1978       1979         1980        1981

                                Change in oil prices (left scale)
                                Inflation rate-CPI (right scale)
                                Unemployment rate (right scale)
                            CASE STUDY:
                        The 1980s oil shocks
                         40%                                               10%
1980s:                   30%
                                                                           8%
A favorable              20%
supply shock--           10%
                                                                           6%
a significant fall in     0%

oil prices.              -10%
                                                                           4%
                         -20%
As the model
                         -30%                                              2%
predicts,
                         -40%
inflation and
                         -50%                                              0%
unemployment                1982   1983    1984     1985      1986      1987
fell:
                                    Change in oil prices (left scale)
                                    Inflation rate-CPI (right scale)
                                    Unemployment rate (right scale)

				
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