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What Explains Business Cycle Fluctuations

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What Explains Business Cycle Fluctuations Powered By Docstoc
					                                                               Agenda
                                                               • Business Cycle Analysis: A Preview.

                                                               • The Problem of Unemployment.
     The IS – LM / AD – AS Model:
       A General Framework for                                 • The Problem of Inflation.
       Macroeconomic Analysis,
                Part 1


                                                        21-1                                                           21-2




Business Cycle Analysis: A Preview                             Business Cycle Analysis: A Preview
• What explains business cycle fluctuations?                   • What explains business cycle fluctuations?

    2 major components of business cycle theories:                 Both theories can be studied in an aggregate
                                                                   demand-aggregate supply (AD-AS) framework.
     • A description of the shocks.
     • A model of how the economy responds to shocks.              The AD-AS model has 3 main components:

    2 major business cycle theories:                                • An aggregate demand (AD) curve,
                                                                    • A short-run aggregate supply (SRAS) curve, and
     • Classical theory.                                            • A long-run aggregate supply (LRAS) curve.
     • Keynesian theory.

                                                        21-3                                                           21-4




                                                                                                                              1
Business Cycle Analysis: A Preview                                       The Aggregate Demand Curve
• AD and AS—A brief introduction:
    The aggregate demand (AD) curve:

     • Shows quantity of goods and services demanded (Y)
       for any price level (P).

     • A higher P means less aggregate demand (lower Y),
        – The aggregate demand curve slopes downward.

     • An increase in aggregate demand for a given P shifts
       the aggregate demand curve to the right.

                                                                  21-5                                          21-6




Business Cycle Analysis: A Preview                                       The Short-run Aggregate Supply Curve
• AD and AS—A brief introduction:

    The short-run aggregate supply (SRAS) curve:

     • The short-run aggregate supply curve shows how much
       output (Y) producers are willing to supply in the short-
       run at any given price level (P).

     • The short-run aggregate supply curve is horizontal.
        – We assume the prices are fixed in the short run.




                                                                  21-7                                          21-8




                                                                                                                       2
Business Cycle Analysis: A Preview                                       The Long-run Aggregate Supply Curve
• AD and AS—A brief introduction:
    The long-run aggregate supply (LRAS) curve:

     • The long-run aggregate supply curve shows how much
       output (Y) producers are willing to supply in the long-
       run at any given price level (P).

     • The long-run aggregate supply curve is vertical at the
       full-employment level of output.




                                                                  21-9                                         21-10




Business Cycle Analysis: A Preview                                       The AD-AS Model
• AD and AS—A brief introduction:
    Equilibrium in the AD—AS model:

     • Short-run equilibrium: At the Y and P where the
       aggregate demand (AD) curve intersects the short-run
       aggregate supply (SRAS) curve.

     • Long-run equilibrium: At the Y and P level where the
       aggregate demand (AD) curve intersects the long-run
       aggregate supply (LRAS) curve.


                                                                 21-11                                         21-12




                                                                                                                       3
Business Cycle Analysis: A Preview                                     Business Cycle Analysis: A Preview
• Business cycles occur because of:                                    • Example: A negative AD shock:

    Aggregate demand shocks:                                               The aggregate demand curve shifts to the left:
     • A positive AD shock shifts the AD curve to the right.
     • A negative AD shock shifts the AD curve to the left.                 • Short-run equilibrium occurs where the AD curve
                                                                              intersects the SRAS curve; Y falls, P is unchanged.
    (Permanent) Aggregate supply shocks:
                                                                            • Long-run equilibrium occurs where the AD curve
     • A positive (permanent) AS shock shifts the LRAS curve                  intersects the LRAS curve; Y is unchanged, P falls.
       to the right.
     • A negative (permanent) AS shock shifts the LRAS curve
       to the left.

                                                               21-13                                                                             21-14




A Negative AD Shock                                                    Business Cycle Analysis: A Preview

          P                   LRAS                                     • Example: A negative AD shock:

                                                                           How long does it take to get to the long run?

                                                                            • Classical theory: prices adjust rapidly.
                                                                               – So recessions are short-lived and
         P0                                       SRAS
                                                                               – There is no need for government intervention.

                                                                            • Keynesian theory: prices and wages adjust slowly.
                                                                               – Adjustment may take several years and
                                                  AD
                                                                               – The government can fight recessions by taking action to shift
                                                                                 the AD curve .
                               Y0             Y
                                                               21-15                                                                             21-16




                                                                                                                                                         4
Business Cycle Analysis: A Preview                                     Business Cycle Analysis: A Preview
• Example: A negative (permanent) AS shock :                           • Example: A negative (permanent) AS shock :

    Permanent aggregate supply shocks shift the                             A permanent, negative aggregate supply shock
    LRAS curve.                                                            reduces full-employment output and shifts the
     • Permanent changes in productivity or labor supply can               LRAS curve to the left.
       cause supply shocks.
                                                                            • The new long-term equilibrium is lower output and a
    Classicals view LRAS shocks as the main cause                             higher price level.
    of fluctuations in output.                                                   – A recession is accompanied by higher price level.

     • Keynesians also recognize the importance of supply
       shocks.

                                                               21-17                                                                   21-18




A Negative Permanent AS Shock                                          Business Cycle Analysis: A Preview

          P                  LRAS                                      • Business cycles are caused by both aggregate
                                                                         demand and aggregate supply shocks hitting
                                                                         the economy.

                                                                           Depending on the type(s) of shock(s), there are a
         P0                                      SRAS                      variety of possible outcomes for Y and P.
                                                                            •   Higher Y, higher P.
                                                                            •   Higher Y, lower P.
                                                 AD
                                                                            •   Lower Y, lower P.
                                                                            •   Lower Y, higher P.
                              Y0             Y
                                                               21-19                                                                   21-20




                                                                                                                                               5
The Problem of Unemployment                                                  The Problem of Unemployment
• The costs of unemployment:                                                 • The costs of unemployment:

    Loss in output from idle resources:                                          Loss in output from idle resources:

     • If full-employment output is $15 trillion, each                            • Workers lose income.
       percentage point of unemployment sustained for one                         • Business firms lose profits.
       year costs $300 billion according to Okun’s Law.                           • Government loses tax revenues.
            »
                                                                                     – And increases spending for unemployment benefits and other
        – Each percentage point of cyclical unemployment is associated                 transfer payments.
          with a loss equal to 2% of full-employment output.




                                                                     21-21                                                                          21-22




The Problem of Unemployment                                                  The Problem of Unemployment
• The costs of unemployment:                                                 • The benefits of unemployment:

     Personal or psychological cost to workers and                               There are some offsetting factors:
    their families.
                                                                                  • Unemployment leads to increased job search and
     • Especially important for those with long spells of                           acquiring new skills, which may lead to increased
       unemployment.                                                                future output.

                                                                                  • Unemployed workers have increased leisure time,
                                                                                    though most wouldn’t feel that the increased leisure
                                                                                    compensated them for being unemployed.


                                                                     21-23                                                                          21-24




                                                                                                                                                            6
The Problem of Inflation                                                  The Problem of Inflation
• The costs of inflation:                                                 • The costs of inflation:

     Perfectly anticipated inflation:                                          Perfectly anticipated inflation:

     • No effect if all prices and wages keep up with                          • Shoe-leather costs: People spend resources to
       inflation.                                                                economize on currency holdings.
                                                                                  – The estimated cost of 10% inflation is 0.3% of GNP.
     • Even returns on assets may rise exactly with inflation.
                                                                               • Menu costs: the costs of changing prices.
                                                                                  – May be mitigated somewhat by technology.




                                                                  21-25                                                                   21-26




The Problem of Inflation                                                  The Problem of Inflation
• The costs of inflation:                                                 • The costs of inflation:

     Unanticipated inflation, when π – πe = 0:                                 Unanticipated inflation, when π – πe = 0:

     • Realized real returns differ from expected real returns:                • Result: unanticipated transfer of wealth.
                                                                                  – From lenders to borrowers when π > πe.
        – Expected r: re = i – πe.                                                – From borrowers to lenders when π < πe.
        – Actual r: r = i – π.
        – Actual r differs from expected r by πe – π.                          • People want to avoid the risk of unanticipated
                                                                                 inflation.
     • Similar effect on wages and salaries.                                      – They spend resources to forecast inflation.


                                                                  21-27                                                                   21-28




                                                                                                                                                  7
The Problem of Inflation                                                      The Problem of Inflation
• The costs of inflation:                                                     • The costs of inflation:

     Unanticipated inflation, when π – πe = 0:                                     The costs of hyperinflation:

     • Loss of valuable signals provided by prices:                                • Hyperinflation is a very high, sustained inflation

        – Confusion over changes in aggregate prices vs. changes in                   – Generally, 50% or more per month.
          relative prices.
                                                                                      – Hungary in August 1945 had inflation of 19,800% per
        – People expend resources to extract correct signals from                       month.
          prices.
                                                                                      – Bolivia had annual rates of inflation of 1281% in 1984,
                                                                                        11,750% in 1985, 276% in 1986.

                                                                      21-29                                                                       21-30




The Problem of Inflation                                                      The Problem of Inflation
• The costs of inflation:                                                     • The costs of inflation:

     The costs of hyperinflation:                                                  The costs of hyperinflation:

     • There are large shoe-leather costs because people                           • Real tax collections fall because people pay taxes with
       minimize cash balances.                                                       money whose value has declined sharply.

     • People spend many resources getting rid of money as                         • Prices become worthless as signals, so markets become
       fast as possible.                                                             extremely inefficient.




                                                                      21-31                                                                       21-32




                                                                                                                                                          8
The Problem of Inflation                                                                The Problem of Inflation
• Fighting inflation:                                                                   • Fighting inflation:

     The role of inflationary expectations:                                                  The role of inflationary expectations:

     • If rapid money growth causes inflation, why do central                                • Disinflation is a reduction in the rate of inflation.
       banks allow the money supply to grow rapidly?
                                                                                                 – But disinflations may lead to recessions.
        – Developing or war-torn countries may not be able to raise
          taxes or borrow, so they print money to finance spending.                              – An unexpected reduction in actual inflation leads to a rise in
                                                                                                   unemployment along the Phillips curve.
        – Industrialized countries may try to use expansionary
          monetary policy to fight recessions, then not tighten monetary                     • The costs of disinflation could be reduced if expected
          policy enough later.
                                                                                               inflation fell at the same time actual inflation fell.
                                                                                21-33                                                                               21-34




The Problem of Inflation                                                                The Problem of Inflation
• Fighting inflation:                                                                   • Fighting inflation:

     The role of inflationary expectations:                                                 The role of inflationary expectations:

                                                                                             • Keynesians disagree with rapid disinflation:
     • Rapid versus gradual disinflation:
                                                                                                 – Price stickiness due to menu costs and wage stickiness due to
        – The classical prescription for disinflation is cold turkey—a                             labor contracts make adjustment slow.
          rapid and decisive reduction in money growth.
                                                                                                 – Cold turkey disinflation would cause a major recession.
            » Proponents argue that the economy will adjust fairly quickly,
              with low costs of adjustment, if a credible policy is announced                    – The strategy might fail to alter inflation expectations.
              well in advance.                                                                       » If the costs of the policy are high, the government might
                                                                                                       reverse the policy.

                                                                                21-35                                                                               21-36




                                                                                                                                                                            9
The Problem of Inflation
• Fighting inflation:

     The role of inflationary expectations:

     • The Keynesian prescription for disinflation is
       gradualism:

        – A gradual approach gives prices and wages time to adjust to
          the disinflation.

        – Such a strategy will be politically sustainable because the
          costs are lower than going cold turkey.


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