2H03

INTERMEDIATE
MACROECONOMICS

Fall 2019
Rizwan Tahir

1
 INTRODUCTION TO
ECONOMIC FLUCTUATIONS

Coverage: Chapter 9

2
 LEARNING OUTCOMES

 Definition, History & Facts about the business cycle

 how the short run differs from the long run
 an introduction to aggregate demand
 an introduction to aggregate supply in the short run and long run
 how the model of aggregate demand and aggregate supply can be used to
analyze the short-run and long-run effects of “shocks.”

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 WHAT IS A BUSINESS CYCLE
◦ Business cycles are fluctuations of aggregate economic activity
◦ There are expansions and contractions

◦ Aggregate economic activity declines in a

contraction or recession until it reaches a trough

◦ After a trough, activity increases in an expansion or

boom until it reaches a peak

◦ A particularly severe recession is called a depression

◦ The sequence from one peak to the next, or from

one trough to the next, is a business cycle
◦ Peaks and troughs are turning points

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 WHAT IS A BUSINESS CYCLE

◦ The business cycle is recurrent, but not

periodic
◦ Recurrent means the pattern of contraction–
trough–expansion–peak occurs again and
again
◦ Not being periodic means that it doesn't
occur at regular, predictable intervals

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 WHAT EXPLAINS BUSINESS CYCLE
FLUCTUATIONS ?
• 2 major components of business cycle theories
• A description of the shocks
• A model of how the economy responds to shocks
• 2 major business cycle theories
• classical theory
• Keynesian theory
• Study both theories in aggregate demand-aggregate
supply (AD-AS) framework

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 WHAT EXPLAINS BUSINESS CYCLE
FLUCTUATIONS ?

• Aggregate demand and aggregate supply: a brief

introduction
• The model (along with the building block IS-LM model)
will be developed in chapters 10
• The model has 3 main components; all plotted in (P, Y)
space
• aggregate demand curve
• short-run aggregate supply curve
• long-run aggregate supply curve

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 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 much differently

when prices are sticky.

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 The Frequency of Price Adjustment

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 Theories of Price Stickiness

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 THEORIES OF PRICE STICKINESS

• Among the dozen theories, coordination failure

tops the list.
• According to Blinder, this is an important finding
because it suggests that the inability of firms to
coordinate price changes plays a key role in
explaining price stickiness and, thus, short-run
economic fluctuations.

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 RECAP OF CLASSICAL MACRO
THEORY
• Output is determined by the supply side:
• supplies of capital, labor
• technology
• Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
• Assumes complete price flexibility.
• Applies to the long run.

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 WHEN PRICES ARE STICKY…

…output and employment also depend on

demand, which is affected by:
• fiscal policy (G and T )
• monetary policy (M )
• other factors, like exogenous changes in
C or I

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 AGGREGATE DEMAND
• The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
• For this chapter’s intro to the AD/AS model,
we use a simple theory of aggregate demand
based on the quantity theory of money.
• Following Chapters develop the theory of
aggregate demand in more detail.

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 THE QUANTITY EQUATION AS AD

• From Chapter 4, recall the quantity equation

MV = PY
• If we assume that velocity V is constant and the
money supply M is fixed by the central bank,
then the quantity equation yields a negative
relationship between the price level P and output
Y.

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THE DOWNWARD-SLOPING AD CURVE

Combinations of P
and Y that satisfy P
the quantity
equation holding
M and V constant.

This downward-
sloping curve is
called the
aggregate
AD
demand curve
Y

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 WHY AD CURVE IS DOWNWARD-
SLOPING ?

• Because we have assumed the velocity of money

is fixed, the money supply determines the dollar
value of all transactions in the economy.
• If the price level rises, each transaction requires
more dollars, so the number of transactions and
thus the quantity of goods and services
purchased must fall.

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 SHIFTING THE AD CURVE

An increase in
the money
supply shifts the
AD curve to the
right. AD2
AD1
Y

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 WHY THE AD CURVE SHIFT
RIGHTWARD?
• With velocity fixed, the quantity equation implies
that PY is determined by M.

• An increase in M causes an increase in PY, which

means higher Y for each value of P, or higher P
for each value of Y.

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 AGGREGATE SUPPLY IN THE LONG
RUN
• Recall:
In the long run, output is determined by
factor supplies and technology

Y  F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
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THE LONG-RUN AGGREGATE SUPPLY
CURVE

P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L )
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 WHY LAS CURVE IS VERTICAL

• “P” on the vertical axis is the economy’s overall

price level – the average price of EVERYTHING.
• A 10% increase in the price level means that, on
average, EVERYTHING costs 10% more.
• Thus, a firm can get 10% more revenue for each
unit it sells.
• But the firm also pays an average of 10% more in
wages, prices of intermediate goods, advertising,
and so on.
• Thus, the firm has no incentive to increase
output.
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 LONG-RUN EFFECTS OF AN INCREASE
IN M

P LRAS
An increase
in M shifts
AD to the
right.
In the long run, P2
this raises the
price level… P1 AD2
AD1

…but leaves Y
output the same.
Y
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 AGGREGATE SUPPLY IN THE SHORT
RUN
• Many prices are sticky in the short run.
• For now, we assume
• all prices are stuck at a predetermined level in the short
run.
• firms are willing to sell as much at that price level as
their customers are willing to buy.
• Therefore, the short-run aggregate supply (SRAS) curve
is horizontal:

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 THE SHORT-RUN AGGREGATE SUPPLY
CURVE

The SRAS curve P

is horizontal:
The price level
is fixed at a
predetermined
level, and firms SRAS
sell as much as P
buyers demand.

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 SHORT-RUN EFFECTS OF AN
INCREASE IN M

In the short run P

…an increase
when prices are in aggregate
sticky,… demand…

SRAS
P
AD2
AD1
Y
…causes output Y1 Y2
to rise.
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 SUMMARY: SHORT RUN & LONG RUN
EFFECTS

• 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 of goods and services.

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 Long-Run Equilibrium

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 HOW SHOCKING!!!

• shocks: exogenous changes in agg. supply or

demand
• Shocks temporarily push the economy away from
full employment.
• Example: exogenous decrease in velocity
If the money supply is held constant, a decrease
in V means people will be using their money in
fewer transactions, causing a decrease in demand
for goods and services.
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 THE EFFECTS OF A NEGATIVE DEMAND
SHOCK

AD shifts left, P LRAS

depressing
output and
employment
in the short run.
B A SRAS
Over time, P
prices fall and
P2 C AD1
the economy
moves down its AD2
demand curve Y
toward full Y2 Y
employment.
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 An Increase in Aggregate Demand

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 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.
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 An Adverse Supply Shock

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 STABILIZATION POLICY

• def: policy actions aimed at reducing the severity

of short-run economic fluctuations.
• Example: Using monetary policy to combat the
effects of adverse supply shocks…

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 STABILIZING OUTPUT WITH
MONETARY POLICY

P LRAS

The adverse
supply shock
moves the B SRAS2
P2
economy to
A SRAS1
point B. P1
AD1

Y
Y2 Y
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 STABILIZING OUTPUT WITH
MONETARY POLICY

But the B.O.C P LRAS

accommodates
the shock by
raising agg.
B C SRAS2
demand. P2
A
results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y
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Short-run & Long-run effects
of shocks to AD/SAS: Summary
Short-Run Long-Run

Shocks to AD +ve (↑ Velocity)

-ve (↓ Velocity)

Shocks to SAS +ve (↓Oil prices)

-ve (↑ Oil prices)

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 CHAPTER SUMMARY

1. Long run: prices are flexible, output and employment

are always at their natural rates, and the classical theory
applies.
Short run: prices are sticky, shocks can push output and
employment away from their natural rates.
2. Aggregate demand and supply:
a framework to analyze economic fluctuations

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 CHAPTER SUMMARY

3. The aggregate demand curve slopes downward.

4. The long-run aggregate supply curve is vertical, because
output depends on technology and factor supplies, but
not prices.
5. The short-run aggregate supply curve is horizontal,
because prices are sticky at predetermined levels.

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 CHAPTER SUMMARY

6. Shocks to aggregate demand and supply cause

fluctuations in GDP and employment in the short run.
7. The Fed can attempt to stabilize the economy with
monetary policy.

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