Macroeconomics & The Global Economy Ace Institute of Management

Chapter 9: Economic Fluctuation (Business Cycle Theory)

Instructor

Sandeep Basnyat

Sandeep_basnyat@yahoo.com

9841 892281

IntroductionIntroduction Continual ups and downs in the rate of growth of national

income

Business cycle is the alternating periods of expanding and contracting economic activity.

Growth rates of real GDP, consumptionPercent change from 4

quarters earlier

Average growth

rate

Real GDP growth rate

Consumption growth rate

Growth rates of real GDP, consumption, investment

Percent change from 4

quarters earlier

Investment growth rate

Real GDP growth rate

Consumption growth rate

UnemploymentPercent of labor

force

Phases of Business CyclePhases of Business Cycle There are four phases of business cycle

Prosperity or Boom

Recession

Depression or Slump

Recovery or Revival

Pro

sper

ity

Recession

Depression

Rev

ival

Periods

Out

put

Why does this happen? What are its implications to an economy?

Different behavior of Price in short and long run

Demand and supply shocks

Behaviour of Price

Short runMany prices are “sticky” at a predetermined level.

Long run Prices are flexible, respond to changes in supply or demand.

The economy behaves much differently when prices are sticky than flexible.

Aggregate demand

The aggregate demand curve shows the relationship between the price level and the quantity of output demanded.

Also. from quantity equation

M V = P Y

If M and V are constant then, this equation implies an inverse relationship between P and Y causing downward sloping AD curve

The downward-sloping AD curve

Y

P

AD

Shifting the AD curve

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

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

Y

P

AD1

AD2

The short-run aggregate supply curve

Y

P

SRAS

The SRAS curve is horizontal:

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

The SRAS curve is horizontal:

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

The long-run aggregate supply curve

Y

P LRAS

has enough time to respond to fixed K,L: does not depend on P, so LRAS is vertical.

has enough time to respond to fixed K,L: does not depend on P, so LRAS is vertical.

Increase in price is followed by increase in cost and suppliers do not have incentives to increase supply

Increase in price is followed by increase in cost and suppliers do not have incentives to increase supply

The Aggregate Demand and supply curves

Y

P LRAS

AD

SRAS

Y

P

AD1

In the short run when prices are sticky,…

…causes output to rise.

SRAS

Y2Y1

AD2

…an increase in aggregate demand…

From short run to Long run

Y

P

AD1

LRAS

SRAS

Y2

A = initial equilibrium

AB

CB = new short-run

eq’m after Central Bank increases M

C = long-run equilibrium

AD2

Short-run effects of an increase in M

Long-run effects of an increase in M

Y

P

AD1

LRAS

P1

P2

AD2

Net Effect

Short run and long run effects of price cause business cycle

18CHAPTER 9 Introduction to Economic Fluctuations

How shocking!!! shocks: exogenous changes in agg. supply or

demand

Shocks temporarily push the economy away from full employment.

19CHAPTER 9 Introduction to Economic Fluctuations

SRAS

LRAS

AD2

The effects of a negative demand shock

Y

P

AD1P2

Y2

AD shifts left, depressing output and employment in the short run.

AD shifts left, depressing output and employment in the short run.

AB

C

Over time, prices fall and the economy moves down its demand curve toward full-employment.

20CHAPTER 9 Introduction to Economic Fluctuations

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.

21CHAPTER 9 Introduction to Economic Fluctuations

CASE STUDY: The 1970s oil shocks

Early 1970s: OPEC coordinates a reduction in the supply of oil.

Oil prices rose11% in 1973 68% in 1974 16% in 1975

Such sharp oil price increases are supply shocks because they significantly impact production costs and prices.

22CHAPTER 9 Introduction to Economic Fluctuations

SRAS1

Y

P

AD

LRAS

Y2

CASE STUDY: The 1970s oil shocks

The oil price shock shifts SRAS up, causing output and employment to fall.

The oil price shock shifts SRAS up, causing output and employment to fall.

A

BIn absence of further price shocks, prices will fall over time and economy moves back toward full employment.

SRAS2

A

Thank You

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