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Macroeconomics & The Global Economy Ace Institute of Management
Chapter 9: Economic Fluctuation (Business Cycle Theory)
Instructor
Sandeep Basnyat
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
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
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
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