Chapter 9: Introduction to Economic Fluctuations Business Cycle Changes in the level of economic activity Real GDP has grown at an average rate of 3% per year in 196095 But, growth has not been smooth: – Recession: 1974-75, 1981-82, 1990-91 – Boom: 1964-69, 1983-84, 1993-95 Time Horizon in Macroeconomics Long run: a time period in which prices are flexible and can respond to changes in demand and supply Prices respond to policy changes Short-run: a time period in which prices are “sticky” at some predetermined level Prices not respond to policy changes Aggregate Demand The relationship between the quantity of output demanded and the price level Money market equilibrium – Money demand for transaction: (M/P) = kY – Money supply = M/P – Equilibrium: M/P = kY where k is a constant Aggregate Demand Line Price level An increase in the price level (P) reduces the real money balances (M/P), which lowers the quantity demanded for goods and services AD Output, Income Shift in Aggregate Demand An increase in the money supply (M) makes the real money balances (M/P) to go up, which increases the level of the AD (this is a shift to the right) An decrease in the money supply (M) reduces lower the real money balances (M/P), which decreases the level of the AD (this is a shift to the left) Shift in Aggregate Demand Price level Increase AD2 Decrease AD1 AD3 Output, Income Aggregate Supply The relationship between the quantity of output supplied and the price level Long-run AS is a vertical line because of complete price flexibility assertion Short-run AS is a horizontal line because of price inflexibility assertion Aggregate Supply Price level Long-run AS Price level P Y Output, Income Short-run AS Output, Income Shift in Aggregate Demand Price level In the short-run, a higher AD results in a greater output at a constant price level SRAS AD2 AD1 Y1 Y2 Output, Income Shift in Aggregate Demand In the long-run, a higher AD results in a higher price level at a constant output Price level LRAS P2 P1 AD2 AD1 Y Output, Income Aggregate Equilibrium Price level LRAS SRAS P AD Y Output, Income Effect of Stabilization Policy An increase in the money supply stimulates the investment demand, causing AD to increase Short-run effect: An increase in the level of output (point A moves to point B) Long-run effect: The rise in income increases the demand for goods, resulting in higher prices As prices rise, output falls to its natural level (point B moves to point C) Effect of Stabilization Policy Results of expansionary policy: Short-run: output growth Long-run: higher price level Price level LRAS C P A B SRAS AD2 AD1 Y Output, Income Effects of a Supply Shock An increase in the production cost, reduces the shortrun AS Short-run effect: A decrease in the level of output and a higher price level (point A moves to point B) Long-run effect: The decline in income decreases the demand for goods, resulting in lower prices As prices fall, output rises to its natural level (point B moves back to A) Effects of a Supply Shock Results of supply shock: Short-run: output decline and price increase Long-run: higher price level Price level LRAS B P SRAS2 A SRAS1 AD1 Y Output, Income Accommodating Supply Shock The offset the short-run output decline, the central bank can increase the money supply to shift the AD up The long-run effect is a permanent price increase Accommodating Supply Shock Price level LRAS C SRAS2 A SRAS1 AD2 AD1 Y Output, Income ... smooth: – Recession: 1974-75, 1981-82, 1990-91 – Boom: 1964-69, 1983-84, 1993-95 Time Horizon in Macroeconomics Long run: a time period in which prices are flexible and can respond to changes in