Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281 Macroeconomics & The Global Economy Ace Institute of Management Chapter 9: Economic Fluctuation (Business Cycle Theory) Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

Introduction 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, consumption Percent change from 4 quarters earlier Real GDP growth rate Consumption growth rate Average 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

Unemployment Percent of labor force

Phases of Business Cycle There are four phases of business cycle Prosperity or Boom Recession Depression or Slump Recovery or Revival Output Recession Revival Prosperity Depression Periods

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

The short-run aggregate supply curve The SRAS curve is horizontal: The price level is fixed at a predetermined level, and firms sell as much as buyers demand. SRAS

The long-run aggregate supply curve Increase in price is followed by increase in cost and suppliers do not have incentives to increase supply Y P LRAS has enough time to respond to fixed K,L: does not depend on P, so LRAS is vertical. Notes for students: In the long run, supply has enough time to respond to fixed factors of production and becomes vertical. A 10% increase in P costs EVERYTHING 10% more- firm get 10% more revenue and also pays 10% more in wages, prices of intermediate goods, advertising, and so on. Thus, the firm has no incentive to increase output and supply curve becomes vertical.

The Aggregate Demand and supply curves LRAS AD SRAS

From short run to Long run Y P In the short run when prices are sticky,… …an increase in aggregate demand… AD2 AD1 SRAS Y2 …causes output to rise. Y1

Short-run effects of an increase in M A = initial equilibrium Y P LRAS AD2 AD1 B = new short-run eq’m after Central Bank increases M C SRAS B A Y2 C = long-run equilibrium

Long-run effects of an increase in M Y P LRAS AD2 AD1 Net Effect Short run and long run effects of price cause business cycle P2 P1

How shocking!!! shocks: exogenous changes in agg. supply or demand Shocks temporarily push the economy away from full employment. CHAPTER 9 Introduction to Economic Fluctuations

The effects of a negative demand shock AD shifts left, depressing output and employment in the short run. Y P LRAS AD1 AD2 SRAS B A Over time, prices fall and the economy moves down its demand curve toward full- employment. Y2 C P2 CHAPTER 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. CHAPTER 9 Introduction to Economic Fluctuations

CASE STUDY: The 1970s oil shocks Early 1970s: OPEC coordinates a reduction in the supply of oil. Oil prices rose 11% in 1973 68% in 1974 16% in 1975 Such sharp oil price increases are supply shocks because they significantly impact production costs and prices. CHAPTER 9 Introduction to Economic Fluctuations

CASE STUDY: The 1970s oil shocks The oil price shock shifts SRAS up, causing output and employment to fall. Y P LRAS AD SRAS2 B In absence of further price shocks, prices will fall over time and economy moves back toward full employment. Y2 SRAS1 A A CHAPTER 9 Introduction to Economic Fluctuations

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