 difference between short run & long run
 introduction to aggregate demand
 aggregate supply in the short run & long run
 see how model of aggregate supply and demand can be used to analyze short-run and long-run effects of “shocks”

Real GDP Growth in the U.S., 1960-2004
10
8
6
4
Average growth rate = 3.4%
2
0
-2
-4
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

 Long run:
Prices are flexible, respond to changes in supply or demand
 Short run: many prices are “sticky” at some predetermined level
The economy behaves much differently when prices are sticky.

 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.
 Complete price flexibility is a crucial assumption, so classical theory applies in the long run.

…output and employment also depend on demand for goods & services, which is affected by
 fiscal policy ( G and T )
 monetary policy ( M )
 other factors, like exogenous changes in C or I .

 the paradigm that most mainstream economists & policymakers use to think about economic fluctuations and policies to stabilize the economy
 shows how the price level and aggregate output are determined
 shows how the economy’s behavior is different in the short run and long run

 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.
 Chapters 10-11 develop the theory of aggregate demand in more detail.

M V = P Y
 For given values of M and V , these equations imply an inverse relationship between P and Y:

(
An increase in the price level causes a fall in real money balances
M/P ), causing a decrease in the demand for goods
& services.
P
AD
Y

P
An increase in the money supply shifts the AD curve to the right.
AD
1
AD
2
Y

 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, the level of output at which the economy’s resources are fully employed.
“Full employment” means that unemployment equals its natural rate.

P LRAS
The LRAS curve is vertical at the full-employment level of output.
Y
Y

P LRAS
An increase in M the shifts
AD curve to the right.
In the long run, this increases the price level…
P
2
P
1
…but leaves output the same.
Y
AD
1
AD
2
Y

 In the real world, many prices are sticky in the short run.
 For now (and throughout Chapters 9-11), we assume that all prices are stuck at a predetermined level in the short run…
 …and that 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:

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

P
In the short run when prices are sticky,…
…causes output to rise.
P
Y
1
…an increase in aggregate demand…
Y
2
SRAS
AD
2
AD
1
Y

Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run equilibrium, if
Y  Y
Y  Y then over time, the price level will rise fall
Y  Y remain constant
This adjustment of prices is what moves the economy to its long-run equilibrium.


A = initial equilibrium
P LRAS
B = new shortrun eq’m after Fed increases M
C = long-run equilibrium
P
2
P
A
Y
C
B
Y
2
SRAS
AD
2
AD
1
Y

 shocks : exogenous changes in aggregate supply or demand
 Shocks temporarily push the economy away from full-employment.
 An example of a demand shock: exogenous decrease in velocity
 If the money supply is held constant, then a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services:

The effects of a negative demand shock
The shock shifts
AD left, causing output and employment to fall in the short run
Over time, prices fall and the economy moves down its demand curve toward fullemployment.
P
P
2
P
B
Y
2
LRAS
Y
A
C
SRAS
AD
2
AD
1
Y

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.)

CASE STUDY:
 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.

CASE STUDY:
The oil price shock shifts SRAS up, causing output and employment to fall.
P
2 In absence of further price shocks, prices will fall over time and economy moves back toward full employment.
P
1
P
B
Y
2
LRAS
Y
SRAS
2
AD
SRAS
1
Y

CASE STUDY:
70%
Predicted effects of the oil price shock:
• inflation 
• output 
• unemployment 
…and then a gradual recovery.
60%
50%
40%
30%
20%
10%
0%
1973
12%
10%
8%
6%
1974 1975 1976
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
1977
4%

CASE STUDY:
60%
Late 1970s:
As economy was recovering, oil prices shot up again, causing another huge supply shock!!!
50%
40%
30%
20%
10%
0%
1977
14%
12%
10%
8%
6%
1978 1979 1980
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
1981
4%

CASE STUDY:
40%
1980s:
A favorable supply shock-a significant fall in oil prices.
As the model would predict, inflation and unemployment fell:
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
1982 1983 1984 1985 1986
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
10%
8%
6%
4%
2%
1987
0%

 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:

P
The adverse supply shock moves the economy to point B.
P
2
P
1
B
LRAS
A
SRAS
2
AD
1
SRAS
1
Y
Y
2
Y

But the Fed accommodates the shock by raising agg. demand.
results:
P is permanently higher, but Y remains at its fullemployment level.
P
2
P
1
P
B
Y
2
LRAS
Y
C
A
SRAS
2
AD
1
AD
2
Y

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

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.

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.

from the DRI macroeconometric model
Estimated value of
 Y/  G
Estimated value of
 Y/  T
Assumption about monetary policy
Fed holds money supply constant
Fed holds nominal interest rate constant
0.60
1.93
 0.26
 1.19

CASE STUDY:
 During 2001,
– 2.1 million people lost their jobs, as unemployment rose from 3.9% to
5.8%.
– GDP growth slowed to 0.8%
(compared to 3.9% average annual growth during 1994-2000).

CASE STUDY:
 Causes: 1) Stock market decline   C
1500
1200
900
600
Standard & Poor’s
500
300
1995 1996 1997 1998 1999 2000 2001 2002 2003

CASE STUDY:
 Causes: 2) 9/11
– increased uncertainty
–
– fall in consumer & business confidence result: lower spending, left
IS curve shifted
 Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc .
– reduced stock prices, discouraged investment

CASE STUDY:
 Fiscal policy response: shifted IS curve right
–
– tax cuts in 2001 and 2003 spending increases
• airline industry bailout
• NYC reconstruction
• Afghanistan war

CASE STUDY:
 Monetary policy response: shifted LM curve right
7
6
5
4
3
2
1
0
Three-month
T-Bill Rate

 The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.
 In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans.
 The Fed changes the money supply and shifts the LM curve to achieve its target.
 Other short-term rates typically move with the federal funds rate.

Why does the Fed target interest rates instead of the money supply?
1) They are easier to measure than the money supply.
2) The Fed might believe that more prevalent than IS
LM shocks are shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply.
(Problem Set #16.)

240 30
220
200
Unemployment
(right scale) 25
20
180 15
160
140
Real GNP
(left scale)
120
1929 1931 1933 1935 1937 1939
10
5
0

THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 asserts that the Depression was largely due to an exogenous fall in the demand for goods & services – a leftward shift of the IS curve.
 evidence: output and interest rates both fell, which is what a leftward IS shift would cause.

THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous  C
–
–
Oct-Dec 1929: S&P 500 fell 17%
Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
– “correction” after overbuilding in the 1920s
– widespread bank failures made it harder to obtain financing for investment
 Contractionary fiscal policy
– Politicians raised tax rates and cut spending to combat increasing deficits.

THE MONEY HYPOTHESIS:
A shock to the LM curve
 asserts that the Depression was largely due to huge fall in the money supply.
 evidence:
M 1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
–
–
P fell even more, so M / P actually rose slightly during 1929-31. nominal interest rates fell, which is the opposite of what a leftward LM shift would cause.

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 asserts that the severity of the Depression was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by the fall in
M , so perhaps money played an important role after all.
 In what ways does a deflation affect the economy?

THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of expected deflation:
  e

 r  for each value of i
I  because I = I ( r )
 planned expenditure & agg. demand 
 income & output 

Why another Depression is unlikely
 Policymakers (or their advisors) now know much more about macroeconomics:
– The Fed knows better than to let M fall so much, especially during a contraction.
– Fiscal policymakers know better than to raise taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread bank failures very unlikely.
 Automatic stabilizers make fiscal policy expansionary during an economic downturn.