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Topic 8: business cycles and economic fluctuations

What has been the trend with amplitudes in RGDP growth
Amplitudes have moderated, they are smaller recently. Recessions have become less frequent, more time in between each recession
What increases during recessions?
unemployment rate
what are the variables used to define business cycles?
unemployment and real GDP
Pro-cyclical variable
a variable that rises when GDP rises, for example, employment
counter-cyclical variable
a variable that falls when GDP rises, for example, unemployment and inventories
who is responsible for dating business cycles?
NBER, National Bureau of Economic Research is responsible for dating the peaks, or starts of recession, and the ends or troughs of recession
recession
-When an economy experiences falling output, rising unemployment
– measured from peak to trough
In the long run, Y=
F(K,L) therefore labor, capital and productivity determine our potential output growth
Okun’s law
– relationship between RGDP and unemployment. The relationship is negative
– %?RGDP= 3-2(?UR)
– this shows that if we are at long run natural rate, ?UR=0, therefore RGDP should naturally grow at a 3% rate
If %?RGDP is negative
indicates a recession
Key assumption to explaining business cycle fluctuations
-prices are sticky, not fully flexible
– only 50% of firms change their prices more than once a year
Graph of AS
SRAS is horizontal in short run if we assume prices completely fixed, but slopes upward if we assume only some prices are sticky
AD in long run
-In the long run, MV=PY and V and Y are fixed in long run, therefore, if M increases or decreases, P follows suit
– long run money neutrality
AD=MV
AD in the short run
– MV=PY and V and P are fixed, so if M increases or decreases, Y will follow suit, therefore money is not neutral in the short run
AD=MV
Comparative static: fed increases the money supply
– increases the money supply through lowering the iff. This can be accomplished through buying bonds, decreasing the rrr, decreasing the interest on reserves or decreasing the discount rate
– increasing the money supply means increasing M, therefore the AD curve will shift out
– In short run, this will increase Y, and prices will not change
– In long run, firms will increase their prices and therefore, SRAS curve will shift up, and output, Y, will fall back down to equilibrium full employment level
Comparative static: velocity shock, Fed does nothing
– an outside factor that affects money demand will cause Md?, and therefore V?.
– If V?, this causes AD? because AD=MV
– AD curve shifts right
– In SR, this causes a decrease in output, Y, but no change in prices
– In long run, firms will lower prices since Y decreased, and therefore SRAS curve will shift down (out). Therefore, if Fed does nothing, prices decrease but output goes back to normal- A?B?C.
Factors that affect money demand (4)
1.) ?Riskiness of alternative assets causes Md?
2.) ?Liquidity of alternative assets causes Md?
3.) ?Efficiency of Payment mechanisms for alternative assets causes Md?
4.) ?Wealth causes Md?
When Md increases, Velocity decreases!
Comparative static: velocity shock Fed Acts
– increase in Md due to outside reason causes Velocity to fall
– When V?, causes AD to decrease, shifts curve right
– AD curve shift causes fall in output in the short run, no change in prices
– Fed sees this fall in output and decides to increase the money supply to counteract the decrease in velocity and meet Md
– When they increase money supply, AD=MV, so AD curve shifts back to its original place. Therefore, prices never fall, and the economy goes from A?B?A, therefore only period of low output was result
assumption for AD curve
velocity does not depend on i, only depends on Md
Comparative static: SR supply shock
– Supply shock that results in a fall in SRAS shifts the SRAS curve up, as this is the same as shifting it in
– shift in SRAS causes Y? and P? in the short run- this is called stagflation
– in long run, Fed will want to stabilize output, so will increase money supply, ?Ms. Fed will do this through ?iff. This will shift the AD curve out because AD=MV, and therefore economy in LR will move back to Yfe, except prices will be permanently higher, which is against dual mandate.
– if ECB, since they care about prices the most, they would tighten monetary policy to stabilize prices at a lower output
Supply shock
– could happen if there was a drought, ?SRAS
– Nationwide strike ?SRAS
– Commodity price shock- example is oil ?SRAS
stagflation
– characterized by falling output and inflation (rising prices)
– happens when there is a negative supply shock
ECB single mandate
– keep inflation at a low, stable rate around 2%
– they do not care about maximum sustainable output and employment
If no action is taken with a supply shock
eventually, conservation efforts will increase, and alternate technology will be explored until SRAS shifts back down and we will move back to original point A

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