Economic Fluctuations (CHAPTER 9)

AGGREGATE DEMAND
1. Aggregate Demand Curve
  1. Aggregate Price Level (P)
  2. Quantity of Aggregate output demanded (Y)
  3. Formula for deriving AD curve:
    1. M/P= K(Y)
      1. M = nominal money supply(constant)
      2. P= Price Level
      3. K = inverse of constant form of money velocity (V)
      4. Y = Quantity of Aggregate Output Demanded
      5. - Price(P) and Output Demanded (Y) are inverse = an increase in price leads to decrease in output demanded
      6. Nominal money Supply (M) : INCREASE leads to a right shift in AD curve, DECREASE leads to a left shift in curve
      7. Money Velocity (K or 1/V) :INCREASE leads to a right shift in AD curve, DECREASE leads to a left shift in curve
Sticky Prices and AGGREGATE SUPPLY in SHORT RUN
1. Unlike LRAS where output is fixed, PRICE is FIXED for SRAS: HORIZONTAL LINE
2. STICKY PRICES
  1. 50% of firms don't change prices or only change once in a year
    1. WHY: Co-ordination failure(waiting for other firms to change price), Nominal contracts(prices fixed by explicit contracts), Costs of changing prices (penalties for firms that change prices)
3. Money supply, velocity, and aggregate output only effect AD, SRAS is not changed
AGGREGATE SUPPLY LONG RUN
1. Aggregate Supply in long run = LRAS
2. LRAS depends on factors of production (Capital(K) and Labor(L)
  1. Since both K and L are constant and output is determined by K(-),L(-) : Output is constant as well -> Y(-)
    1. THEREFORE, LRAS is a vertical line
    2. A change in money supply, velocity, price only affects AD doesn't effect LRAS line
    3. ALSO: Output depends on technology
Aggregate Demand and Supply create DEMAND and SUPPLY SHOCKS
1. Shocks are EXOGENOUS changes in aggregate supply or demand
2. Supply Shock
  1. Changes the cost of production, prices of G+S
  2. UNFAVORABLE supply shocks
    1. Increase cost of production, increase prices
      1. EX) Drought, Environmental protection law, Increase in international cartel prices
  3. FAVORABLE supply shocks:
    1. Decrease cost of production(G+S), decrease prices
      1. EX) Breakup of international cartel
3. Demand Shock
  1. Positive demand shocks result in increase in AD, negative demand shocks Vice versa
    1. Ex) Increase M = Increase AD (positive), Decrease V = Decrease AD (negative)
4. Exception: changing SUPPLY leads to a change in SRAS
  1. EX) INCREASE in oil prices B/C of DECREASE in SUPPLY leads to INCREASING SRAS = Stagflation (Inflation + Recession)
Stabilization policies
2. Purpose: REDUCE the IMPACT of fluctuations in SHORT RUN (Output returns to equilibrium)
3. 2 Types of Policies
  1. MONETARY POLICY
    1. Works by changing the money supply
      1. If output greater than equilibrium (Y > Y(-)), INCREASE money supply (Expansionary Policy
      2. If output less than equilibrium, DECREASE money supply (Contractionary Policy)
  2. FISCAL POLICY
    1. Change in government spending levels, taxation
      1. Y > Y(-), INCREASE G
      2. Y < Y(-), DECREASE G
4. Easier to stabilize positive shocks than negative shocks
  1. EX 1) INCREASE velocity = INCREASE in AD, to adjust: DECREASE money supply,
    1. Price and Output at Equilibrium
  2. EX 2) DECREASE velocity = DECREASE in AD, to adjust: INCREASE money supply
    1. Output at Equilibrium, Price remains higher than equilibrium
Long Run = Prices are flexible and respond to changes to supply and demand, output is constant
1. Short Run = Prices are fixed/STICKY at a predetermined level
  1. Short Run Fluctuations are the business cycle
    1. IF Y>Y(-) = LOW unemployment, HIGH demand, DECREASE in prices (Expansion)
    2. If Y< Y(-) = HIGH unemployment, LOW demand, INCREASE prices (Recession)
Long Run: change is determined by movementalong the AD line
Short Run: change is determined by shifting the AD line

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Economic Fluctuations (CHAPTER 9)

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	Created by Terry Lye about 8 years ago