FACT 2: Most macroeconomic quantities fluctuate together.

The Reality of Short-Run Fluctuations

Model of aggregate demand and aggregate supply

The AD curve shows the quantity of all g&s demanded in the economy at any given price level. Why the AD curve slopes downward? Y = C + I + G + NX Assume G is fixed by government policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX.

The Wealth Effect (P and C ): • Suppose the price level, P, declines – Increase in the real value of money – Consumers are wealthier – Increase in consumer spending, C – Increase in quantity demanded of goods and services

The Interest-Rate Effect (P and I): • Suppose the price level, P, declines –Buying goods and services requires fewer dollars: people buy bonds and other assets – Decrease in the interest rate – Increase spending on investment goods, I – Increase in quantity demanded of goods and services

The Exchange-Rate Effect (P and NX ): • Suppose the U.S. price level, P, declines – Decrease in the U.S. interest rate – U.S. dollar depreciates (decline in the real value of the dollar in foreign-exchange markets) –Stimulates U.S. net exports, NX – Increase in quantity demanded of goods and services

Why the AD curve slopes downward An increase in P reduces the quantity of goods and services demanded because: • the wealth effect (C falls) • the interest-rate effect (I falls) • the exchange-rate effect (NX falls)

Why the AD Curve Might Shift: • Changes in C – Stock market boom/crash – Preferences re: consumption/saving tradeoff – Tax hikes/cuts 16 • Changes in I – Firms buy new computers, equipment, factories – Expectations, optimism/pessimism – Interest rates, – Monetary policy, – Investment Tax Credit or other tax incentives • Changes in G – Federal spending, e.g., defense – State & local spending, e.g., roads, schools 17 • Changes in NX – Booms/recessions in countries that buy our exports – Appreciation/depreciation resulting from international speculation in foreign exchange market

The Sticky-Wage Theory: • Imperfection: – Nominal wages are sticky in the short run, they adjust sluggishly. • Due to labor contracts, social norms • Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. • If P > PE, – Revenue is higher, but labor cost is not. –Production is more profitable, so firms increase output and employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward

The Sticky-Price Theory: • Imperfection: – Many prices are sticky in the short run. • Due to menu costs, the costs of adjusting prices. • Examples: cost of printing new menus, the time required to change price tags –Firms set sticky prices in advance based on PE Suppose the Fed increases the money supply unexpectedly – In the long run, P will rise – In the short run: • Firms without menu costs can raise their prices immediately • Firms with menu costs wait to raise prices. With relatively low prices: increase demand for their products: increase output and employment Hence, higher P is associated with higher Y.

The Misperceptions Theory: • Imperfection: – Firms may confuse changes in P with changes in the relative price of the products they sell. • If P rises above PE – A firm sees its price rise before realizing all prices are rising. • The firm may believe its relative price is rising, and may increase output and employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

What the 3 theories have in common :

Why the Short-Run Aggregate-Supply Curve Might Shift: Everything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left.

The effects of a shift in AD Use the AD–AS diagram to show the effect of a stock market crash. 1. Affects C, AD curve 2. C falls, so AD shifts left 3. SR equilibrium at B. P and Y lower, unemployment higher 4. Over time, PE falls, SRAS shifts right, until LR equilibrium at C. Y and unemployment back at initial levels.

The effects of a shift in SRAS: Use the AD–AS diagram to show the effect of an increase in oil prices (assume the LRAS is constant) 1. Increases costs, shifts SRAS 2. SRAS shifts left 3. SR equilibrium at point B. P higher, Y lower, unemployment higher From A to B, stagflation, a period of falling output and rising prices.

The Theory of Liquidity Preference

The Downward Slope of the Aggregate-Demand Curve

Changes in the Money Supply

The Role of Interest-Rate Targets in Fed Policy

The Zero Lower Bound

• Fiscal policy: –Setting the level of government purchase (G) and taxation (T) by government policymakers –An increase in G and/or decrease in T, shifts AD right –A decrease in G and/or increase in T, shifts AD left

• How big is the multiplier effect? – Depends on how much consumers respond to increases in income. • Marginal propensity to consume, MPC=ΔC/ΔY –Fraction of extra income that households consume rather than save • Example – If MPC = 0.8 and income rises $100, C rises $80.

• Calculate the spending multiplier when MPC is 0.5, 0.75, and 0.9. • What is the relationship between the MPC and the simple multiplier? 27 • If MPC = 0.5, multiplier = 1 / (1-MPC) = 2 • If MPC = 0.75, multiplier = 4 • If MPC = 0.9, multiplier = 10 • The bigger the MPC, the bigger the multiplier. A bigger MPC means changes in Y cause bigger changes in C, which in turn cause bigger changes in Y.

• The multiplier effect: –Each $1 increase in G can generate more than a $1 increase in aggregate demand. –Also true for the other components of GDP (C, I, G, NX)

EXAMPLE 4: How big of a change in AD? Suppose a recession overseas reduces the demand for U.S. net exports by $10 billion. • What is the initial change in AD? • If MPC = 0.8, what is the change in output? 29 • Initially, AD falls by $10 billion • The spending multiplier = 5 • The decrease in Y is 5 * $10 billion = $50 billion

• The crowding-out effect –Offset in aggregate demand – Results when expansionary fiscal policy raises the interest rate –Thereby reduces investment spending –Which reduces the net increase in aggregate demand. –So, the size of the AD shift may be smaller than the initial fiscal expansion.

• A tax cut – Increases households’ take-home pay – Households respond by spending a portion of this extra income, shifting AD to the right – The size of the shift is affected by the multiplier and crowding-out effects • Another factor: households perception –Permanent tax cut – large impact on AD –Temporary tax cut – small impact on AD

• Monetary policy affects economy with a long lag: – Firms make investment plans in advance, so I takes time to respond to changes in r – Most economists believe it takes at least 6 months for monetary policy to affect output and employment • Fiscal policy also works with a long lag: – Changes in G and T require acts of Congress. – Legislative process can take months or years • Due to these long lags – Critics of active policy argue that such policies may destabilize the economy rather than help it: • By the time the policies affect aggregate demand, the economy’s condition may have changed. • Contend that policymakers should focus on long-run goals like economic growth and low inflation.

• Keynes: “Animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment. • Also, other factors cause fluctuations, – Booms and recessions abroad – Stock market booms and crashes • If policymakers do nothing – These fluctuations are destabilizing to businesses, workers, consumers. • Proponents of active stabilization policy –Government should use policy to reduce these fluctuations: • When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession. • When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom

• Automatic stabilizers: – Changes in fiscal policy that stimulate aggregate demand when economy goes into recession –Occur without policymakers having to take any deliberate action • The tax system – In recession, taxes fall automatically, which stimulates aggregate demand • Government spending – In recession, more people apply for public assistance (welfare, unemployment insurance) • Government spending on these programs automatically rises, which stimulates aggregate demand