Chapter 9: Introduction to Economic Fluctuations
Differences between the
short-run and the long-run
1. In the
long run prices are flexible and respond to changes in supply and demand resulting
in market clearing outcomes and a vertical aggregate supply curve.
2. In the short run prices are sticky at some
predetermined level so that the non market clearing outcomes prevail.
3. The
classical dichotomy will not hold in the short run if wages and prices are
sticky.
4. Sticky
prices in the short-run are analogous to menu
prices that are only changed at some cost.
Short-run equilibrium with
sticky prices
1. Aggregate Demand is downward sloping
according to the quantity theory of money and is given for any quantity of
money (assuming the velocity of money is fixed.)
2. Shifts in
aggregate demand are due to (a) changes in the money supply or (b) changes in
the velocity of money (discussed more fully in chapters 9 and 10).
3. Aggregate supply is vertical in the
long-run with flexible wages and prices, but is flat in the short-run if all
prices (including money wages) are fixed.
4. Shifts in
aggregate demand only influence output if prices are not fully flexible, ie. the
short-run.
Short run versus long run
1. In the very
short-run the aggregate supply is flat; in the long run the aggregate supply
curve is vertical (even with fixed capital, labor, and technology); in the very
long run the aggregate supply curve can shift.
2.
Fluctuations in aggregate demand may lead to instability in output in
the short run. These demand shocks
temporarily change the rate of output from its natural level, but eventually
output will return to its natural rate.
Shocks to aggregate demand
1. Shocks that affect the
velocity of money.
2.
Exogenous money shocks from Fed policy.
3.
Causes short-run effect on output but no long term effect
Shocks to aggregate supply
in the short-run (higher costs of production)
1. New environmental regulation
2.
Increase in union aggressiveness
3.
Oil cartel
4. May
temporarily lower output until prices adjust and return to natural rate of output
with a permanently higher price level.
Stagflation combines falling
output in response to adverse supply shock with rising prices (inflation). What are the two alternative policy
responses by the Fed?
1. Hold
aggregate demand (money) constant and wait for prices to fall to restore the
natural rate of output, or
2. Expand
aggregate demand (money) to accelerate the movement to full employment even
though it results in a permanently higher price level.