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.