Ch.10. THE ECONOMY IN THE SHORT RUN:
Introduction to economic fluctuations.
-Short-run vs. the long run:
In the long run prices are flexible whereas in short
run they are sticky (or not as flexible as in the long run).
Okun's law: Short run
relationship between Change
in Unemployment Rate and Economic Growth (EG):
EG =
3.0% - 2* (change in UR)
- If no change in UR--> EG=3.0%
- If UR increases from 7% to 8% --> EG=1 %
Aggregate
Demand:
- Quantity equation: MV=PY or
P
= (MV)/Y
which implies AD is
downward sloping. [ higher
(lower)
Price level decreases (increases) real money balances =>
reduces (increases) demand for goods and services.
- If Money supply or velocity change => AD shifts.
- In general: AD = C + I + G + NX.
If any of the components change (change in C, I, G
or NX), AD shifts.
Aggregate
Supply:
-
vertical in long run (independent of the price level ;
determined by factors of production (ch. 3))
-
horizontal (or upward sloping) in short run.
-
Short run supply represents cost of production.
- Labor that is hired (and the unemployment rate) fluctuates in
the short-run.
- Output (GDP) in the long run = "full
employment" output
Full employment is where the
unemployment
rate is equal to the natural rate of unemployment..
Exercises:
- What are the effect on short-run equilibrium output
and unemployment when
:
AD shocks:
Money supply increases (or velocity increases).
AS shocks (negative
vs. positive)
Increases in oil prices (stagflation: STAGnation=lower output and
inFLATION) due to OPEC's decisions or Middle East instability (oil
price changes caused by shifts in supply of oil)..
Case Study p. 305: How OPEC helped cause
stagflation
in the 1970's
- Long
run
equilibrium following AD or AS shock (role of labor market (wages)).
How should the FED respond to changes
in AS or AD
- Fed's monetary policy objectives
- Price stability vs. output stability