INTRODUCTION TO
ECONOMIC
FLUCTUATIONS
CHAPTER9
INTRODUCTION
• Economic fluctuations present a recurring problem for economists and policymakers.
• On average, the real GDP of the United States grows between 3 and 3.5 percent per
year.
• These fluctuations in the economy’s output are closely associated with fluctuations
in employment.
• When the economy experiences a period of falling output and rising unemployment,
the economy is said to be in recession.
• Economists call these short-run fluctuations in output and employment the
business cycle.
THE FACTS ABOUT THE BUSINESS CYCLE
GDP AND ITS COMPONENTS
Growth in Consumption and Investment: When the economy heads into a
recession, growth in real consumption and investment spending both decline.
Investment spending, shown in panel (b), is considerably more volatile than
consumption spending, shown in panel (a). The shaded areas represent periods
of recession.
UNEMPLOYMENT AND OKUN’S LAW
Unemployment: The unemployment rate rises
significantly during
periods of recession, shown here by the shaded areas.
UNEMPLOYMENT AND OKUN’S LAW
• What relationship should we expect to find between
unemployment and real GDP?
• Because employed workers help to produce goods and services and
unemployed workers do not, increases in the unemployment rate
should be associated with decreases in real GDP.
• This negative relationship between unemployment and GDP is called
Okun’s law, after Arthur Okun, the economist who first studied it.
UNEMPLOYMENT AND OKUN’S LAW
Okun’s Law
This figure is a scatterplot of the
change in the unemployment
rate on the horizontal axis and
the percentage change in real
GDP on the vertical axis, using
data on the U.S economy.
Each point represents one year.
The negative correlation between
these variables shows that
increases in unemployment tend
to be associated with lower-than-
normal growth in real GDP.
LEADING ECONOMIC INDICATORS
• Business economists are interested in forecasting to help their companies
plan for changes in the economic environment.
• Government economists are interested in forecasting for two reasons.
1. The economic environment affects the government; for example, the state of
the economy influences how much tax revenue the government collects.
2. The government can affect the economy through its use of monetary and
fiscal policy.
• Economic forecasts are, therefore, an input into policy planning.
• Leading indicators – are variables that tend to fluctuate in advance of the
overall economy.
LEADING ECONOMIC INDICATORS
• New orders for consumer goods and materials, adjusted for inflation.
• Index of supplier deliveries.
• New building permits issued.
• Index of stock prices.
• Money supply (M2), adjusted for inflation.
• Interest rate spread: the yield spread between 10-year Treasury notes
and 3-month Treasury bills.
• Index of consumer expectations.
TIME HORIZONS IN MACROECONOMICS
• Why do economists need different models for different time
horizons?
• Classical macroeconomic theory applies to the long run but not
to the short run.
• But why is this so?
HOW THE SHORT RUN AND LONG RUN DIFFER
• The key difference between the short run and the long run is
the behavior of prices.
• In the long run, prices are flexible and can respond to changes in
supply or demand.
• In the short run, many prices are “sticky’’ at some predetermined
level.
• Because prices behave differently in the short run than in the long run,
various economic events and policies have different effects
over different time horizons.
HOW THE SHORT RUN AND LONG RUN DIFFER
• Classical dichotomy – the theoretical separation of real and nominal
variables
• Monetary neutrality – the irrelevance of the money supply for the
determination of real variables.
• These classical ideas describe how the economy works in the long run
• In the long run, changes in the money supply do not cause
fluctuations in output and employment, rather it simply causes
prices to rise.
HOW THE SHORT RUN AND LONG RUN DIFFER
• In the short run, many prices are sticky.
• A model of economic fluctuations must take into account this short-run
price stickiness.
• The failure of prices to adjust quickly and completely to changes in the
money supply means that, in the short run, real variables such as
output and employment must do some of the adjusting
instead.
THE MODEL OF AGGREGATE SUPPLY
AND AGGREGATE DEMAND
• In classical macroeconomic theory, the amount of output depends on
the economy’s ability to supply goods and services, which in
turn depends on the supplies of capital and labor and on the
available production technology.
• Flexible prices are a crucial assumption of classical theory.
• The theory posits, that prices adjust to ensure that the quantity of
output demanded equals the quantity supplied.
THE MODEL OF AGGREGATE SUPPLY
AND AGGREGATE DEMAND
• The economy works quite differently when prices are sticky.
• In this case, as we will see, output also depends on the economy’s
demand for goods and services.
• Demand, in turn, depends on a variety of factors: consumers’ confidence
about their economic prospects, firms’ perceptions about the profitability of
new investments, and monetary and fiscal policy.
• Monetary and fiscal policy can influence demand, and demand in turn
can influence the economy’s output over the time horizon when prices are
sticky
THE MODEL OF AGGREGATE SUPPLY AND
AGGREGATE DEMAND
• This macroeconomic model allows us to study how the aggregate
price level and the quantity of aggregate output are
determined in the short run.
• It also provides a way to contrast how the economy behaves in the
long run and how it behaves in the short run.
• The model of aggregate supply and aggregate demand is a
sophisticated model that incorporates the interactions among many
markets.
AGGREGATE DEMAND
• Aggregate demand (AD) is the relationship between the quantity of
output demanded and the aggregate price level.
• In other words, the aggregate demand curve tells us the quantity of
goods and services people want to buy at any given level of prices.
AGGREGATE DEMAND
The Aggregate Demand Curve
The aggregate demand curve AD
shows the relationship between the
price level P and the quantity of goods
and services demanded Y.
It is drawn for a given value of the
money supply M.
The aggregate demand curve slopes
downward: the higher the price level
P, the lower the level of real balances
M/P, and therefor the lower the
quantity o goods and services
demanded Y.
This downward-sloping curve is called
the aggregate demand curve.
SHIFTS IN THE AGGREGATE DEMAND CURVE
• If the Fed changes the money supply, then the possible combinations
of P and Y change, which means the aggregate demand curve shifts.
SHIFTS IN THE AGGREGATE DEMAND CURVE
• Changes in the money supply shift the aggregate demand curve.
• In panel (a), a decrease in the money supply M reduces the nominal value of output
PY.
• For any given price level P, output Y is lower.
• Thus, a decrease in the money supply shifts the aggregate demand curve inward
from AD1 to AD2.
• In panel (b), an increase in the money supply M raises the nominal value of output
PY.
• For any given price level P, output Y is higher.
• Thus, an increase in the money supply shifts the aggregate demand curve outward
from AD1 to AD2.
AGGREGATE SUPPLY
• Aggregate supply (AS) is the relationship between the quantity of goods
and services supplied and the price level.
• Because the firms that supply goods and services have flexible prices in the
long run but sticky prices in the short run, the aggregate supply
relationship depends on the time horizon.
• We need to discuss two different aggregate supply curves: the long-run
aggregate supply curve LRAS and the short-run aggregate supply curve SRAS.
• We also need to discuss how the economy makes the transition from the short
run to the long run.
THE LONG RUN: THE VERTICAL AGGREGATE
SUPPLY CURVE
• Because the classical model describes how the economy behaves in
the long run, we derive the long-run aggregate supply curve from the
classical model.
• According to the classical model, output does not depend on the price
level.
• To show that output is fixed at this level, regardless of the price level,
we draw a vertical aggregate supply curve
THE LONG RUN: THE VERTICAL AGGREGATE
SUPPLY CURVE The Long-Run
Aggregate Supply
Curve
In the long run, the
level of output is
determined by the
amounts of capital
and labor and by the
available technology;
it does not depend on
the price level.
The long-run
aggregate supply
curve, LRAS, is
vertical.
AGGREGATE DEMAND AND LRAS
• If the aggregate supply curve is vertical, then changes in aggregate
demand affect prices but not output.
• If the money supply falls, the aggregate demand curve shifts
downward.
• The economy moves from the old intersection of aggregate supply and
aggregate demand, point A, to the new intersection, point B.
• The shift in aggregate demand affects only prices.
AGGREGATE DEMAND AND LRAS
Shifts in Aggregate
Demand in the Long Run
A reduction in the money
supply shifts the aggregate
demand curve downward from
AD1 to AD2.
The equilibrium for the
economy moves from point A
to point B.
Because the aggregate supply
curve is vertical in the long
run, the reduction in
aggregate demand affects the
price level but not the level of
output.
AGGREGATE DEMAND AND LRAS
• The vertical aggregate supply curve satisfies the classical dichotomy,
because it implies that the level of output is independent of the money
supply.
• This long-run level of output, Y, is called the full-employment,
or natural, level of output.
• It is the level of output at which the economy’s resources are fully
employed or, more realistically, at which unemployment is at its
natural rate.
THE SHORT RUN: THE HORIZONTAL
AGGREGATE
SUPPLY CURVE
• Because of this price stickiness, the short-run aggregate supply curve
is not vertical.
• Thus, all prices are stuck at predetermined levels.
• At these prices, firms are willing to sell as much as their customers are
willing to buy, and they hire just enough labor to produce the amount
demanded.
• Because the price level is fixed, we represent this situation with a
horizontal aggregate supply curve.
THE SHORT RUN: THE HORIZONTAL
AGGREGATE
SUPPLY CURVE The Short-Run
Aggregate
Supply Curve
In this extreme
example, all prices
are fixed in the
short run.
Therefore, the
short-run
aggregate supply
curve, SRAS, is
horizontal.
SHORT RUN RELATIONSHIP
Shifts in Aggregate
Demand
in the Short Run
A reduction in the money
supply shifts the aggregate
demand curve downward
from AD1 to AD2.
The equilibrium for the
economy moves from point
A to point B.
Because the aggregate
supply curve is horizontal
in the short run, the
reduction in aggregate
demand reduces the level
of output.
FROM THE SHORT RUN TO THE LONG RUN
• Over long periods of time, prices are flexible, the aggregate
supply curve is vertical, and changes in aggregate demand
affect the price level but not output.
• Over short periods of time, prices are sticky, the aggregate supply
curve is flat, and changes in aggregate demand do affect the
economy’s output of goods and services.
FROM THE SHORT RUN TO THE LONG RUN
Long-Run Equilibrium
In the long run, the economy
finds itself at the intersection
of the long-run aggregate
supply curve and the
aggregate demand curve.
Because prices have adjusted
to this level, the short-run
aggregate supply curve
crosses this point as well.
A REDUCTION IN AGGREGATE DEMAND
The economy begins in long-
run equilibrium at point A.
A reduction in aggregate
demand, perhaps caused by a
decrease in the money supply,
moves the economy from point
A to point B, where output is
below its natural level.
As prices fall, the economy
gradually recovers from the
recession,
moving from point B to point C.
STABILIZATION POLICY
• Fluctuations in the economy as a whole come from changes in
aggregate supply or aggregate demand.
• Economists call exogenous events that shift these curves shocks to the
economy.
• A shock that shifts the aggregate demand curve is called a demand shock,
and a shock that shifts the aggregate supply curve is called a supply
shock.
• Economists use the term stabilization policy to refer to policy actions
aimed at reducing the severity of short-run economic fluctuations.
SHOCKS TO AGGREGATE DEMAND
An Increase in Aggregate
Demand
The economy begins in long-run
equilibrium at point A.
An increase in aggregate
demand, perhaps due to an
increase in the velocity of
money, moves the economy
from point A to point B, where
output is above its natural level.
As prices rise, output gradually
returns to its natural level, and
the economy moves from point
B to point C.
SHOCKS TO AGGREGATE SUPPLY
• A supply shock is a shock to the economy that alters the cost of
producing goods and services and, as a result, the prices that
firms charge.
• Because supply shocks have a direct impact on the price level, they are
sometimes called price shocks.
SHOCKS TO AGGREGATE SUPPLY
• Examples include:
■ A drought that destroys crops. The reduction in food supply pushes up food
prices.
■ A new environmental protection law that requires firms to reduce their
emissions of pollutants.
■ An increase in union aggressiveness - pushes up wages and the prices of the
goods produced.
■ The organization of an international oil cartel – curtails competition, the major
oil producers can raise the world price of oil.
All these events are adverse supply shocks, which means they push costs and
prices upward.
A favorable supply shock, such as the breakup of an international oil cartel,
reduces costs and prices.
AN ADVERSE SUPPLY SHOCK
An adverse supply shock
pushes up costs and thus
prices.
If aggregate demand is held
constant, the economy
moves from point A to point
B, leading to stagflation, a
combination of increasing
prices and falling output.
Eventually, as prices fall,
the economy returns to the
natural level of output,
point A.
ACCOMMODATING AN ADVERSE SUPPLY
SHOCK
In response to an
adverse supply shock,
the Fed can increase
aggregate demand to
prevent a reduction in
output.
The economy moves
from point A to point
C.
The cost of this policy
is a permanently
higher level of prices.