Short-RunEconomicFluctuations
◆Economicactivityfluctuatesfromyeartoyear.◆ Inmostyearsproductionofgoodsandservicesrises.◆ Onaverageoverthepast50years,productionintheU.S.economyhasgrownbyabout3percentperyear.
◆ Insomeyearsnormalgrowthdoesnotoccur,causingarecession.
Short-RunEconomicFluctuations
◆Arecession isaperiodofdecliningrealGDP,fallingincomes,andrisingunemployment.◆Adepression isasevererecession.
ThreeKeyFactsAboutEconomicFluctuations
◆Economicfluctuationsareirregularandunpredictable.◆ Fluctuationsintheeconomyareoftencalledthebusinesscycle.
◆Mostmacroeconomicvariablesfluctuatetogether.◆Asoutputfalls,unemploymentrises.
Recessions
(a) Real GDP
Billions of1992 Dollars
1965 1970 1975 1980 1985 1990 19952,5003,0003,5004,0004,5005,0005,5006,0006,500
$7,000Real GDP
A Look At Short-Run Economic Fluctuations
ThreeKeyFactsAboutEconomicFluctuations
◆Mostmacroeconomicvariablesfluctuatetogether.◆Mostmacroeconomicvariablesthatmeasuresometypeofincomeorproductionfluctuatecloselytogether.
◆ Althoughmanymacroeconomicvariablesfluctuatetogether,theyfluctuatebydifferentamounts.
Recessions
(b) Investment Spending
Billions of1992 Dollars
300400500600700800900
1,000$1,100
Investment spending
1965 1970 1975 1980 1985 1990 1995
A Look At Short-Run Economic Fluctuations
ThreeKeyFactsAboutEconomicFluctuations
◆Asoutputfalls,unemploymentrises.◆ ChangesinrealGDPareinverselyrelatedtochangesintheunemploymentrate.
◆ Duringtimesofrecession,unemploymentrisessubstantially.
Recessions
(c) Unemployment Rate
Unemployment rate
0
2
4
6
8
10
12
1965 1970 1975 1980 1985 1990 1995
Percent ofLabor Force
A Look At Short-Run Economic Fluctuations
HowtheShortRunDiffersFromtheLongRun
◆Mosteconomistsbelievethatclassicaltheorydescribestheworldinthelongrunbutnotintheshortrun.◆ Changesinthemoneysupplyaffectnominalvariablesbutnotrealvariablesinthelongrun.
◆ Theassumptionofmonetaryneutralityisnotappropriatewhenstudyingyear-to-yearchangesintheeconomy.
TheBasicModelofEconomicFluctuations
◆Twovariablesareusedtodevelopamodeltoanalyzetheshort-runfluctuations.◆ Theeconomy’soutputofgoodsandservicesmeasuredbyrealGDP.◆ TheoverallpricelevelmeasuredbytheCPIortheGDPdeflator.
TheBasicModelofEconomicFluctuations
Economistusethemodelofaggregatedemand andaggregatesupply toexplainshort-runfluctuationsineconomicactivityarounditslong-runtrend.
TheBasicModelofEconomicFluctuations
◆Theaggregatedemandcurve showsthequantityofgoodsandservicesthathouseholds,firms,andthegovernmentwanttobuyateachpricelevel.
TheBasicModelofEconomicFluctuations
◆Theaggregatesupplycurve showsthequantityofgoodsandservicesthatfirmsproduceandsellateachpricelevel.
AggregateDemandandAggregateSupply...
Equilibriumoutput
Quantity ofOutput
PriceLevel
0
Equilibriumprice level
Aggregatesupply
Aggregatedemand
TheAggregateDemandCurve
◆ThefourcomponentsofGDP(Y)contributetotheaggregatedemandforgoodsandservices.
Y = C + I + G + NX
TheAggregate-DemandCurve...
Quantity ofOutput
PriceLevel
0
Aggregatedemand
P1
Y1 Y2
P2
2. …increases the quantity of goods and services demanded.
1. A decrease in the price level...
WhytheAggregateDemandCurveIsDownwardSloping
◆ThePriceLevelandConsumption:TheWealthEffect◆ThePriceLevelandInvestment:TheInterestRateEffect◆ThePriceLevelandNetExports:TheExchange-RateEffect
ThePriceLevelandConsumption:TheWealthEffect
◆Adecreaseinthepricelevelmakes consumersfeelmorewealthy,whichinturnencouragesthemtospendmore.
◆Thisincreaseinconsumerspendingmeanslargerquantitiesofgoodsandservicesdemanded.
ThePriceLevelandInvestment:TheInterestRateEffect
◆Alowerpricelevelreducestheinterestrate,whichencouragesgreaterspendingoninvestmentgoods.
◆Thisincreaseininvestmentspendingmeansalargerquantityofgoodsandservicesdemanded.
ThePriceLevelandnetExports:TheExchange-RateEffect
◆WhenafallintheU.S.pricelevelcausesU.S.interestratestofall,therealexchangeratedepreciates,whichstimulatesU.S.netexports.
◆Theincreaseinnetexportspendingmeansalargerquantityofgoodsandservicesdemanded.
WhytheAggregateDemandCurveMightShift
◆Thedownwardslopeoftheaggregatedemandcurveshowsthatafallinthepricelevelraisestheoverallquantityofgoodsandservicesdemanded.◆Manyotherfactors,however,affectthequantityofgoodsandservicesdemandedatanygivenpricelevel.◆Whenoneoftheseotherfactorschanges,theaggregatedemandcurveshifts.
WhytheAggregateDemandCurveMightShift
◆ShiftsarisingfromConsumption◆ShiftsarisingfromInvestment◆ShiftsarisingfromGovernmentPurchases◆ShiftsarisingfromNetExports
TheAggregateSupplyCurve
◆Inthelongrun,theaggregate-supplycurveisvertical.◆Intheshortrun,theaggregate-supplycurveisupwardsloping.
TheLong-RunAggregateSupplyCurve
◆Inthelong-run,aneconomy’sproductionofgoodsandservicesdependsonitssuppliesoflabor,capital,andnaturalresourcesandontheavailabletechnologyusedtoturnthesefactorsofproductionintogoodsandservices.◆Thepriceleveldoesnotaffectthesevariablesinthelongrun.
TheLong-RunAggregate- SupplyCurve...
Quantity ofOutput
Natural rateof output
Price Level
0
Long-runaggregate
supplyP1
P2 2. …does not affect the quantity of goods and services supplied in the long run.
1. A change in the price level…
TheLong-RunAggregateSupplyCurve
◆Thelong-runaggregatesupplycurveisverticalatthenaturalrateofoutput.◆Thislevelofproductionisalsoreferredtoaspotentialoutput orfull-employmentoutput.
WhytheLong-RunAggregateSupplyCurveMightShift
◆Anychangeintheeconomythataltersthenaturalrateofoutputshiftsthelong-runaggregate-supplycurve.◆Theshiftsmaybecategorizedaccordingtothevariousfactorsintheclassicalmodelthataffectoutput.
WhytheLong-RunAggregateSupplyCurveMightShift
◆ShiftsarisingfromLabor◆ShiftsarisingfromCapital◆ShiftsarisingfromNaturalResources◆ShiftsarisingfromTechnologicalKnowledge
1. In the long-run, technological progress shifts long-run aggregate supply...
LRAS2000LRAS1990
Long-RunGrowthandInflation...
Quantity ofOutput
Price Level
0
P1980
Y1980
AD1980
P2000
P1990
LRAS1980
2. …and growth in the money supply shifts aggregate-demand...
AD2000
AD1990
4. …and ongoing inflation.
Y1990 Y2000
3. …leading to growth in output...
Long-RunGrowthandInflation
Short-runfluctuationsinoutputandpricelevelshouldbeviewedasdeviationsfromthecontinuinglong-runtrends.
WhytheShort-RunAggregateSupplyCurveSlopesUpwardintheShortRun
◆Intheshortrun,anincreaseintheoveralllevelofpricesintheeconomytendstoraisethequantityofgoodsandservicessupplied.◆Adecreaseinthelevelofpricestendstoreducethequantityofgoodsandservicessupplied.
TheShort-RunAggregateSupplyCurve...
Quantity ofOutput
Price Level
0
Short-runaggregate
supply
Y1
P1
Y2
2. reduces the quantity of goods and services supplied in the short run.
P2
1. A decrease in the price level
WhytheShort-RunAggregateSupplyCurveSlopesUpwardintheShort
Run
◆TheMisperceptionsTheory◆TheSticky-WageTheory◆TheSticky-PriceTheory
TheMisperceptionsTheory
◆Changesintheoverallpriceleveltemporarilymisleadsuppliersaboutwhatishappeninginthemarketsinwhichtheyselltheiroutput:◆Alowerpricelevelcausesmisperceptionsaboutrelativeprices.◆ Thesemisperceptionsinducesupplierstodecreasethequantityofgoodsandservicessupplied.
TheSticky-WageTheory
◆Nominalwagesareslowtoadjust,orare“sticky”intheshortrun:◆Wagesdonotadjustimmediatelytoafallinthepricelevel.◆ Alowerpricelevelmakesemployment andproductionlessprofitable.
◆ Thisinducesfirmstoreducethequantityofgoodsandservicessupplied.
TheSticky-PriceTheory
◆Pricesofsomegoodsandservicesadjustsluggishlyinresponsetochangingeconomicconditions:◆ Anunexpectedfallinthepricelevelleavessomefirmswithhigher-than-desiredprices.
◆ Thisdepressessales,whichinducesfirmstoreducethequantityofgoodsandservicestheyproduce.
WhytheAggregateSupplyCurveMightShift
◆ShiftsarisingfromLabor◆ShiftsarisingfromCapital◆ShiftsarisingfromNaturalResources.◆ShiftsarisingfromTechnology.◆ShiftsarisingfromtheExpectedPriceLevel.
WhytheAggregateSupplyCurveMightShift
◆Anincreaseintheexpectedpricelevelreducesthequantityofgoodsandservicessuppliedandshiftstheshort-runaggregatesupplycurvetotheleft.◆Adecreaseintheexpectedpricelevelraisesthequantityofgoodsandservicessuppliedandshiftstheshort-runaggregatesupplycurvetotheright.
TheLong-RunEquilibrium
Quantity ofOutput
PriceLevel
0
Short-run aggregatesupply
Long-runaggregate
supply
Aggregatedemand
AEquilibriumprice
Natural rateof output
1. A decrease inaggregate demand…
AD2
AContractioninAggregateDemand...
Quantity ofOutput
PriceLevel
0
Short-run aggregatesupply, AS1
Long-runaggregate
supply
Aggregatedemand, AD1
AP1
Y1
BP2
Y2
2. …causes output to fall in the short run…
AS2
CP3
3. …but over time,the short-run aggregate-supply curve shifts…
4. …and output returnsto its natural rate.
ShiftsinAggregateDemand
◆Intheshortrun,shiftsinaggregatedemandcausefluctuationsintheeconomy’soutputofgoodsandservices.◆Inthelongrun,shiftsinaggregatedemandaffecttheoverallpricelevelbutdonotaffectoutput.
AnAdverseShiftinAggregateSupply
◆Adecreaseinoneofthedeterminantsofaggregatesupplyshiftsthecurvetotheleft:◆ Outputfallsbelowthenaturalrateofemployment.◆ Unemploymentrises.◆ Thepricelevelrises.
1. An adverse shift in the short-run aggregate-supply curve…
AS2
Long-runaggregate
supplyShort-run aggregatesupply, AS1
Quantity ofOutput
PriceLevel
0Aggregate demand
A
Y1
P1
An AdverseShiftinAggregateSupply...
3. …and the price level to rise.
P2
2. …causes output to fall…
B
Y2
Stagflation
◆Adverseshiftsinaggregatesupplycausestagflation—acombinationofrecessionandinflation.◆ Outputfallsandpricesrise.◆ Policymakerswhocaninfluenceaggregatedemandcannotoffsetbothoftheseadverseeffectssimultaneously.