SHORT-RUN ECONOMIC FLUCTUATIONS

SHORT-RUN ECONOMIC FLUCTUATIONS
8 SHORT-RUN ECONOMIC FLUCTUATIONS

Aggregate Demand and Aggregate Supply
15 Aggregate Demand and Aggregate Supply

Short-Run Economic Fluctuations
What causes short-run fluctuations in economic activity? What, if anything, can the government do to stop GDP from falling and unemployment from rising? And if the government can’t stop the occurrence of bad times, can it at least make them less damaging in terms of duration and severity?

Economic activity fluctuates from year to year. Real GDP increases in most years. On average over the past 50 years, real GDP in the U.S. economy has grown by about 3.2 percent per year—see chapter 10 Real GDP per person has grown at the rate of about 2 percent per year—see chapter 12 In some years normal growth does not occur, causing a recession.

A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. An expansion is a period of increasing real incomes, and falling unemployment.

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Three Key Facts About Economic Fluctuations
Fact 1: Economic fluctuations are irregular and unpredictable Source: downloaded on Nov. 29, 2011.

Economic fluctuations are irregular and unpredictable
Recessions start at the peak of a business cycle and end at the trough. The length of a business cycle may be measured by the time between one peak and the next or the time between one trough and the next. The peaks and troughs of the US business cycle are officially registered by the NBER. During , there have been 11 cycles in the US. The average recession lasted 11 months and the average expansion lasted 59 months, thereby making the average cycle roughly 70 months long.

Fact 2: Most macroeconomic variables fluctuate together. When real GDP falls in a recession, so do many other variables: personal income, corporate profits, consumption spending, investment spending, industrial production, retail sales, home sales, auto sales, etc. However, investment fluctuates a lot more than other variables. Even though investment is about one-seventh of GDP, much of the fall in GDP during recessions is due to the fall in investment spending.

Fact 2: Most macroeconomic variables fluctuate together -- business investment is especially volatile Downloaded from on November 29, 2011.

Fact 3: As output falls, unemployment rises. The unemployment rate never approaches zero; instead it fluctuates around its natural rate of about 5 percent.

Fact 3: As Output Falls, Unemployment Rises Downloaded from on November 29, 2011.

theory

Recap: long-run theory
Chapter 7: GDP depends on number of workers physical capital per worker human capital per worker natural resources per worker technological knowledge laws, government policies, and their enforcement Chapter 8: saving, investment, and the real interest rate depend on the supply and demand for loanable funds Chapter 10: unemployment depends on how well the labor market matches unemployed workers to job vacancies, and how close the wage is to the equilibrium wage Chapter 12: the price level depends on the quantity of money, and the rate of inflation depends on the growth rate of the quantity of money The factors that affect the real interest rate (Ch. 8) and the inflation rate (Ch. 12) together determine the nominal interest rate

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
Most economists believe that the long run theory we’ve studied in previous chapters does not explain short run fluctuations in the long run, changes in the money supply affect nominal variables but not real variables. This is monetary neutrality; see chapter 12. But monetary neutrality is not true in the short run

Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Real GDP (Y) Ch. 5 Measuring a Nation’s Income The Price Level (P) GDP Deflator Ch. 5 The CPI Ch 6 Measuring the Cost of Living The theory of aggregate demand and aggregate supply is based on two theoretical links between Y and P.

The aggregate-demand curve shows the total quantity of “Made in USA” goods and services that everybody—households, firms, the government, and foreigners—wants to buy at each price level. The aggregate-supply curve shows the total quantity of “Made in USA” goods and services that US firms would like to produce and sell at each price level.

Figure 2 Aggregate Demand and Aggregate Supply
Price Level Aggregate supply Aggregate demand Equilibrium output price level Quantity of Output

Aggregate demand

Aggregate Demand = C + I + G + NX
The aggregate demand for goods and services has four components: Aggregate Demand = C + I + G + NX Aggregate Supply = Y In equilibrium, supply = demand Therefore, in equilibrium Y = C + I + G + NX

Figure 3 The Aggregate-Demand (AD) Curve is downward sloping
Price Level Aggregate Demand (AD) C + I + G + NX P Y 1. A decrease in the price level . . . Y2 P2 Quantity of increases the quantity of goods and services demanded. Output

Bonus slide: why the demand curve for ice cream can’t explain the AD curve
The demand curve for an individual commodity is downward sloping because of two effects: Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute) Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice cream Review Chapter 4 The Market Forces of Supply and Demand But the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effect It is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.

Why the Aggregate-Demand Curve Is Downward Sloping: three reasons
The Wealth Effect: a lower price level boosts consumption spending by households The Interest-Rate Effect: a lower price level boosts investment spending by businesses The Exchange-Rate Effect: a lower price level boosts net exports

Why the Aggregate-Demand Curve Is Downward Sloping: Wealth Effect
P↓ causes the purchasing power of consumers’ monetary wealth ↑ This causes consumption ↑ Besides, if a price decline is perceived to be temporary it makes sense to buy what you need now, while prices are still low C ↑ causes aggregate demand (C+I+G+NX) ↑

Bonus slide: Wealth Effect Controversy
P↓ causes the real burden of the monetary debts of debtors ↑ This causes debtors’ consumption ↓ Therefore, if the decrease in debtors’ consumption exceeds the increase in the consumption of others, it is possible that C ↓ Therefore, P↓ could cause aggregate demand (C+I+G+NX) ↓ For this reason, the economist Paul Krugman has argued that the AD curve may be upward rising!

P↓ causes nominal interest rate ↓
Why the Aggregate-Demand Curve Is Downward Sloping: Interest Rate Effect P↓ causes nominal interest rate ↓ See Ch. 16 for more on this. nominal interest rate ↓ encourages greater investment spending by businesses (I ↑) I ↑ means aggregate demand (C+I+G+NX) ↑

Why the Aggregate-Demand Curve Is Downward Sloping: Exchange-Rate Effect
P↓ causes nominal interest rate ↓ See Ch. 16 for more on this. Foreigners sell the dollars they had been holding in US banks The value of the dollar ↓ As a result, US goods become cheaper relative to foreign goods. This makes U.S. net exports increase (NX ↑) NX↑ means aggregate demand (C+I+G+NX) ↑

Shifts in the Aggregate Demand Curve
We have seen why the AD curve is negatively sloped. We know why aggregate demand would increase from Y1 to Y2 when the price level decreases from P1 to P2. But what are the reasons why the AD curve might shift? In other words, what are the reasons why aggregate demand might increase to Y2 even if the price level stays put at P1? Price Level D2 P1 Y2 P2 Aggregate demand, D1 Y1 Y2 Quantity of Output

Why the Aggregate-Demand Curve Might Shift
P↓ causes C+I+G+NX ↑ This explains the downward slope of the aggregate demand curve Many other factors can affect C+I+G+NX even when the price level stays unchanged. When these factors change, the aggregate demand curve shifts. P AD C + I + G + NX

Why the Aggregate-Demand Curve Might Shift
Shifts arising from Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate) Investment: technological progress, business confidence, tax rates, money supply Government Purchases Net Exports: foreign GDP, expectations about exchange rates P Y

The aggregate-demand curve: summary (a)
Table 1 The aggregate-demand curve: summary (a) Why Does the Aggregate-Demand Curve Slope Downward? 1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption. 2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment. 3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports

The aggregate-demand curve: summary (b)
Table 1 The aggregate-demand curve: summary (b) Why Might the Aggregate-Demand Curve Shift? 1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to the right. An event that makes consumers spend less at a given price level (a tax hike, a stock-market decline) shifts the aggregate-demand curve to the left. 2. Shifts Arising from Investment: An event that makes firms invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that makes firms invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left. 3. Shifts Arising from Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left. 4. Shifts Arising from Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange-rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left .

Aggregate supply

THE AGGREGATE-SUPPLY CURVE
In the long run, the aggregate-supply (LRAS) curve is vertical. In the short run, the aggregate-supply (SRAS) curve is upward sloping.

THE AGGREGATE-SUPPLY CURVE: long run
An economy’s long-run output of goods and services is also called the natural rate of output or potential output or full-employment output See Chapter 7 Long-run output depends on: labor physical capital human capital natural resources Technology Laws, government policies, and their enforcement The price level does not affect these variables in the long run.

Figure 4 The Long-Run Aggregate-Supply Curve
Price Level Long-run aggregate supply P 1. A change in the price level . . . P2 does not affect the quantity of goods and services supplied in the long run. Natural rate Quantity of of output Output

Why the Long-Run Aggregate-Supply Curve Might Shift
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve. Labor: population growth, immigration, natural rate of unemployment Capital, physical or human Natural Resources: price of imported oil Technology Laws, government policies P Y

Figure 5 Long-Run Growth and Inflation
and growth in the money supply shifts aggregate demand . . . Long-run aggregate supply, LRAS 1980 Y 1990 LRAS Y 2000 LRAS Price Aggregate Demand, AD 2000 Level 1. In the long run, technological progress shifts long-run aggregate supply . . . AD 1990 P 2000 and ongoing inflation. P 1990 P 1980 AD 1980 Y 1980 leading to growth in output . . . Quantity of Output

A New Way to Depict Long-Run Growth and Inflation
Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

The Aggregate-Supply Curve Slopes Upward in the Short Run
In the short run, an increase in the overall level of prices tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied. Why?

Figure 6 The Short-Run Aggregate-Supply Curve
Price Level Short-run aggregate supply Y P 1. A decrease in the price level . . . Y2 P2 reduces the quantity of goods and services supplied in the short run. Quantity of Output

The Sticky-Wage Theory The Sticky-Price Theory
Why the Aggregate-Supply Curve Slopes Upward in the Short Run: three theories The Sticky-Wage Theory The Sticky-Price Theory The Misperceptions Theory But, they all reach the same conclusion: Quantity of output supplied Natural rate of output Actual price level Expected price level = + a ✕ −

The Short Run Aggregate-Supply Curve
According to the SRAS formula, if the overall price level is equal to the expected price level (P = Pe), then output supplied is equal to the natural rate of output (Y = YN). P AS 140 Pe = 120 Also, if P > Pe, then Y > YN. That is, the SRAS curve is upward rising. YN Y Quantity of output supplied Natural rate of output Actual price level Expected price level = + a ✕ − Y = YN + a ✕ (P – Pe)

We have just seen that if P↑ then Y↑. AS1 P AS2 That is, the SRAS curve is upward rising. But the SRAS equation shows that output supplied can increase (Y↑) even when P is unchanged, as long as Pe↓ or YN↑. Pe1 = 120 Pe2 = 100 So, if either Pe↓ or YN↑, the AS curve shifts down or to the right YN1 YN2 Y Quantity of output supplied Natural rate of output Actual price level Expected price level = + a ✕ − Y = YN + a ✕ (P – Pe)

AS1 To summarize, the SRAS equation implies that The SRAS curve is upward rising, and The SRAS curve shifts right if The expected price falls, or The natural rate of output increases P AS2 Y Quantity of output supplied Natural rate of output Actual price level Expected price level = + a ✕ − Y = YN + a ✕ (P – Pe)

The Sticky-Wage Theory
Suppose wages for 2010 were set in 2009 These wage agreements were based on the output prices that were expected to prevail in 2010 Suppose actual prices in 2010 fall short of what was expected Wages do not adjust immediately to the unexpectedly low price level. An unexpectedly low price level and an unchanged wage level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.

Shape of the AS Curve: The Sticky-Wage Theory
AS shows the aggregate supply curve for 2010 Back in 2009, workers and their bosses had reached an agreement on wages for 2010 During the negotiations, they had all expected that prices in 2010 would be Pe = 120 If the actual price level in 2010 (P) turns out to be 120, the bosses’ expectations are fulfilled and nobody gets fired. So, output in 2010 is the full-employment output, YN. Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve If the actual price level in 2010 (P) turns out to be 140, production is more profitable than was expected because the prices are higher than expected and the wages are unchanged at the previously agreed level So, production increases beyond the full-employment level (blue dot) In other words, the AS curve is upward rising P AS 140 Pe = 120 YN Y

Shape of the AS Curve: The Sticky-Price Theory
Prices of some goods and services adjust sluggishly in response to changing economic conditions An unexpected fall in the price level leaves some firms with higher-than-desired prices. This depresses their sales, which induces these firms to reduce the quantity of goods and services they produce. For consistency, title this slide, “Why the Aggregate supply curves slopes upward in the short run” like the previous two slides. Then move “The sticky-price theory” in large print to the top bullet (like the previous two slides).

Shape of the AS Curve: The Sticky-Price Theory
AS shows the aggregate supply curve for 2010 Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140 Menu costs make frequent price changes impractical. E-type (O-type) firms set prices at the beginning of even-numbered (odd-numbered) months If the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN. Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve If demand falls sharply on Jan. 15, businesses must reduce prices to keep their customers. On Feb. 1, only E-type firms reduce their prices. They keep their customers. They do not layoff any employees. But O-type firms cannot cut their prices. They lose customers and layoff some employees So, production decreases below the full-employment level (blue dot) I am assuming that firms do not produce products that are perfectly substitutable In other words, the AS curve is upward rising P AS Pe = 140 120 YN Y

Shape of the AS Curve: The Misperceptions Theory
Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output A lower price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

Suppose an overall decline in demand reduces all prices A wheat farmer, however, sees only that wheat prices have fallen and continues to believe that the prices of the things that she buys (milk, shoes, clothes, etc.) are unchanged at the level she had expected This makes work less attractive and the farmer reduces her production of wheat. I am assuming that the wheat farmer knows only how to produce wheat When this is repeated across the economy, both the overall price level and total output fall

AS shows the aggregate supply curve for 2010 Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140 If the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN. Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve If the prices fall unexpectedly in 2010 to 120, a wheat farmer becomes aware of a fall in the price of the wheat she sells, but may be unaware that the prices of the stuff she buys have also fallen Disappointed, the wheat farmer chooses to work less and produce less So, production decreases below the full-employment level (blue dot) In other words, the AS curve is upward rising P AS Pe = 140 120 YN Y

How the AS curve shifts AS1 shows the aggregate supply curve for 2010
We saw in previous slides that the green dot, which represents the expected price level and the natural rate of output, must be on the AS curve If either Pe↓ or YN↑, the green dot moves down or to the right When the green dot shifts, so must the AS curve AS1 P AS2 Pe1 = 120 Pe2 = 100 YN1 YN2 Y So, if either Pe↓ or YN↑, the AS curve shifts down or to the right

The Short-Run Aggregate-Supply Curve Shifts to the Right if:
The natural rate of output increases This happens when there is an increase in: Labor Physical Capital Human capital Natural Resources Technology. The Expected Price Level decreases. Price Level Quantity of Output

Table 2: The Short-Run Aggregate-Supply Curve: Summary

Recessions caused by decreases in aggregate demand
Long-run equilibrium, short-run equilibrium following a disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium Recessions caused by decreases in aggregate demand

Figure 7 The Long-Run Equilibrium
Price Level Long-run aggregate supply Short-run aggregate supply Aggregate demand A Equilibrium price Natural rate of output Quantity of Output

Figure 8 A Contraction in Aggregate Demand
causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AD2 A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 Quantity of Output If the shock to AD is temporary, it will soon go back to AD1. But what if the shock to AD is permanent?

causes output to fall in the short run . . . Price Level If the shock to AD is permanent, people will realize that in the long run the economy will end up at C. Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AD2 They will expect the price level to fall to P3. A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 Quantity of Output

causes output to fall in the short run . . . Price Level Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD AS2 AD2 but over time, the short-run aggregate-supply curve shifts . . . A P Y B P2 Y2 1. A decrease in aggregate demand . . . C P3 and output returns to its natural rate. Quantity of 5. The government could also use expansionary monetary/fiscal policies to push AD back to AD1. Output

ECONOMIC FLUCTUATIONS: AD
Contraction (leftward shift) in Aggregate Demand In the short run, output decreases, the overall price level decreases, and the unemployment rate increases In the long run, the overall price level decreases, but output and the unemployment rate remain unchanged at their long-run levels

ECONOMIC FLUCTUATIONS: AD (bonus slide)
Note that the decrease in demand could be caused by A decrease in the quantity of money (M), or Some other (non-monetary) reason Either way, the long run effect is that P↓ and Y stays unchanged. Therefore, P ✕ Y ↓. But in the long run, the quantity equation of chapter 17 is assumed to be true: M ✕ V = P ✕ Y. Therefore, M ✕ V must fall. If M is unchanged, then V must fall So, the theory predicts that any non-monetary decrease in AD must cause V to fall in the long run

Policy response to a fall in aggregate demand
If production and employment take too long to return to their long-run levels, the government could step in to hasten the process The government could push the aggregate demand curve back where it was by: increasing the money supply (expansionary monetary policy) Cutting taxes or increasing government spending (expansionary fiscal policy)

Great Depression, recession of 2001, Great Recession of 2008
history

Two big shifts in aggregate demand: Great Depression and World War II
Early 1930s: large drop in real GDP The Great Depression Largest economic downturn in U.S. history From 1929 to 1933 Real GDP fell by 27% Unemployment rose from 3 to 25% Price level fell by 22% Cause: decrease in aggregate demand Decline in money supply (by 28%) Decreasing: consumer spending, investment spending

Two big shifts in aggregate demand: Great Depression and World War II
Early 1940s: large increase in real GDP Economic boom World War II More resources to the military Government purchases increased Aggregate demand – increased Doubled the economy’s production of goods and services 20% increase in the price level Unemployment fell from 17 to 1%

U.S. real GDP growth since 1900
Figure 9 U.S. real GDP growth since 1900 Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.

The Recession of 2001 2001: Recession
Unemployment rate December 2000: 3.9% August 2001: 4.9% June 2003: 6.3% January 2005: 5.2% Three events – decrease in aggregate demand The end of dot-com bubble in stock market Stock prices fell (25%) Reduced consumer & investment spending Aggregate-demand curve - shifted to left

The recession of 2001 Three events – decrease in aggregate demand
Terrorist attacks on September 11, 2001 Stock market fell (12%) in one week Increased uncertainty about the future Aggregate-demand curve – shifted further to left Series of corporate accounting scandals Enron and WorldCom Stock market fell

The recession of 2001 2001: Recession Policymakers - quick to respond
The Fed - expansionary monetary policy Interest rates fell; Federal funds rate fell Stimulated spending Congress Tax cut in 2001; Immediate tax rebate; Tax cut in 2003 To stimulate consumer & investment spending Aggregate-demand curve – shifted to right Offset the three contractionary shocks

Crisis of 2008

Roots of the Crisis of 2008 The crisis of 2008 may have been caused by the Fed’s overreaction to the recession of 2001 The Fed cut interest rates sharply kept them low for too long

Roots of the Crisis of 2008 Those low interest rates may have fueled a ‘bubble’ in home prices

The Recession of 2008–2009 Developments in the mortgage market
Easier for subprime borrowers to get loans Borrowers with a higher risk of default (income and credit history) Securitization Process by which a financial institution (mortgage originator) makes loan Then (investment bank) bundles them together mortgage-backed securities

The Recession of 2008–2009 Developments in the mortgage market
Mortgage-backed securities Sold to other institutions, which may not have fully appreciated the risks in these securities Other issues Inadequate regulation for these high-risk loans Misguided government policy Encouraged this high-risk lending

The Recession of 2008–2009 Increase in housing demand Increase in housing prices More than doubled , housing prices fell 30% Substantial rise in mortgage defaults and home foreclosures Financial institutions that owned mortgage-backed securities Huge losses, stopped making loans

The Recession of 2008–2009 Large contractionary shift in AD
Real GDP fell sharply By 4% between the forth quarter of 2007 and the second quarter of 2009 Employment fell sharply Unemployment rate rose from 4.4% in May 2007 to 10.1% in October 2009

The Recession of 2008–2009 Three policy actions - aimed in part at returning AD to its previous level The Fed Cut its target for the federal funds rate From 5.25% in September 2007 to about zero in December 2008 Started buying mortgage-backed securities and other private loans In open-market operations Provided banks with additional funds

The Recession of 2008–2009 Three policy actions
October 2008, Wall Street bailout $700 billion For the Treasury to use to rescue the financial system To stem the financial crisis on Wall Street To make loans easier to obtain Equity injections into banks U.S. government – temporarily became a part owner of these banks

The Recession of 2008–2009 Three policy actions Economy
January 2009, President Barack Obama $787 billion stimulus bill, February 17, 2009 To be spent over two years Economy Starting to recover from the economic downturn Real GDP - growing again Unemployment – 9.5% in June 2010

Crisis of 2008: housing bubble pops!
This is where it all began Downloaded from on November 29, 2011.

Crisis of 2008: the stock market tanked
This reduced people’s wealth … which reduced consumption … which reduced aggregate demand Downloaded from on November 29, 2011.

Crisis of 2008: consumption spending tanked
This was a major blow to aggregate demand Downloaded from on November 29, 2011.

Crisis of 2008: consumption spending began tanking early
We got hit by the collapse of the housing prices bubble … and by the collapse in share prices

Crisis of 2008: business investment tanked
This was a major blow to aggregate demand Businesses got scared way back in 2006! Downloaded from on November 29, 2011.

Crisis of 2008: business investment tanked
Businesses got scared way back in 2006!

Crisis of 2008: Real GDP fell sharply
This was the worst recession since the Great Depression Downloaded from on November 2011.

Crisis of 2008: Real GDP fell sharply
Growth of real GDP turned negative Downloaded from on November 2011.

Crisis of 2008: unemployment spiked
Demand had collapsed … so jobs disappeared Downloaded from on November 29, 2011.

Crisis of 2008: prices actually fell
… for a while Downloaded from and on November 29, 2011.

Crisis of 2008: no inflation
We had deflation, for a while

Crisis of 2008: our net exports improved
This was a consequence of our falling incomes But this did not help aggregate demand all that much Downloaded from and on November 29, 2011.

Crisis of 2008: government spending rose
This helped aggregate demand Downloaded from on November 29, 2011.

Crisis of 2008: government spending rose sharply as a percentage of GDP
But it wasn’t enough

Crisis of 2008: government receipts tanked
Incomes fell … so tax payments fell too … automatic stabilizers in action!

Crisis of 2008: fiscal policy stimulus

The government went on a borrowing binge to stimulate the economy Downloaded from on November 29, 2011.

The government went on a borrowing binge to stimulate the economy

Crisis of 2008: monetary stimulus
Real money supply kept rising at a slightly faster than usual pace

Crisis of 2008: monetary stimulus
The Federal Reserve did all it could But the Federal Funds Rate could not be reduced below zero! Downloaded from on November 29, 2011.

Recessions caused by decreases in aggregate supply

ECONOMIC FLUCTUATIONS: AS
A leftward shift in Short-Run Aggregate Supply Output falls below the natural rate of employment Unemployment rises The price level rises If the government does nothing, the SRAS will shift back to where it was. The price level, total production and unemployment will be unaffected in the long run. Stagflation!

Figure 10 An Adverse Shift in Aggregate Supply
1. An adverse shift in the short- run aggregate-supply curve . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate supply Aggregate demand B Y2 P2 Y A P and the price level to rise. Quantity of causes output to fall . . . Output

Stagflation Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

The Effects of a Shift in Aggregate Supply
Policy Responses to Recession Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using (expansionary) monetary and fiscal policy.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply
1. When short-run aggregate supply falls . . . Price Level Long-run Short-run aggregate supply, AS AS2 aggregate AD2 supply C P3 policymakers can accommodate the shift by expanding aggregate demand . . . which causes the price level to rise further . . . P2 A P but keeps output at its natural rate. Aggregate demand, AD Natural rate Quantity of of output Output

Economic fluctuations in the U.S. economy
Oil and the economy Economic fluctuations in the U.S. economy Since 1970 Some: originated in the oil fields of the Middle East Some event - reduces the supply of crude oil flowing from Middle East Price of oil - rises around the world Aggregate-supply curve – shifts left Stagflation Mid-1970s Late-1970s

Some event – increases the supply of crude oil from Middle East
Oil and the economy Some event – increases the supply of crude oil from Middle East Price of oil decreases Aggregate-supply curve – shifts right Output – rapid growth Unemployment – falls Inflation rate – falls

2008 - world oil prices – rising significantly
Oil and the economy Recent years: World market for oil – not an important source of economic fluctuations Conservation efforts Changes in technology world oil prices – rising significantly Increased demand from a rapidly growing China

John Maynard Keynes (1883-1946)
Our understanding of the short-run behavior of the economy grew out of economists’ attempts to understand why the Great Depression happened Published in 1936, Keynes’s The General Theory of Employment, Interest and Money laid the foundations TIME Cover, December 31, 1965

John Maynard Keynes (1883-1946)
“The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.” A Tract on Monetary Reform (1923)

Summary All societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

Summary Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model. According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

Summary The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect. Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.

Summary In the long run, the aggregate supply curve is vertical.
The short-run, the aggregate supply curve is upward sloping. The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory. Bullet three, move the misperceptions theory to the end.

Summary Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve. Also, the position of the short-run aggregate-supply curve depends on the expected price level. One possible cause of economic fluctuations is a shift in aggregate demand.

Summary A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices.

SHORT-RUN ECONOMIC FLUCTUATIONS

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SHORT-RUN ECONOMIC FLUCTUATIONS

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