BUSINESS CYCLE by Caterina Ficiarà

An economic system is characterized by fluctuations. In some years, the production of goods and services rises and this growth allows everyone to enjoy a higher standard of living. But in some years, firms are unable to sell all the goods they produce and this causes unemployment and the real GDP and other measures of income fall.

So we have: -recession; a period of falling incomes and rising unemployment - depression; a severe recession

Fluctuations in the economy are also called “business cycle”. This is a word that could create misunderstandings, because it seems to suggest that economic fluctuations follow a regular,predictable pattern (and it’s obvious that is not like that).

Studying changes that come out during a short- run, we can see that the variable mostly used is the real GDP (= gross domestic product, known with the word “PIL” in Italy). GDP measures the value of all final goods produced within a given period. In Italy the GDP is declining year by year and this is related to the economic crysis that affectes the whole world.

Anyway, many macroeconomic variables that measure some type of income, spending, or production fluctuate together. When real GDP falls in a recession, the same happens to personal income, corporate profits, consumer spending, investment spending, industrial production.

When the real GDP falls, this affects the utilization of labor force and in this way the uneployment rises. This happens because firms decide to produce a smaller quantity of goods (they do not require a high level of labor force to do it)

The basic model of a short-run economic fluctuations focuses on two variables: -The economy’s output of good and services,that is measured by the real GDP (as we said previously) -The overall price level, that is measured by the GDP deflator ( nominal GDP / real GDP X 100 )

Moreover, we analyze fluctuations in the economy as a whole with the model of the aggregate demand and aggregate supply. The aggregate-demand curve shows the quantity of goods and services that people, firms and the government want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level. According to this model, the price level and the quantity of output adjust in order to balance aggregate demand and aggregate supply.

Price level Quantity of output Aggregate supply curve Aggregate demand curve Equilibrium price level Equilibrium output

The aggregate-demand curve talks about the quantity of all goods and services demanded in the economy at any given price level. Ceteris paribus, a fall in the economy’s overall level of prices tends to raise the quantity of goods and services demanded. We have to recall the components of GDP, that are consumption, investment, the expenditure of public sector and net exports.

There are three different but related reasons which explain why a fall in the price level increases the quantity of goods and services demanded: - Consumers are encouraged to spend more, which stimulates the demand for consumption goods. - Interest rates fall, which stimulates the demand for investment goods. - The exchange rate depreciates, which stimulates the demand for net exports. So a fall in the level of prices has the effect to stimulate the increase of these components, which means a larger quantity of goods and services demanded. This is why the aggregate demand curve slopes downward.

But many other factors affect the quantity of goods and services demanded at a given price level. When one of these other factors changes, the aggregate- demand curve shifts. So we have: -Shifts caused from consumption (the quantity of goods demanded by the consumers) -Shifts caused from investment (how much firms want to invest) -Shifts caused from Government Purchases - Shifts caused from Net export (if a country is in recession, it buyes a fewer quantity of goods from foreign countries)

The aggregate-supply curve talks about the total quantity of goods and services that firms produce and sell at any given price level. In the long run, the aggregate-supply curve is vertical (it depends on the quantities of labor,capital,natural resourses and technology) instead, in the short run, the aggregate-supply curve slopes upward (instead of the aggregate demand curve, which is downward sloping).

The long-run aggregate supply curve is vertical at the so-called nature rate of output, that is the level of production reached by the economy in a long-run analysis.

In the long run, even the aggregate-supply curve can shift. -Shifts caused from Labor (a greater number of workers increases the production of goods) -Shifts caused from Capital (an increase in the capital stock increases the productivity and,in this way, the quantity of goods supplied) - Shifts caused from Natural Resources (for example, a discovery of a new mineral deposit) - Shifts caused from Technological Knowledge (for example, the industrial revolution)

We said the aggregate supply curve slopes upward in the short-run. There many theories which try to explain it: -The misperceptions theory; a lower price level creates misperception about relative prices (which are the prices of those goods compared to other prices), which induces firms to decrease their production of goods - The sticky-wage theory; wages do not immediatly adjust to the price level, a lower price level makes employment and production less profitable,which induces firms to reduce their quantity of goods

- The sticky-price theory; not all the prices adjust immediatly when the conditions change and this creates an unexpected fall of the price,which induces firms,that want to reach a higher price level, to reduce their quantity of goods.

A contraction of the aggregate demand curve has different effects. -If we are in the short-run, it affects the production of outputs,causing fluctuations -If we are in the long-run, it affects the overall price level (and not the level of outputs produced)

Ex. Great depression of 1929 In this period, in the USA, the real GDP fell by 27 percent and the unemployment (which is strictly related to the level of the production) rose from 3 percent to 25 percent. But what caused this big contraction of the aggregate-demand curve? Many economists think the reason was the decline in the money supply, due to problems in the banking system. Other economists suggest this collapse in the aggregate-demand was related to the fact that stock prices fell, depressing consumers.

And what about the aggregate supply curve’s shift? It could create the so-called stagflation,which means a period of falling output and rising prices. Ex. Suez Channel crysis

To sum up, one possible reason of fluctuations (= also known with the term “business cycle”) is related to shifts of the aggregate demand curve, instead the other one is related to shifts of the aggregate supply curve.