1. SHORT-RUN ECONOMIC FLUCTUATIONS12
SHORT-RUN ECONOMIC FLUCTUATIONS

2. Aggregate Demand and Aggregate Supply33
Aggregate Demand and Aggregate Supply

3. Short-Run Economic Fluctuations
Economic activity fluctuates from year to year.
In most years production of goods and services rises.
The U.S. economy has grown by about 3 percent per year on average, for the past 50 years.
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.

4. 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.
Macroeconomic variables that measure some type of income or production fluctuate closely together.
Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

5. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
As output falls, unemployment rises.
Changes in real GDP are inversely related to changes in the unemployment rate.
During times of recession, unemployment rises substantially.

6. Figure 1 A Look At Short-Run Economic Fluctuations
(a) Real GDP
Billions of
1996 Dollars
$10,000
9,000
Real GDP
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © South-Western

7. Figure 1 A Look At Short-Run Economic Fluctuations
(b) Investment Spending
Billions of
1996 Dollars
$1,800
1,600
1,400
Investment spending
1,200
1,000
800
600
400
200
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © South-Western

8. Figure 1 A Look At Short-Run Economic Fluctuations
(c) Unemployment Rate
Percent of
Labor Force 12 10 8
Unemployment rate 6 4 2
1965
1970
1975
1980
1985
1990
1995
2000
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9. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
How the Short Run Differs from the Long Run
Most economists believe that classical theory describes the world in the LR but not in the SR.
Changes in the money supply affect nominal variables but not real variables in the long run.
However, the assumptions of classical theory (dichotomy, monetary neutrality) are not appropriate when studying SR (year-to-year) changes in the economy.
We need new model(s) to understand SR fluctuations.

10. The Basic Model of Economic Fluctuations
Two variables are used to develop a model to analyze the short-run fluctuations.
The economy’s output of goods and services measured by real GDP.
The overall price level measured by the CPI or the GDP deflator.
The Basic Model of Aggregate Demand and Aggregate Supply
Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

11. The Basic Model of Economic Fluctuations
The Basic Model of Aggregate Demand and Aggregate Supply
The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.
The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

12. Figure 2 Aggregate Demand and Aggregate Supply...
Price
Level
Aggregate
supply
Aggregate
demand
Equilibrium
output
price level
Quantity of
Output
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13. THE AGGREGATE-DEMAND (AD) CURVE
The four components of GDP (Y) contribute to the aggregate demand for goods and services.
Y = C + I + G + NX

14. Figure 3 The Aggregate-Demand Curve...
Price
Level
Aggregate
demand P Y
1. A decrease
in the price
level . . . Y2 P2
Quantity of
increases the quantity of
goods and services demanded.
Output
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15. Why the AD Curve Is Downward Sloping
The Price Level and Consumption: The Wealth Effect
The Price Level and Investment: The Interest Rate Effect
The Price Level and Net Exports: The Exchange-Rate Effect

16. Why the AD Curve Is Downward Sloping
The Price Level and Consumption: The Wealth Effect
A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more.
This increase in consumer spending means larger quantities of goods and services demanded.

17. Why the AD Curve Is Downward Sloping
The Price Level and Investment: The Interest Rate Effect
A lower price level reduces the interest rate, which encourages greater spending on investment goods (also consumption on durable goods like car).
Lower price level decreases money demand, leading to lower interest rate (households try to reduce money holding, increasing interest-bearing asset).
This increase in investment spending means a larger quantity of goods and services demanded.

18. Why the AD Curve Is Downward Sloping
The Price Level and Net Exports: The Exchange-Rate Effect
When a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, which stimulates U.S. net exports.
As interest rate in US decreased, capital outflow would occur leading to depreciation of US$ relative to foreign currency.
The increase in net export spending means a larger quantity of goods and services demanded.

19. Why the AD Curve Might Shift
The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded.
Many other factors, however, affect the quantity of goods and services demanded at any given price level.
When one of these other factors changes, the aggregate demand curve shifts.

20. Why the AD Curve Might Shift
Shifts arising from
Consumption
Eg. Stock market boom, change in pension system.
Investment
Eg. Investment tax credit, change in money supply
Government Purchases
Eg. Policy changes regarding gov’t purchase
Net Exports
Eg. Recession in the major export countries

21. Shifts in the Aggregate Demand Curve
Price
Level D2 P1 Y2
Remove bullet in graph – graph needs no additional title???
Aggregate
demand, D1 Y1
Quantity of
Output

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

23. THE AGGREGATE-SUPPLY (AS) CURVE
The Long-Run Aggregate-Supply Curve
In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used in production process.
The price level does not affect these variables in the long run.
The long-run aggregate-supply curve is vertical at the natural rate of output.
This level of production is also referred to as potential output or full-employment output.

24. 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
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25. Why the Long-Run AS Curve Might Shift
Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.
We may call it economic development (growth).

26. Why the Long-Run AS Curve Might Shift
The shifts may be categorized according to the factors in the classical model that affect output.
Labor: eg. Immigration, change in natural rate of unemployment (change in unemployment insurance
Capital: capital accumulation (physical, human), decrease in capital stock (eg. Natural disaster)
Natural Resources: eg. Discovery of new mineral resources,
Technological Knowledge: eg. technological progress

27. 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
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28. A New Way to Depict Long-Run Growth and Inflation
Long-run trend:
Both the long-run AS curve and AD curve have been shifting outward.
Eg. Technological progress and increase in money supply
Another way of classical analysis of growth and inflation.
The new model (AS-AD model) is good for short-run analysis.
Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

29. Why the AS Curve Slopes Upward in the Short Run?
In the short run, an increase (decrease) in the overall level of prices in the economy tends to raise (reduce) the quantity of goods and services supplied.
Price level does affect the economy’s output, with an upward sloping SR AS curve.
<cf: LR AS curve.
Why so?

30. 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
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31. Why the AS Curve Slopes Upward in the Short Run?
The Sticky-Wage Theory
The Sticky-Price Theory
The Misperceptions Theory
A common theme of the three theories:
The aggregate supply deviates from its long-run level, when the actual price level deviates from the price level that people expected to prevail.
The order of discussion in Mankiw has been changed. The “misperceptions theory” must be moved to the bottom of the list. (This may affect the entire order of presentation following this slide.)

32. Why the AS Curve Slopes Upward in the Short Run?
The Sticky-Wage Theory
Nominal wages are slow to adjust, or are “sticky” in the short run, based on long-term ‘contract’:
Nominal wages do not adjust immediately to a fall (or increase) in the price level.
A lower price level (than expected when labor contract was made) makes employment and production less profitable.
This induces firms to reduce the employment (workhours), and consequently the quantity of goods and services supplied.

33. Why the AS Curve Slopes Upward in the Short Run?
The Sticky-Price Theory
Prices of some goods and services adjust sluggishly in response to changing economic conditions:
There are costs to adjusting prices, called menu costs.
An unexpected fall in the price level leaves some firms with higher-than-desired prices, but cannot lower their prices.
Eg. Unexpected contraction in money supply.
This depresses sales, which induces 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).

34. Why the AS Curve Slopes Upward in the Short Run?
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 (overall) price level causes misperceptions about relative prices.
They mistakenly believe their relative price have fallen.
Workers may see a fall in nominal wage as a fall in real wage, before realizing the prices of the goods they buy are also falling.
These misperceptions induce suppliers to decrease the quantity of goods and services supplied.
Move this slide so that it follows the next two slides. That puts the discussion in the new order of the text.

35. Why the AS Curve Slopes Upward in the Short Run?
Summary:
(SR) aggregate output supplied
= natural rate of output
+ a (actual price level – expected price level).

36. Why the Short-Run AS Curve Might Shift
Shifts in (SR) AS curve arise, due to :
Labor: eg. Increase in minimum wage.
Capital
Natural Resources.
Technology.
Expected Price Level.
An increase (decrease) in the expected price level reduces (increases) the quantity of goods and services supplied and shifts the SR aggregate supply curve to the left(right)
The change in this is the key in transition from SR to LR thru adjustment of expected price level.

37. TWO CAUSES OF ECONOMIC FLUCTUATIONS
We are ready to analyze the SR fluctuations of the economy.
Assume the economy begins in a long-run equilibrium. (Fig. 7).
The expected price level have adjusted to equal the actual price level at long-run equilibrium, so that SR AS curve crosses the (LR) equilibrium point as well.

38. 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
Copyright © South-Western

39. TWO CAUSES OF ECONOMIC FLUCTUATIONS
Shifts in Aggregate Demand
In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services.
Eg. Outbreak of war, stock market crash, change in money supply, etc.
In the long run, shifts in aggregate demand affect the overall price level only, not affecting output.
Transition from SR equilibrium to LR equilibrium is based on the adjustment of the expected price level.
See the Figure 8.

40. 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
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
Output
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41. TWO CAUSES OF ECONOMIC FLUCTUATIONS
What should (can) government do when faced with a sudden fall in AD?
Do nothing, waiting for the return to the LR equilibrium.
Take some action to increase the AD, to respond to the recession (decreased output, increased unemployment, etc) .
Increase in government spending (fiscal policy) or increase in money supply (monetary policy).
Possibly return to the original equilibrium (A in Figure).

42. TWO CAUSES OF ECONOMIC FLUCTUATIONS
An Adverse Shift in Aggregate Supply (called, supply shock)
Sudden increase in production costs, due to eg. bad weather, war in the Middle East, etc.
Increase in costs (or adverse change in other determinants of AS) shift the (SR) aggregate supply curve to the left:
Output falls below the natural rate of employment.
Unemployment rises.
The price level rises.

43. 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
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44. The Effects of a Shift in Aggregate Supply
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.

45. 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.
The adjustment process could be rocky, having wage-price spiral for a while, but ultimately return to the LR equilibrium.
Take action to increase aggregate demand by using monetary and fiscal policy.
Inflation would be inevitable in this case, as policymakers accommodate the shift in AS.

46. 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
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47. 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.

48. 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.

49. 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.

50. 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.

51. 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.

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