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Economic Fluctuation and the Business Cycle

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1 Economic Fluctuation and the Business Cycle
The business cycle is up-and-down movement in production and jobs. A business cycle has two phases, expansion and recession, and two turning point, a peak and a trough. A Recession is a decrease in real GDP that lasts for at least two quarters (six months) or a period of significant decline in total output, income, employment. Ques: When is unemployment above/below it’s natural rate? At what point is unemployment at its lowest?

2 Aggregate Supply and Aggregate Demand
Recall- We covered models determining real output, the market for loanable funds, and the money market. (can someone comment on some major aspects of these models?) We need a model to analyze economic fluctuation. The AS-AD model is one that helps explain economic fluctuation, the business cycle, and the aim of government policy. AS-AD prices and money supply does affect real GDP.

3 AGGREGATE SUPPLY Aggregate supply is the relationship between the quantity of real GDP supplied and the price level when all other influences on production plans remain the same. -a change in the price level changes the quantity of real GDP supplied. n.B There is a 1) short run AS curve that slopes upward. Shifters- Changes in firm’s cost of production (i.e wages , rent , interest rates, corporate tax rates). 2) Long run AS curve, that identifies the level of potential GDP. ( the idea is the output will always return to its long run potential. Shifters- Factors that change potential GDP. (recall) n.b- A shift of the long run AS curve also shifts the short run curve.


5 AGGREGATE DEMAND Aggregate demand is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same. A change in price impacts the quantity of AD via three effects. Wealth Effect, Interest Rate Effect, Exchange Rate effect. Can you think how they work. Recall- Y= C+I+G+(N-X) Shifters Expectations on future income, profits. Government and Fed policy Overseas economies.

6 AGGREGATE DEMAND Government can use fiscal policy to influence aggregate demand. Fiscal policy is changing taxes, transfer payments, and government expenditure on goods and services. The Federal Reserve can use monetary policy to influence aggregate demand. Monetary policy is changing the quantity of money and the interest rate.

Three possible macroeconomic equilibriums are 1. Below full-employment equilibrium, when potential GDP exceeds equilibrium real GDP. 2. Full-employment equilibrium, when equilibrium real GDP equal potential GDP. 3. Above full-employment equilibrium, when equilibrium real GDP exceeds potential GDP.

8 Analysis of the Business Cycle Fluctuation
4 step analysis. Decide if there is a shift in AS, AD or both. Decide which direction Describe how output, prices, and wages are affected. Keep track of short-run and long-run equilibrium. Describe how the economy transitions to long run. Example. New technology is created increasing the profitability of firms. Analyse the possible economic fluctuation that may occur. Don’t neglect the predictions of the model. This is the payoff for the student. With this simple model, we can now say quite a lot about growth, inflation, and the business cycle. However, when you do so, be aware that the AS-AD model predicts a fall in the price level when either aggregate demand decreases or aggregate supply increases. And the model predicts that real GDP decreases when either aggregate supply or aggregate demand decreases. But, some students object by pointing out that GDP rarely decreases and the price level rarely falls. These students are bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, aggregate supply and aggregate demand almost always are increasing. When we use the model to simulate the effects of a decrease in either aggregate supply and aggregate demand, we’re studying what happens relative to the trends in real GDP and the price level. A fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation. The story is similar for real GDP.

Ex. 2 Analyze the short run and long run impact of a global rise in oil prices. What we see occur is called stagflation/stagnation. Stagflation is a combination of recession (falling real GDP) and inflation (rising price level).


11 Definitions Inflationary gap is a gap that exists when real GDP exceeds potential GDP and that brings a rising price level. Recessionary gap is a gap that exists when potential GDP exceeds real GDP and that brings a falling price level. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the AS curve is not difficult. But the notion that the AS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the AS curve so that the students realize that wages and other input prices remain constant along an AS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of prices, the AS curve shifts leftward. Avoid confusing students by using ‘up’ to correspond to a decrease in aggregate supply. But do point out that that when the AS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the AS curve shifts leftward once they see that rising input prices shift the curve vertically upward

12 Figure 13.12 shows adjustments toward full employment.
Real GDP exceeds potential GDP — there is an inflationary gap —and the price level rises. As the money wage rate gradually rises, aggregate supply decreases, real GDP decreases, and the price level rises farther.

13 Potential GDP exceeds real GDP—recessionary gap— and the price level falls.
Eventually, the money wage rate starts to fall, aggregate supply increases, real GDP increases, and the price level falls farther.

14 Additional Questions Use the AS-AD model to describe how Real GDP and prices are impacted in the short-run and long run if there is a An increase in the corporate tax rate A reduction in wages A increase in the average education level. 2) Use the AS-AD model to identify a Fed policy that may remove a recessionary gap. Fiscal policy that may combat an inflationary gap. 3)Use the AS-Ad model to analyze the business cycle created by the wall street crisis. Analyze the policy tools used to shorten the recessionary period.

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