This document discusses short-run economic fluctuations and the aggregate demand and aggregate supply model. It provides background on recessions and the business cycle. It then explains key aspects of the aggregate demand and aggregate supply model, including how the aggregate demand curve slopes downward and how the aggregate supply curve slopes upward in the short-run due to price/wage stickiness. Factors that can shift the curves, such as consumption, investment and expected inflation, are also outlined.

1. 12 SHORT-RUN ECONOMIC FLUCTUATIONS

2. 33 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. On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession.

4. Short-Run Economic Fluctuations A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession.

5. 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.

6. Figure 1 A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars Real GDP (a) Real GDP $10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

7. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Most macroeconomic variables fluctuate together. Most macroeconomic variables that measure some type of income or production fluctuate closely together. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts.

8. Figure 1 A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars (b) Investment Spending $1,800 1,600 1,400 1,200 1,000 800 600 400 200 1965 1970 1975 1980 1985 1990 1995 2000 Investment spending Copyright © 2004 South-Western

9. 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.

10. Figure 1 A Look At Short-Run Economic Fluctuations Percent of Labor Force (c) Unemployment Rate 0 2 4 6 8 10 12 1965 1970 1975 1980 1985 1990 1995 2000 Unemployment rate Copyright © 2004 South-Western

11. 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 long run but not in the short run. Changes in the money supply affect nominal variables but not real variables in the long run. The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

12. 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.

13. The Basic Model of Economic Fluctuations 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.

14. 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.

15. The Basic Model of Economic Fluctuations The Basic Model of Aggregate Demand and Aggregate Supply The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

16. Figure 2 Aggregate Demand and Aggregate Supply... Quantity of Output Price Level 0 Copyright © 2004 South-Western Aggregate supply Aggregate demand Equilibrium output Equilibrium price level

17. THE AGGREGATE-DEMAND CURVE The four components of GDP ( Y ) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

18. Figure 3 The Aggregate-Demand Curve... Quantity of Output Price Level 0 Copyright © 2004 South-Western Aggregate demand P Y Y 2 P 2 1. A decrease in the price level . . . 2. . . . increases the quantity of goods and services demanded.

19. Why the Aggregate-Demand 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

20. Why the Aggregate-Demand 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.

21. Why the Aggregate-Demand 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. This increase in investment spending means a larger quantity of goods and services demanded.

22. Why the Aggregate-Demand 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. The increase in net export spending means a larger quantity of goods and services demanded.

23. Why the Aggregate-Demand 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.

24. Why the Aggregate-Demand Curve Might Shift Shifts arising from Consumption Investment Government Purchases Net Exports

25. Shifts in the Aggregate Demand Curve 0 P 1 Y 1 Quantity of Output Price Level Aggregate demand, D 1 D 2 Y 2

26. THE AGGREGATE-SUPPLY CURVE In the long run, the aggregate-supply curve is vertical . In the short run, the aggregate-supply curve is upward sloping .

27. THE AGGREGATE-SUPPLY 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 to turn these factors of production into goods and services. The price level does not affect these variables in the long run.

28. Figure 4 The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 Copyright © 2004 South-Western Long-run aggregate supply P 2 1. A change in the price level . . . 2. . . . does not affect the quantity of goods and services supplied in the long run. P

29. THE AGGREGATE-SUPPLY CURVE The Long-Run Aggregate-Supply Curve 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.

30. Why the Long-Run Aggregate-Supply Curve Might Shift Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve. The shifts may be categorized according to the various factors in the classical model that affect output.

31. Why the Long-Run Aggregate-Supply Curve Might Shift Shifts arising Labor Capital Natural Resources Technological Knowledge

32. Figure 5 Long-Run Growth and Inflation Quantity of Output Price Level 0 Copyright © 2004 South-Western Y 1980 AD 1980 AD 1990 Aggregate Demand, AD 2000 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P 1980 1. In the long run, technological progress shifts long-run aggregate supply . . . 4. . . . and ongoing inflation. 3. . . . leading to growth in output . . . P 1990 P 2000 2. . . . and growth in the money supply shifts aggregate demand . . .

33. 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.

34. Why the Aggregate-Supply Curve Slopes Upward in the Short Run In the short run, an increase in the overall level of prices in the economy 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.

35. Figure 6 The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Copyright © 2004 South-Western Short-run aggregate supply 1. A decrease in the price level . . . 2. . . . reduces the quantity of goods and services supplied in the short run. Y P Y 2 P 2

36. Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory

37. Why the Aggregate-Supply 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 price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

38. Why the Aggregate-Supply Curve Slopes Upward in the Short Run The Sticky-Wage Theory Nominal wages are slow to adjust, or are “sticky” in the short run: Wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce the quantity of goods and services supplied.

39. 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 sales, which induces firms to reduce the quantity of goods and services they produce.

40. Why the Short-Run Aggregate-Supply Curve Might Shift Shifts arising Labor Capital Natural Resources. Technology. Expected Price Level.

41. Why the Aggregate Supply Curve Might Shift An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right.

42. Figure 7 The Long-Run Equilibrium Quantity of Output Price Level 0 Copyright © 2004 South-Western Natural rate of output Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price

43. Figure 8 A Contraction in Aggregate Demand Quantity of Output Price Level 0 Long-run aggregate supply Copyright © 2004 South-Western Short-run aggregate supply, AS Aggregate demand, AD A P Y AD 2 AS 2 1. A decrease in aggregate demand . . . 2. . . . causes output to fall in the short run . . . 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output returns to its natural rate. C P 3 B P 2 Y 2

44. 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. In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

45. TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

46. Figure 10 An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Long-run aggregate supply Copyright © 2004 South-Western Aggregate demand 3. . . . and the price level to rise. 2. . . . causes output to fall . . . 1. An adverse shift in the short- run aggregate-supply curve . . . Short-run aggregate supply, AS Y A P AS 2 B Y 2 P 2

47. 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.

48. 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 monetary and fiscal policy.

49. Figure 11 Accommodating an Adverse Shift in Aggregate Supply Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply Aggregate demand, AD Copyright © 2004 South-Western Short-run aggregate supply, AS P 2 A P AS 2 3. . . . which causes the price level to rise further . . . 4. . . . but keeps output at its natural rate. 2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . 1. When short-run aggregate supply falls . . . AD 2 C P 3

50. 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.

51. 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.

52. 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.

53. 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.

54. 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.

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