8 SHORT-RUN ECONOMIC FLUCTUATIONS

1. 8 SHORT-RUN ECONOMIC FLUCTUATIONS

2. 15 Aggregate Demand and Aggregate Supply

3. 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?

4. Short-Run Economic Fluctuations • 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.

5. Short-Run Economic Fluctuations • 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.

6. Facts

7. 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.

8. Three Key Facts About Economic Fluctuations • Fact 1: Economic fluctuations are irregular and unpredictable

9. 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 1945-2009, 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.

10. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • 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.

11. Three Key Facts About Economic Fluctuations • Fact 2: Most macroeconomic variables fluctuate together -- business investment is especially volatile

12. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS • Fact 3: As output falls, unemployment rises. • The unemployment rate never approaches zero; instead it fluctuates around its natural rate of about 5 percent.

13. Three Key Facts About Economic Fluctuations • Fact 3: As Output Falls, Unemployment Rises

14. theory

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

16. Aggregate Demand and Aggregate Supply • 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.

17. Aggregate Demand and Aggregate Supply • 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.

18. Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Figure 2 Aggregate Demand and Aggregate Supply Price Level Quantity of 0 Output

19. Aggregate demand

20. AGGREGATE DEMAND • 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

21. P P2 1. A decrease Aggregate Demand (AD) in the price C + I + G + NX level . . . Y Y2 2. . . . increases the quantity of goods and services demanded. Figure 3 The Aggregate-Demand (AD) Curve is downward sloping Price Level Quantity of 0 Output

22. 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.

23. 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

24. 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) ↑

25. 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!

26. 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) ↑

27. 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) ↑

28. Price Level D2 Aggregate demand, D1 Y2 Quantity of Output 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? P1 P2 0 Y2 Y1

29. 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

30. Table 1 The aggregate-demand curve: summary (a)

31. Table 1 The aggregate-demand curve: summary (b) .

32. Aggregate supply

33. 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.

34. 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.

35. Long-run aggregate supply P P2 2. . . . does not affect 1. A change the quantity of goods in the price and services supplied level . . . in the long run. Figure 4 The Long-Run Aggregate-Supply Curve Price Level Quantity of 0 Natural rate Output of output

36. 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

37. 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?

38. Short-run aggregate supply P P2 2. . . . reduces the quantity 1. A decrease of goods and services in the price supplied in the short run. level . . . Y2 Y Figure 6 The Short-Run Aggregate-Supply Curve Price Level Quantity of 0 Output

39. 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 ✕ −

40. The Short Run Aggregate-Supply Curve P 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). 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)

41. The Short Run Aggregate-Supply Curve We have just seen that if P↑ then Y↑. AS1 AS2 P 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)

42. The Short Run Aggregate-Supply Curve 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 AS2 P Y Quantity of output supplied Natural rate of output Actual price level Expected price level = + a ✕ − Y = YN + a✕ (P – Pe)

43. 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.

44. 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

45. 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.

46. 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

47. 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.

48. Shape of the AS Curve: The Misperceptions Theory • 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

49. Shape of the AS Curve: The Misperceptions 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 • 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

50. How the AS curve shifts AS1 • 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 AS2 P Pe1 = 120 Pe2 = 100 YN1 YN2 Y So, if either Pe↓ or YN↑, the AS curve shifts down or to the right