Topic F

Economic Fluctuations:
An Introduction
 IN THIS TOPIC, YOU WILL LEARN:

 facts about the business cycle

 how the short run differs from the long run
 an introduction to aggregate demand
 an introduction to aggregate supply in the short
run and long run
 how the model of aggregate demand and
aggregate supply can be used to analyze the
short-run and long-run effects of “shocks.”

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Facts about the business cycle
 GDP growth averages 3–3.5 percent per year
over the long run with large fluctuations in the
short run.
 Consumption and investment fluctuate with
GDP, but consumption tends to be less volatile
and investment more volatile than GDP.
 Unemployment rises during recessions and falls
during expansions.
 Okun’s law: the negative relationship between
GDP and unemployment.
Growth rates of real GDP, consumption
Growth rates of real GDP, C, I
Unemployment
Okun’s Law
Index of Leading Economic Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
6-9 months into the future.
 Used in planning by businesses and govt,
despite not being a perfect predictor.
Components of the LEI index
 Average workweek in manufacturing
 Initial weekly claims for unemployment insurance
 New orders for consumer goods and materials
 New orders, nondefense capital goods
 Vendor performance
 New building permits issued
 Index of stock prices
 M2
 Yield spread (10-year minus 3-month) on Treasuries
 Index of consumer expectations
 Index of Leading Economic Indicators,
1970-2012
120
110
100
90
2004 = 100

80
70
60
50
40
30
20
10
Source: 0
Conference
1970 1975 1980 1985 1990 1995 2000 2005 2010
Board
Time horizons in macroeconomics
 Long run
Prices are flexible, respond to changes in supply
or demand.
 Short run
Many prices are “sticky” at a predetermined
level.

The economy behaves much

differently when prices are sticky.
Recap of classical macro theory

 Output is determined by the supply side:

 supplies of capital, labor
 technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.
When prices are sticky…
…output and employment also depend on
demand, which is affected by:
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes in
C or I
The model of
aggregate demand and supply
 The paradigm most mainstream economists
and policymakers use to think about economic
fluctuations and policies to stabilize the economy
 Shows how the price level and aggregate output
are determined
 Shows how the economy’s behavior is different
in the short run and long run
Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 We use a simple theory of aggregate demand
based on the quantity theory of money.
 We develop the theory of aggregate demand in
more detail.
The Quantity Equation as
Aggregate Demand
 Recall the quantity equation
MV = PY
 For given values of M and V,
this equation implies an inverse relationship
between P and Y …
The downward-sloping AD curve

P
An increase in the
price level causes
a fall in real money
balances (M/P),
causing a
decrease in the
demand for goods
& services. AD
Y
Shifting the AD curve
Aggregate supply in the long run

 Recall:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
The long-run aggregate supply curve

P LRAS
Y does not
depend on P,
so LRAS is
vertical.

Y
Y
 F (K , L )
Long-run effects of an increase in M

P LRAS
An increase
in M shifts
AD to the
right.
In the long run, P2
this raises the
price level… P1 AD2
AD1

…but leaves Y
output the same.
Y
Aggregate supply in the short run

 Many prices are sticky in the short run.

 For now, we assume
 all prices are stuck at a predetermined level in
the short run.
 firms are willing to sell as much at that price
level as their customers are willing to buy.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:
The short-run aggregate supply curve

P
The SRAS
curve is
horizontal:
The price level
is fixed at a
SRAS
predetermined P
level, and firms
sell as much as
buyers demand. Y
Short-run effects of an increase in M

In the short run P

…an increase
when prices are
in aggregate
sticky,…
demand…

SRAS
P
AD2
AD1
Y
…causes Y1 Y2
output to rise.
The SR & LR effects of ΔM > 0

A = initial P LRAS
equilibrium

B = new short-
run eq’m P2 C
after C.B. B SRAS
increases M P A AD2
AD1
C = long-run
equilibrium Y
Y Y2
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run then over time,
equilibrium, if P will…
Y Y rise
Y Y fall

Y Y remain constant

The adjustment of prices is what moves

the economy to its long-run equilibrium.
How shocking!!!

 shocks: exogenous changes in agg. supply or

demand
 Shocks temporarily push the economy away from
full employment.
 Example: exogenous decrease in velocity
If the money supply is held constant, a decrease in
V means people will be using their money in fewer
transactions, causing a decrease in demand for
goods and services.
The effects of a negative demand shock

AD shifts left, P LRAS

depressing output
and employment
in the short run.
B A SRAS
Over time, P
prices fall and
P2 C AD1
the economy
moves down its AD2
demand curve Y
toward full Y2 Y
employment.
Supply shocks

 A supply shock alters production costs, affects the

prices that firms charge. (also called price shocks)
 Examples of adverse supply shocks:
 Bad weather reduces crop yields, pushing up
food prices.
 Workers unionize, negotiate wage increases.
 New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
 Favorable supply shocks lower costs and prices.
CASE STUDY:
The 1970s oil shocks
 Early 1970s: OPEC coordinates a reduction in
the supply of oil.
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.
 CASE STUDY:
The 1970s oil shocks
The oil price shock P LRAS
shifts SRAS up,
causing output and
employment to fall.
B SRAS2
P2
In absence of
A SRAS1
further price P1
shocks, prices will AD
fall over time and
economy moves
Y
back toward full Y2 Y
employment.
CASE STUDY:
The 1970s oil shocks
60% 14%
Late 1970s: 50% 12%
As economy
40%
was recovering, 10%
oil prices shot up 30%
8%
again, causing 20%
another huge 6%
10%
supply shock!
0% 4%
1977 1978 1979 1980 1981

Change in oil prices (left scale)

Inflation rate-CPI (right scale)
Unemployment rate (right scale)
Stabilization policy
 def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
 Example: Using monetary policy to combat the
effects of adverse supply shocks…
Stabilizing output with
monetary policy
P LRAS

The adverse
supply shock
B SRAS2
moves the P2
economy to
A SRAS1
point B. P1
AD1

Y
Y2 Y
Stabilizing output with
monetary policy
But the C.B. P LRAS
accommodates
the shock by
raising agg.
B C SRAS2
demand. P2
A
results: P1 AD2
P is permanently AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y
 TOPIC SUMMARY
1. Long run: prices are flexible, output and employment are
always at their natural rates, and the classical theory
applies.
Short run: prices are sticky, shocks can push output and
employment away from their natural rates.
2. Aggregate demand and supply:
a framework to analyze economic fluctuations

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 TOPIC SUMMARY
3. The aggregate demand curve slopes downward.
4. The long-run aggregate supply curve is vertical, because
output depends on technology and factor supplies, but
not prices.
5. The short-run aggregate supply curve is horizontal,
because prices are sticky at predetermined levels.

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 TOPIC SUMMARY
6. Shocks to aggregate demand and supply cause
fluctuations in GDP and employment in the short run.
7. The C.B. can attempt to stabilize the economy with
monetary policy.

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