Chapter 20. Short-Run Economic Fluctuations KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

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1 Chapter 2 urpose of Chapter 2: Develop a model that economists use to analyze the economy s short-run fluctuations - the model of demand and. 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 5 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. A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. Figure 1 A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars $1, 9, 8, 7, 6, 5, 4, 3, (a) Real GD Real GD 2,

2 Figure 1 A Look At Short-Run Economic Fluctuations Billions of 1996 Dollars (b) Investment Spending $1,8 1,6 1,4 Investment spending 1,2 1, Figure 1 A Look At Short-Run Economic Fluctuations ercent of Labor Force 12 1 As output falls, unemployment rises (c) Unemployment Rate Unemployment rate EXLAINING 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 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. The Basic Model of Economic Fluctuations ( Demand and Supply) Economist use the model of demand and to explain short-run fluctuations in economic activity around its long-run trend. The -demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. The - curve shows the quantity of goods and services that firms choose to produce and sell at each price level. 2

3 Figure 2 Demand and Supply... THE AGGREGATE-DEMAND CURVE The four components of GD (Y) contribute to the demand for goods and services. Y = C + I + G + NX Equilibrium price level demand Equilibrium output Figure 3 The -Demand Curve A decrease in the price level... Y Y increases the quantity of goods and services demanded. demand Why the -Demand Curve Is Downward Sloping and Consumption: The Wealth Effect A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more. and Investment: Interest Rate Effect A lower price level reduces the interest rate. How? Lower prices reduce the amount of money people want to hold. As a result of falling IR, investment spending increase. and Net Exports: 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. Why? US good cheaper overseas. 3

4 Why the -Demand Curve Might Shift Shifts arising from Consumption Investment Government urchases Net Exports Y = C + I + G + NX. Shifts in the Demand Curve 1 D 2 demand, D 1 Y 1 Y 2 THE AGGREGATE-SULY CURVE In the long run, the - curve is vertical. 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. In the short run, the - curve is upward sloping. Figure 4 The Long-Run -Supply Curve 2 1. A change in the price level... Natural rate of output does not affect the quantity of goods and services supplied in the long run. 4

5 THE AGGREGATE-SULY CURVE The Long-Run -Supply Curve The long-run - curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment output. Shifts arising (roductivity) Labor Capital Natural Resources Technological Knowledge Figure 5 Long-Run Growth and Inflation and growth in the money shifts demand..., LRAS 198 LRAS 199 LRAS 2 1. In the long run, technological progress shifts long-run and ongoing inflation. 199 Demand, AD AD 199 AD 198 Y 198 Y 199 Y leading to growth in output... Why the -Supply Curve Slopes Upward in the Short Run Figure 6 The Short-Run -Supply Curve Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. 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 A decrease in the price level... Short-run reduces the quantity of goods and services supplied in the short run. Y 2 Y 5

6 Why the -Supply Curve Slopes Upward in the Short Run The Misperceptions Theory The Sticky-Wage Theory The Sticky- Theory Why the -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. Why the -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. The Sticky- Theory s 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. 6

7 Why the Short-Run -Supply Curve Might Shift Shifts arising Labor Capital Natural Resources. Technology. Expected. Why the Supply Curve Might Shift An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run curve to the right. Figure 7 The Long-Run Equilibrium Figure 8 A Contraction in Demand Short-run causes output to fall in the short run... Short-run, AS AS 2 Equilibrium price A Natural rate of output demand 2 3 Y 2 B Y A C AD and output returns to its natural rate but over time, the short-run - curve shifts, wages prices adjust A decrease in demand... demand, AD 7

8 TWO CAUSES OF ECONOMIC FLUCTUATIONS Shifts in Demand In the short run, shifts in demand cause fluctuations in the economy s output of goods and services. In the long run, shifts in demand affect the overall price level but do not affect output. TWO CAUSES OF ECONOMIC FLUCTUATIONS An Adverse Shift in Supply A decrease in one of the determinants of shifts the curve to the left: falls below the natural rate of employment. Unemployment rises. The price level rises. Figure 1 An Adverse Shift in Supply and the price level to rise. B A 1. An adverse shift in the shortrun - curve... AS 2 Short-run, AS demand The Effects of a Shift in Supply olicy Responses to Recession olicymakers 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 demand by using monetary and fiscal policy. Y causes output to fall... Y 8

9 Figure 11 Accommodating an Adverse Shift in Supply 1. When short-run falls... AS 2 Short-run, AS which causes the price level to rise further but keeps output at its natural rate. A C Natural rate of output policymakers can accommodate the shift by expanding demand... AD 2 demand, AD 9

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