• What are economic fluctuations? What are their
characteristics?
• How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
• Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in the
short run? In the long run?
What shifts the AS curve(s)?
1
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2
IN THIS CHAPTER
• What are economic fluctuations? What are their
characteristics?
• How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
• Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in the
short run? In the long run?
What shifts the AS curve(s)?
3
Introduction
• Real GDP over the long run, U.S.
– Grows about 3% per year on average
• GDP in the short run
– Fluctuates around its trend
• Recessions
– Periods of falling real incomes and rising unemployment
• Depressions
– Severe recessions (very rare)
4
ECONOMIC
FLUCTUATIONS
KEY TAKEAWAYS
>Economic fluctuations are simply fluctuations in
the level of the national income of a country
representing growth or contraction.
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5
Three facts about economic fluctuations – 1
FACT 1: Economic fluctuations are irregular and unpredictable
Real Gross Domestic Product 1969-2019
6
Three facts about economic fluctuations – 2
FACT 2: Most macroeconomic quantities fluctuate together.
Real Gross Private Domestic Investment 1969-2019
7
Three facts about economic fluctuations – 3
FACT 3: As output falls, unemployment rises.
Unemployment Rate 1969-2019
8
The Assumptions of Classical Economics
• The Classical Dichotomy
– Separation of variables into two groups:
• Real – quantities, relative prices
• Nominal – measured in terms of money
• The neutrality of money:
– Changes in the money supply affect nominal but not real
variables
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9
AGGREGATE
KEY TAKEAWAYS
DEMAND
>Aggregate demand is an economic measure
of the total amount of demand for all finished
goods and services produced in an economy.
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10
AGGREGATE
SUPPLY
KEY TAKEAWAYS
>Total goods produced at a specific price
point for a particular period are aggregate
supply.
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11
Model of aggregate demand and aggregate supply
The price level
The model
determines the
equilibrium price
level
and equilibrium
output (real GDP).
P
“Short-Run
Aggregate Supply”
SRAS
P1
Y1
AD
“Aggregate
Demand”
Y
Real GDP, the
quantity of output
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12
The aggregate-demand (AD) curve
The AD curve shows the
P
quantity of all g&s
demanded in the economy P2
at any given price level.
Why the AD curve slopes
downward?
P1
Y = C + I + G + NX
Assume G is fixed by
government policy.
AD
Y2
Y1
Y
To understand the slope of AD, must determine how a
change in P affects C, I, and NX.
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13
THREE REASONS WHY
AGGREGATE DEMAND
SLOPES DOWNWARD
14
WEALTH
KEY TAKEAWAYS
EFFECT
>The wealth effect posits that consumers feel
more financially secure and confident about
their wealth when their homes or investment
portfolios increase in value.
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15
The Wealth Effect (P and C )
• Suppose the price level, P, declines
– Increase in the real value of money
– Consumers are wealthier
– Increase in consumer spending, C
– Increase in quantity demanded of goods and services
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16
INTEREST
EFFECT
KEY TAKEAWAYS
>As interest rates move up, the cost of borrowing
becomes more expensive. This means that
demand for lower-yield bonds will drop,
causing their price to drop.
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17
The Interest-Rate Effect (P and I)
• Suppose the price level, P, declines
– Buying goods and services requires fewer dollars: people
buy bonds and other assets
– Decrease in the interest rate
– Increase spending on investment goods, I
– Increase in quantity demanded of goods and services
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18
EXCHANGE-RATE
KEY TAKEAWAYS
EFFECT
>An exchange rate is the value of a country's
currency vs. that of another country or
economic zone.
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19
The Exchange-Rate Effect (P and NX )
• Suppose the price level, P, declines
– Decrease in the U.S. interest rate
– U.S. dollar depreciates (decline in the real value of the
dollar in foreign-exchange markets)
– Stimulates U.S. net exports, NX
– Increase in quantity demanded of goods and services
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20
Why the AD curve slopes downward
An increase in P
P
reduces the quantity of
goods and services
P2
demanded because:
• the wealth effect
(C falls)
P1
• the interest-rate
effect (I falls)
• the exchange-rate
effect (NX falls)
AD
Y2
Y1
Y
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21
EXAMPLE 1: A shift in the AD curve
What is the effect of a
stock market boom on
P
the AD curve?
A stock market (rapid &
significant sales growth)
boom makes households P1
feel wealthier, C rises,
the AD curve shifts right.
Any event that changes
C, I, G, or NX (except
a change in P) will shift
the AD curve.
AD2
AD1
Y1
Y2
Y
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22
Why the AD Curve Might Shift – 1
• Changes in C
– An event that causes consumers to spend more at a given price
level (a tax cut, a stock market boom) shifts the aggregatedemand curve to the right.
An event that causes consumers to spend less at a given price
level (a tax hike, a stock market decline) shifts the aggregate
demand curve to the left.
23
Why the AD Curve Might Shift – 1
• Changes in I
An event that causes firms to invest more at a given price level
(optimism about the future, a fall in interest rates due to an
increase in the money supply) shifts the aggregate demand
curve to the right.
– An event that causes firms to invest less at a given price level
(pessimism about the future, a rise in interest rates due to a
decrease in the money supply) shifts the aggregate demand
curve to the left.
24
Why the AD Curve Might Shift – 2
• Changes in G
– An increase in government purchases of goods and
services(greater spending on defense or highway construction)
shifts the aggregate-demand curve to the right.
A decrease in government purchases on goods and services (a
cutback in defense or highway spending) shifts the aggregate
demand curve to the left.
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25
Why the AD Curve Might Shift – 2
• Changes in NX
– An event that raises spending on net exports at a given price
level (a boom overseas, speculation that causes an exchange-rate
depreciation) shifts the aggregate-demand curve to the right.
An event that reduces spending on net exports at a given price
level (a recession overseas, speculation that causes an exchangerate appreciation) shifts the aggregate-demand curve to the
left.
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license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
26
The aggregate-supply (AS ) curves
The AS curve shows
the total quantity of
goods and services
firms produce and sell
at any given price
level.
P
LRAS
SRAS
AS is:
 upward-sloping in
Y
short run
 vertical in long run
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27
The long-run aggregate-supply curve (LRAS)
The natural rate of output
P
(YN) is the amount of
output the economy
produces when
unemployment is at its
natural rate.
LRAS
Also called
potential output
or
full-employment output.
YN
Y
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28
Why LRAS is vertical
YN determined by the
economy’s stocks of labor,
capital, and natural resources,
and on the level of technology.
An increase in P
does not affect any of these, so
it does not
affect YN.
(Classical dichotomy)
P
LRAS
P2
P1
YN
Y
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29
EXAMPLE 2: A shift in the LRAS curve
What is the effect of an
increase in immigration
on the LRAS curve?
P
LRAS1 LRAS2
Immigration increases the
economy’s stock of labor,
L, causing YN to rise.
Any event that changes
any of the determinants
of YN will shift LRAS.
YN
Y’
N
Y
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30
Short run aggregate supply (SRAS) curve
The SRAS curve
is upward sloping:
P
SRAS
Over the period
of 1–2 years,
an increase in P
• causes an increase
in the quantity of
goods and services
supplied.
P2
P1
Y1
Y2
Y
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31
Why the Slope of SRAS Matters
If AS is vertical,
P
fluctuations in AD
Phi
do not cause
fluctuations in output or
Phi
employment.
If AS slopes up,
then shifts in AD
do affect output and
employment.
LRAS
SRAS
ADhi
Plo
AD1
Plo
ADlo
Ylo
Y1
Yhi
Y
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32
THREE REASONS WHY
SHORT-RUN AGGREGATE
SUPPLY SLOPES UPWARD
33
STICKY WAGE
KEY TAKEAWAYS
THEORY
>Sticky wage theory argues that employee
pay is resistant to decline even under
deteriorating economic conditions.
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34
The Sticky-Wage Theory – 1
• Imperfection:
– Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms
• Firms and workers set the nominal wage in advance
based on PE, the price level they expect to prevail.
(It is easier to raise than to lower it).
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35
The Sticky-Wage Theory – 2
• If P > PE,
– Revenue is higher, but labor cost is not.
– Production is more profitable, so firms increase output and
employment.
Hence, higher P causes higher Y, so the SRAS curve slopes
upward.
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36
STICKY PRICE
THEORY
KEY TAKEAWAYS
>Price stickiness, or sticky prices, is the failure
of market price(s) to change quickly, despite
shifts in the broad economy suggesting a
different price is optimal.
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37
The Sticky-Price Theory – 1
• Imperfection:
– Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting prices.
• Examples: cost of printing new menus,
the time required to change price tags
– Firms set sticky prices in advance based
on PE
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38
The Sticky-Price Theory – 2
• Suppose the Fed increases the money supply unexpectedly
– In the long run, P will rise
– In the short run:
• Firms without menu costs can raise their prices immediately
• Firms with menu costs wait to raise prices. With relatively low
prices: increase demand for their products: increase output and
employment
Hence, higher P is associated with higher Y.
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39
MISPERCEPTION
KEY TAKEAWAYS
THEORY
>People misinterpret changes in general
price level as changes of relative prices
(signals about relative value/ profitability).
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40
The Misperceptions Theory
• Imperfection:
– Firms may confuse changes in P with changes in the relative price
of the products they sell.
• If P rises above PE
– A firm sees its price rise before realizing all prices are rising.
• The firm may believe its relative price is rising, and may
increase output and employment.
So, an increase in P can cause an increase in Y, making the SRAS curve
upward-sloping.
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41
Why the AS Curve Might Shift – 2
• Changes in Labor
– An increase in the quantity of labor available (perhaps due to a
fall in the natural rate of unemployment) shifts the aggregatesupply curve to the right.
A decrease in the quantity of labor available (perhaps due to a
rise in the natural rate of employment) shifts the aggregatesupply curve to the left.
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42
Why the AS Curve Might Shift – 2
• Changes in Capital
– An increase in physical or human capital
shifts the aggregate-supply curve to the right.
A decrease in physical or human capital shifts the aggregatesupply curve to the left.
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43
Why the AS Curve Might Shift – 2
• Changes in Natural Resources
– An increase in the availability of the natural resources shifts the
aggregate-supply curve to the right.
A decrease in the availability of natural resources shifts the
aggregate-supply curve to the left.
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44
Why the AS Curve Might Shift – 2
• Changes in Technology
– An advance in technological knowledge shifts the aggregatesupply curve to the right.
A decrease in the available technology (perhaps due to
government regulation) shifts the aggregate-supply curve to the
left.
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45
• What are economic fluctuations? What are their
characteristics?
• How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
• Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in the
short run? In the long run?
What shifts the AS curve(s)?
46
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
47
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
48
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
49
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
50
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
51