Business Cycles
What are we modelling?
Focus on explaining fluctuations in real
GDP, Y, and the GDP Deflator, P.
 Framework reminiscent of the supply and
demand model.

SUPPLY
Two Aspects of Potential Output

Potential Output is unrelated to the price
level but is determined by capital
infrastructure, efficiency of labor markets,
population, technological know-how.
◦ Output increases above potential only if
unemployment falls below natural level;
◦ if unemployment rises above natural level,
output will be below potential.
Potential output and labor market.
Potential output can be viewed as a level
consistent with equilibrium in labor
market.
 When output is above potential output,
low unemployment and the search for
workers will push up wages.
 When output is below potential, high
unemployment and the surplus of
workers will push down wages.

Potential Output
YP
P
Unemployment
above natural rate
Downward
Pressure on
Wages
Unemployment
below natural rate
Upward
Pressure
on Wages
Y
Sticky Wages & SRAS
Money wages paid to workers adjust
dynamically over time through negotiation.
 At a given wage, a rise in the price level
reduces the cost of labor relative to value of
goods produced making hiring labor to
produce goods more attractive.
 At a given wage rate, higher prices induce
higher production → in the short run,
supply is positively associated with output.

Aggregate Supply Curve
P
YP
SRAS
Y
1. Shift in Potential Output
Advance in Technology Frontier, PP& E, or
expansion in potential labor force
(population, demographics).
 Shifts SRAS w/ potential output.

2. Shifts in SRAS
When dollar cost of labor (or prices of
energy) shift, changes in costs are passed
on into prices.
 Wages and other cost shifters shift SRAS
at a given level potential output.

1. Expansion in Output Potential
P
YP
SRAS
YP '
SRAS'
Y
2. Increase in Wages
P
YP
SRAS'
SRAS
Y
DEMAND
Expenditure: C + I + G + NX
Prices and Spending
Wealth Effect – Real value of monetary assets
rises as prices fall. This adds to wealth of
households stimulating consumption.
 Competitiveness Effect – Holding exchange
rate constant, a lower price level makes
domestic exports more attractive and
foreign imports less stimulating net exports.

Prices and Liquidity
Depending on monetary policy, there may
be a negative relationship between prices
and the liquidity that central banks make
available.
 More on that later.

Aggregate Demand Curve
P
AD
Y
AS-AD MODEL
Equilibrium

Equilibrium in the competitive market occurs
when the price is set at a level (P*) such that
the amount that consumers want to buy is equal
to the amount that sellers want to sell (Y*).
Excess Supply If P were above equilibrium, sellers
would want to sell more goods than buyers would
want to buy. Competition between sellers would
force prices down.
Excess Demand If P were below equilibrium,
customers would want to buy more goods than
people would want to sell. Competition between
buyers would force prices up.
Equilibrium GDP and Price Level
P
SRAS
P*
AD
Y*
Y
Output below potential: Recessionary Gap.
P
YP
AS
1
P*
GAP
Y*
AD
Y
Output above potential: Inflationary Gap.
P
YP
AS
2
P*
AD
GAP
Y*
Y
Self Correction Process
Business cycles have a natural end. The
equilibrium output may be greater than or
less than potential output, however, in that
case surplus or shortage of workers in labor
markets will be putting downward or
upward pressure on wages.
 Pressure on wage costs will shift the supply
curve until equilibrium output is equal to
potential output.

AS1
YP
P
AS
W↓
AS2
1
P*
W↑
2
AD
Y
Movement to Long Term Equilibrium
Cyclical Fluctuations
Period-by-period, different important events
will impact the economy. We will think of
these events as primarily driving the
demand side of the economy (shifting the
AD curve) or primarily driving the supply
side (shifting the supply side).
 The strength of these will determine the
correspondence between movements in
output and inflation.

Demand side shocks cause output and prices to
move together.
P
AS
P*
1
P**
2
AD1
AD2
Y**
Y*
Y
Output below potential. Downward pressure on wages.
Cost of production falls and AS shifts down
P
YP
AS
AS2
1
Wages fall
P***
2
3
As costs fall,
competitive prices
fall, there is a
movement along
the AD curve.
AD1
AD2
Y**
Y
Wages will keep falling until the surplus of labor is absorbed –
when prices fall enough that demand reaches
potential
output
P
AS2
AS4
P**
3
Wages fall
4
AD1
AD2
Y**
YP
Y
What shifts the AD curve?
Shift outward in AD
Shift inward in AD
Increasing Optimism
Increasing Pessimism
Increasing Value of Assets
Falling Value of Assets
Increasing Foreign GDP
Decreasing Foreign GDP
Expansionary Monetary Policy
Contractionary Monetary Policy
Expansionary Fiscal Policy
Contractionary Fiscal Policy
Consumer
Confidence
and…
http://hk.nielsen.com/news/20091103.s
html
http://business.asiaone.com/
Business/News/Story/A1Sto
ry20091229-188708.html
BNP Parabis Research
..and Business
Confidence…
..and changes in Asset Prices..
http://urbanpolicy.berkeley.edu/pdf/CQSAdvMacro2005Web.pdf
AS-AD and Expected inflation
Potential GDP generally increases at a
consistent rate.
 On average, aggregate quantity of liquid
assets tends to increase faster than
potential GDP.
 Workers wages will tend to rise to match
increases in the cost of living.
 AD does not always rise evenly with GDP.

Dynamic AS-AD Model: Trend Path
YtP
P
P*t+1
ASt
YPt+1
ASt+1
Demand
expansion
matches
supply
expansion
Average Inflation
Pt*
ADt+1
ADt
Yt*
Y*t+1
Y
Dynamic AS-AD Model: Inflation Acceleration
YtP
P
ASt
YPt+1
ASt+1
Demand
expands
faster than
expected
P*t+1
Expected Inflation
Pt*
Inflation
rises
more
than
usual
ADt+1
ADt
Gap
Yt*
Positive
Output Gap
Y
Y*t+1
Dynamic AS-AD Model: Recession, Inflation
Deceleration
YtP
P
P*t+1
Pt*
YP
ASt
t+1
ASt+1
Demand
expands
slower than
expected
Expected Inflation
Inflation
rises
less than
usual
ADt+1
ADt
Gap
Yt*
Y*t+1
Negative
Output Gap
Y
Inflation Acceleration: πt – πt-1
UK 1992-2008
2
Inflation Acceleraton
1
0
-4
-3
-2
-1
0
-1
-2
-3
-4
Output Gap
1
2
3
Supply side shocks cause output and prices to move
in opposite directions: Stagflation
AS2
P
AS
2
P**
P*
1
AD1
Y**
Y*
Y
Bank of England Report
Commodity
Prices
increase..

In 2007, rising
commodity &
energy prices
lead to global
inflation
Stagflation in the 1970s
Learning Outcomes
Students should be able to
 Explain how various events will shift the
aggregate supply or demand curves.
 Construct an aggregate supply and
demand model of business cycles and use
it to explain equilibrium outcomes.
 Describe the short-term and long-term
dynamics of business cycles.