• Recession: a period of declining real incomes and rising unemployment

• Depression: a severe recession

• The model of aggregate demand and aggregate supply is commonly used among economists to explain short-run fluctuations

33-1 Three Key Facts About Economic Fluctuations

Fact 1: Economic Fluctuations are Irregular and Unpredictable

• Fluctuations are referred to as the business cycle.

• The fluctuations are not regular and almost impossible to predict.

Fact 2: Most Macroeconomic Quantities Fluctuate Together

• Real GDP is commonly used to watch short-run changes in the economy. It measures the value of all final goods and services produced within a given period of time and measures the total income of everyone in the economy.

• But when real GDP falls, so does personal income, profits, spending, investments, etc. They fluctuate by different amounts.

Fact 3: As Output Falls, Unemployment Rises

• When smaller quantities of goods and services are being produced, fewer workers are needed and therefore people are laid off

• When recessions end and real GDP expands, the unemployment rate declines. The unemployment rate is never 0

33-2 Explaining Short-Run Economic Fluctuations

The Assumptions of Classical Economics

• Nominal variables are the first things we see in an economy because economic variables are expressed in units of money

• Real variables are more important, and we need to understand the forces that determine them

• Money itself is insignificant, but the effect that it has on everyone is

The Reality of Short-Run Fluctuations

• Most economists believe that classical theory describes the world in the long run but not in the short run

  • Beyond a period of years, changes in the money supply affect prices and nominal variables but do NOT affect real GDP, unemployment, and real variables

• We have to focus on how real and nominal variables interact with each other

The Model of Aggregate Demand and Aggregate Supply

• First variable → economy output of goods and services

• Second variable → average level of prices (via CPI or GDP deflator)

• Model of aggregate demand and aggregate supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

• Aggregate-demand curve: a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

• Aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

  • The price level and quantity of output adjust to bring aggregate demand and aggregate supply in balance

33-3 The Aggregate-Demand Curve

Why the Aggregate-Demand Curve Slopes Downward

• Y = C + I + G + NX

• The Price Level and Consumption (The Wealth Effect): A decrease in the price level raises the real value of money and makes consumers weather, making them want to spend more. The increase in consumer spending relates to a larger quantity of goods and services demanded. The converse is true.

• The Price Level and Investment (The Interest Rate Effect): A lower price level reduces the interest rate, encourages greater spending on investment goods, and increases the quantity of goods and services demanded. The converse is true.

• The Price Level and Net Exports (The Exchange-Rate Effect): When a fall in the US price level causes US interest rates to fall, the real value of the dollar declines in foreign exchange markets. This increases the quantity of goods and services demanded by stimulating US net exports. The converse is true.

Why the Aggregate-Demand Curve Might Shift

• Shifts Arising from Changes in Consumption: When consumption is reduced, the curve shifts to the left. When consumption is increased, the curve shifts to the right.

• Shifts Arising from Changes in Investment: When the quantity of goods and services demanded is higher, the curve shifts to the right. When the demand is lower, it shifts to the left. The money supply also affects this, it lowers the interest rate in the long run when increased, shifting the demand curve to the right. The converse is true.

• Shifts Arising from Changes in Government Purchases: When government purchases are reduced, the curve shifts to the left. When government purchases are increased, the curve shifts to the right.

• Shifts Arising from Changes in Net Exports: When net exports decline because of another country's inability to trade, the country that exports have a curve that shifts to the left. When the country is able to buy again, the country that exports have a curve that shifts to the right.

33-4 The Aggregate-Supply Curve

• In the long run, the aggregate-supply curve is vertical.

• In the short run, the aggregate-supply curve slopes upward.

Why the Aggregate-Supply Curve is Vertical in the Long Run

• (In the long run): the real GDP depends on supplies of labor, capital, and natural resources and on the available technology used to produce goods and services.

• Because the price level does not affect these factors, the aggregate supply curve is vertical.

Why the Long-Run Aggregate-Supply Curve Might Shift

• The long-run level of production is sometimes called potential output or full-employment output.

• Natural level of output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

• Shifts Arising from Changes in Labor: Increased immigration means more workers, so the quantity of supplies increases. The curve shifts to the right. The opposite is also true.

• Shifts Arising from Changes in Capital: An increase in capital stock increase productivity and supplies. The curve shifts to the right. The opposite is also true. This includes both physical and human capital.

• Shifts Arising from Changes in Natural Resources: New minerals, better weather, and better yields increase supply, and the curve shifts to the right. The opposite is also true.

• Shifts Arising from Technological Knowledge: Better technology means more supplies produced. The curve shifts to the right. The opposite is also true (restrictions on technology, regulations, etc.)

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

• Technology and monetary policy are the two most important influencers of the economy in practice.

• The short-run fluctuations in output and the price level can be viewed as deviations from the long-run trends of output growth and inflation.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• Price levels influence the economy’s output in the short term. This creates a slope upwards.

• The quantity of output supplied deviates from its long-run (natural) level when the actual price level in the economy deviates from the price level that people expect to sell best.

• Sticky-Wage Theory: Wages are slow to change when economic conditions change. They do not respond immediately when the actual price level is different than the expected price level. The stickiness of wages provides an incentive to produce less output (when the price level is lower) and more output (when the price level is higher).

• Sticky-Price Theory: The slow adjustment of certain prices is called menu costs. This includes printing and communicating new prices to the public, which slows price changes down. During the time a firm has sticky prices, there is a positive association between the overall price level and quantity of output (represented by the upward slope of the short-run aggregate-supply curve

• The Misperceptions Theory: Changes in the overall price level can mislead suppliers about what actually occurs in certain markets where their products are sold. Supplies might notice prices of output rising and therefore think relative prices are rising. They respond to the higher price level by increasing the outputs supplied.

• The similarity between all 3 theories is that the actual price level deviates from the expected price level.

  • Quantity of output supplied = natural level of output + a * (actual price level - expected price level) when a represents the amount of output responding to unexpected changes

Why the Short-Run Aggregate Supply Curve Might Shift

• Shifts in the long-run aggregate supply curve arise from changes in labor, capital, natural resources, or technological knowledge. These also shift the short-term supply curve.

• Quantity of output supplied depends on the three theories: the sticky wage theory, the sticky price theory, and the misperceptions theory.

• A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

33-5 Two Causes of Economic Fluctuations

The Effects of a Shift in Aggregate Demand

• Consider a wave of caution: the aggregate-demand curve shifts and aggregate demand is reduced. Pessimism about the future leads to falling incomes and rising unemployment.

• With this, the price level also falls to offset the shift. People get used to the relative prices. This is a nominal change (price level is lower) but not a real change (output is the same).

• In the short run, shifts in aggregate demand cause fluctuations in the economy's output of goods and services.

• In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

• Because policymakers influence aggregate demand, they may change the severity of economic fluctuations.

The Effects of a Shift in Aggregate Supply

• Consider a production cost increase for firms: The aggregate-supply curve is changed. Firms produce a smaller amount of output.

• The economy experiences both falling output and rising prices.

  • Stagnation: falling output

  • Inflation: rising prices

  • Stagflation: a period of falling outputs and rising prices

• Higher costs lead to higher wages which mean higher prices, leading to a wage-price spiral. This slows at some point

• As the price level falls and the quantity of output reaches its natural level, the economy returns to a “normal” state

• Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices).

• Policymakers who can influence aggregate demand can navigate the adverse impact on output but only at the cost of making inflation worse.