CHAPTER 10: INTRODUCTION TO ECONOMIC FLUCTUATIONS

- Recession – period of falling output and rising unemployment

- Business Cycle – short-run fluctuations in output and employment
The Facts about the Business Cycle
GDP and Its Components
- Business Cycle Peak – starting date of each recession
- Business Cycle Trough – ending date of each recession
- According to an old rule of thumb, a recession is a period of at least two consecutive quarters of
declining real GDP (but there’s no fixed rule)
- 2 major components of GDP: consumption & investment (both growth decline during recession)
o But investment spending is more volatile than consumption spending (investment has
more substantial declines during recession)
Unemployment and Okun’s Law
- Unemployment also rises in each recession (as well as job vacancies) -> jobs are harder to find
- Employed workers help to produce goods and services while unemployed workers don’t
- Okun’s Law – increases in unemployment rate are associated with decreases in real GDP
o Tells us that forces that govern the short-run business cycle are very different from
those that shape long-run economic growth.
o Long-Run: technological progress Short-Run: labor force (utilization)
Leading Economic Indicators
- Economists in business and government are interested in forecasting short-run fluctuations
o Business: help company plan for changes in economic environment
o Government: tax revenue and use of fiscal & monetary policy
- Thus, economic forecasts are input into policy planning
- Leading Indicators – variables that tend to fluctuate in advance of the overall economy
- Index of Leading Economic Indicators by the Conference Board
o Average weekly hours in manufacturing : Longer workweek -> higher demands for
products -> increase hiring and production in the future
o Average weekly initial claims for unemployment insurance : Increase in the number of
people making new claims for unemployment insurance -> firms are laying off workers
and cutting back on production -> unemployment will soon rise, production will decline
o Manufacturers’ new orders for consumer goods and materials : Increase in new orders ->
higher demand -> increase in production and employment
o Manufacturers’ new orders for nondefense capital goods, excluding aircraft : increase in
new orders for investment goods -> increase in production and employment (aircraft
orders are excluded because they are placed so far in advance)
o ISM new orders index: Institute of Supply Management report on increased orders
minus decreased orders of companies; many firms experience increased orders ->
higher production and employment will follow
o Building permits for new private housing units : New building is part of investment which
is a volatile component of GDP; increase in building permits -> planned construction is
increasing -> rise in overall economic activity
 o Index of stock prices: Investors bid up prices when they expect companies to be
profitable; increase in stock prices -> expect economy will grow rapidly
o Leading Credit Index: When credit conditions are adverse, consumers and businesses
find it harder to get the financing they need to make purchases; deterioration of credit
conditions -> decline in spending, production, and employment
o Interest rate spread: the yield on 10-year Treasury bonds minus the federal funds rate :
Reflects the market’s expectation about future interest rates. Thus, condition of
economy; large spread -> interest rates are expected to rise -> economic activity rises
o Average consumer expectations for business and economic conditions : Increased
optimism about future economic conditions -> increased demand for goods and services
-> expand production and employment
- Index of leading indicators is far from being precise but is still a useful input into planning by
both businesses and the government
Time Horizons in Macroeconomics
How the Short Run and the Long Run Differ
- Long run: flexible prices/elastic Short run: sticky prices/inelastic
- Changes in the money supply do not cause fluctuations in output and employment (money
supply increases, nominal variables such as nominal wage will increase but not real variables like
output and employment)
- Short run: Many prices do not respond to changes in monetary policy
o Money supply falls -> firms don’t immediately cut wage, price tags, catalogs, restaurant
menus; there is little immediate change in many prices -> sticky
- In the short run, real variables such as output and employment must do some of the adjusting
instead (classical dichotomy no longer works)
- Nominal variables can influence real variables, and the economy can deviate from the
equilibrium predicted by the classical model
The Model of Aggregate Supply and Aggregate Demand
- Classical Theory: Amount of output depends on the economy’s ability to supply goods & services
(depends on the supplies of capital and labor & available production technology)
o Prices adjust to ensure that quantity of output demanded = quantity supplied (flexible)
- Short Run: output depends on demand (which in turn depends on consumers’ confidence about
their economic prospects, firms’ perceptions about the profitability of new investments, and
monetary and fiscal policy) -> policies are useful to stabilize economy in the short run
- Model of Aggregate Supply and Aggregate Demand – allows us to study how the aggregate price
level and the quantity of aggregate output are determined in the short run
o Provides a way to contrast how the economy behaves in the long run and how it
behaves in the short run
- Model of Supply and Demand: considers only one good within a large economy
Model of Aggregate Supply and Aggregate Demand: sophisticated model that incorporates the
interactions among many markets
Aggregate Demand
- Aggregate Demand (AD) – relationship between the quantity of output demanded and the
aggregate price level (quantity of products people want to buy at any given level of prices)
The Quantity Equation as Aggregate Demand
 - If V is constant and M is fixed by central bank, quantity equation yields a negative relationship
between the price level P and output Y
Why the Aggregate Demand Curve Slopes Downward
- The money supply M and the velocity of money V determine the nominal value of output PY .
Once PY is fixed, if P goes up, Y must go down
- Because we have assumed the velocity of money is fixed, the money supply determines the
dollar value of all transactions in the economy. If the price level rises, each transaction requires
more dollars, so the number of transactions and thus the quantity of goods and services
purchased must fall
- If output is higher, people engage in more transactions and need higher real balances M / P. For
a fixed money supply M , higher real balances imply a lower price level
- If the price level is lower, real money balances are higher; the higher level of real balances
allows a greater volume of transactions, which means a greater quantity of output is demanded
Shifts in the Aggregate Demand Curve
- AD curve tells us the possible combinations of P and Y for a given value of M (fixed M )
o If M is changed -> combinations of P and Y must change -> AD curve shifts
- Quantity equation MV =PY : reduction in the money supply leads to a proportionate reduction
in the nominal value of output PY ; increase in M increases PY
 - Fluctuations in AD: not only caused by money supply; also influenced by changes in velocity
Aggregate Supply
- Aggregate Supply (AS) - relationship between the quantity of products supplied & the price level
o Depends on time horizon (prices are flexible in the long run but sticky in the short run)
The Long Run: The Vertical Aggregate Supply Curve
- Y =F ( K , L) -> Y =Y
- Output does not depend on the price level -> vertical supply curve
- intersection of the ADC with this vertical ASC determines the price level.
- Vertical ASC: changes in aggregate demand affect prices but not output
o Money supply falls -> ADC shifts downward (shift only affects prices)
- Full-Employment or Natural – long run level of output independent of money supply (economy’s
resources are fully employed or unemployment rate is at its natural rate)

The Short Run: The Horizontal Aggregate Supply Curve

- Changes in aggregate demand do affect the level of output
- Lower money supply -> ADC shifts inward -> decline in output but price level is fixed (simple
assumption: changing prices in catalogs is too costly so prices are stuck at predetermined levels)
- Fall in aggregate demand reduces output in the short run because prices do not adjust instantly
- Sudden fall in demand -> firms stuck with high price -> sell less products -> reduce promotion
and lay off workers -> recession
From the Short Run to the Long Run
- Summary: Over long periods of time, prices are flexible, the aggregate supply curve is vertical,
and changes in aggregate demand affect the price level but not output. Over short periods of
time, prices are sticky, the aggregate supply curve is flat, and changes in aggregate demand do
affect the economy’s output of goods and services.

- Long run equilibrium: intersection of AD and LRAS

- When the economy is in its long run equilibrium, the SRAS curve must cross this point as well

- Suppose Fed reduces money supply -> short run: sticky prices so economy moves from A to B ->
output and employment fall -> recession -> low demand so wages and prices soon fall -> gradual
reduction in price level move the economy downward along AD to C (new long-run equilibrium)
- Long run equilibrium: Output and employment are back to their natural levels but prices are
lower than in the old long-run equilibrium (A)
- Shift in aggregate demand affects output in the short run, but this effect dissipates over time as
firms adjust their prices
Stabilization Policy
- Shocks – exogenous events that shift the aggregate demand and aggregate supply curve
o Disrupt the economy by pushing output & employment away from their natural levels
- Demand Shock – shock that shifts the aggregate demand curve
- Supply Shock – shock that shifts the aggregate supply curve
- One goal of the model of AS and AD is to show how shocks cause economic fluctuations
o As well as evaluate how macroeconomic policy can respond to these shocks
 - Stabilization Policy – policy actions aimed at reducing the severity of short-run economic
fluctuations (dampens the business cycle by keeping output and employment as close to their
natural levels as possible)
Shocks to Aggregate Demand
- Introduction and expanded availability of credit cards: more convenient way of making
purchases than using cash -> reduce quantity of money people want to hold -> reduction in
money demand -> increase in velocity of money
o If money supply is constant: increase in velocity causes nominal spending to rise -> AD
curve shifts outward

- In the short-run, increase in demand raises the output of the economy -> economic boom ->
firms sell more output at old prices. Therefore, they hire more workers, ask their existing
workers to work longer hours, and make greater use of their factories and equipment.
- Over time, the high level of AD pulls up wages and prices. As the price level rises, the quantity of
output demanded declines, and the economy gradually approaches the natural level of
production. But during the transition to the higher price level, the economy’s output is higher
than its natural level.
o How to dampen the boom and keep output closer to the natural level: Fed might reduce
money supply to offset increase in velocity -> stabilize aggregate demand
Shocks to Aggregate Supply
- Supply Shock – shock to the economy that alters the cost of producing goods and services
(causes prices that firms charge)
o Called Price Shocks because it can directly impact price level
- Drought destroys food crops -> reduced food supply -> food prices rise
Environmental protection law requires firms to reduce pollutants -> added cost to firms ->
charge higher price to consumers
Increase in union aggressiveness -> pushes wage up as well as the price of the products
produced by the union workers
Organization of an international oil cartel -> curtail/limits competition -> major oil producers can
raise the world price of oil
- Adverse – push costs and prices upward (like the examples above)
- Favorable – breakup of an international oil cartel, reduces costs and prices
 - Stagflation – combines stagnation (falling output and thus rising unemployment) and inflation
- Fed has 2 options: Figure 10-14 (Option 1) and Figure 10-15 (Option 2)
- Option 1: Hold AD constant -> output and employment are lower than the natural level ->
eventually, prices will fall to restore full employment at the old price level (point A)
o Cost: recession (during the adjustment process)

- Option 2: expand AD to bring the economy toward the natural level of output more quickly ->
economy moves from A to C -> Fed accommodates the supply shock
o Cost: price level is permanently higher. There is no way to adjust aggregate demand to
maintain full employment and keep the price level stable
Summary
1. Economies experience (unpredictable) short-run fluctuations in economic activity, measured
most broadly by real GDP. These fluctuations are associated with movement in many
macroeconomic variables. In particular, when GDP growth declines, consumption growth falls
(typically by a smaller amount), investment growth falls (typically by a larger amount), and
unemployment rises.
2. Main difference of how economy works: prices are flexible in the long run but sticky in the short
run. The model of AS and AD provides a framework to analyze economic fluctuations and see
how the impact of policies and events varies over different time horizons.