Chapter 13-Business Fluctuations: Aggregate Demand and Supply

Business fluctuations(aka business cycles)-the short-run movements in

real GDP around its long-term trend; fluctuations of real GDP around its
long-term trend or normal growth rate
Recessions-a significant, widespread decline in real income and
employment
Some unemployment is normal, not all sources are always
efficiently used
Better if recessions could to limited and less severe
Aggregate demand=AD
Aggregate supply=AS
Unexpected disturbances or shocks can temp. increase or
decrease GR
The AD/AS model has 3 curves: aggregate demand curve, the
long-run aggregate supple curve, and the short-run aggregate
supply curve
Two types of shocks:
Real shocks (aka Aggregate supply shocks)
Aggregate Demand shocks
The Aggregate Demand Curve-curve that shows all the combos of
inflation and real growth are consistent with a specified rate of
spending growth(M+v)
M+v=Inflation+real growth
More spending plus same goods=higher prices
Inflation is caused when more money chases the same goods
o So if more money is chasing an increased quantity of goods,
then, all else being equal, the inflation rate will be less than
the increase in money growth
5%=Inflation-real growth
the AD curve for a spending growth rate of 5% is all the combos of
inflation and real growth that add up to 5%
AD(spending growth=M+V=5%)

Chapter 13-Business Fluctuations: Aggregate Demand and Supply

TheLongRunAggregateSupplyCurve
Solowgrowthrateaneconomyspotentialgrowthrate,therateofeconomic
growththatwouldoccurgivenflexiblepricesandtheexistingrealfactorsof
production
Inthelongrun,moneyisneutral
LongrunaggregatesupplycurveaverticallineattheSolowgrowthrate
GrowthratedoesNOTdependontherateofinflation!!!

Chapter 13-Business Fluctuations: Aggregate Demand and Supply

ShiftsintheLongRunAggregateSupplyCurve
PlottingADandlongrunAggregateSupplycurvetogetherwillexplainbusiness
fluctuationsthatarecausedbyrealshocks
Inflationrateisdeterminedbytheintersectionbtwn

Realshocks(akaproductivityshock)anyshockthatincreasesordecreasesthe
potentialgrowthrate>causingincreaseordecreaseintheSolowgrowthrate
RealshockscanshifttheLRAScurvetotherightandleft
o Rightshiftsreduceinflationandincreaserealgrowth
o Leftshiftsincreaseinflationandreducerealgrowth
Slowerthegrowthratemeansthattherearefewergoodstospend
moneyonandinflationincreases
ShockstotheLRASwillchangegrowthrateandinflationratetemp.b/cLRASis
alwaysshiftingbackandforthasnewshockshittheeconomy
Businessfluctuationsaresimplychangesineconomicgrowthintheshortrun
drivenbyrealshocks

Chapter 13-Business Fluctuations: Aggregate Demand and Supply

RealShocksrapidchangesineconomicconditionsthatincreaseordiminishthe
productivityoffcapitalandlabor,inturninfluencingGDPandemployment
BackthenweatherwasbigfactorinGDPandproductivityofagriculturebutmore
recentlytechnologyhaspreventedtheeffectsofweatheroncrops,ratherother
shockscanstillrockeconomy

OilShocks
Machinesdependonoiltorun,whenoilisreduced,capital/laboraredecreased
Decreaseddemandforlargercar/increaseddemandforbiggercars
Changesaffecteconomybuttheyeventuallybringeconomybacktostability
10%increaseinoilpriceaffectsbutafter5quarters,economystartstobetter,and
at10returnstonormal,adjustingtohigherpriceandGRreturnstonormal

Chapter 13-Business Fluctuations: Aggregate Demand and Supply

MoreShocks
wars,terroristsattacks,newregulations,taxchanges,massstrikesandnew
techareallshocks
economyiscontinuouslyhitbysmallshocks;somearegood/bad
inatypicalyear,goodshocksoutweighthebadonesandeconomygrows
AggregateDemandShocksandtheShortRunAggregateSupplyCurve
parabletellsthatpositiveshocktospendingincreasesoutputatfirstbutinthe
longrunitonlyincreasesprices,peoplerealizetherealworthofmoney
intheshortrun,anincreaseinspendingwillbesplitbetweenincreasesin
inflationandincreasesinrealgrowth
inflationandrealgrowthratearepositivelyrelatedinshortrunwhentheprices
aresticky

inflationrate
expectedinflationrateE()
AnIncreaseinMshiftstheADCurveOutincreaseinADincreasesrealgrowthinthe
shortrun

Chapter 13-Business Fluctuations: Aggregate Demand and Supply

nominalwageconfusionsituationthatoccurswhenworkersrespondtotheirnominal
wageinsteadtotheirrealwage,thatis,whenworkersrespondtothewagenumberon
theirpaychecksratherthanwhattheirwagecanbuyingoodsandservices(thereal
wage)
menucostscostsofchangingprices
inthelongrun,unexpectedinflationalwaysturnsintoexpectedinflation
asexpectationsandpricesadjust,moreisreflectedintheinflationrateandlessinthe
realgrowthrate;inthelongrunallisreflectedintheinflationrate
wedontwanttojustreduceAdandreduceinflationcauseitcancauserecession,
longtimetoadjust

wagesarestickierindownwarddirection,slow
decreaseinspendingthatrequiresexpectedwagegrowthtodecreasewillcreate
largedecreaseingrowthrage
ShockstotheComponentsofAD

Chapter 13-Business Fluctuations: Aggregate Demand and Supply