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8 SHORT-RUN ECONOMIC FLUCTUATIONS. 15. Aggregate Demand and Aggregate Supply. Short-Run Economic Fluctuations. What causes short-run fluctuations in economic activity? What, if anything, can the government do to stop GDP from falling and unemployment from rising?

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Slide1 l.jpg

8

SHORT-RUN ECONOMIC FLUCTUATIONS


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15

Aggregate Demand and Aggregate Supply


Short run economic fluctuations l.jpg
Short-Run Economic Fluctuations

  • What causes short-run fluctuations in economic activity?

  • What, if anything, can the government do to stop GDP from falling and unemployment from rising?

  • And if the government can’t stop the occurrence of bad times, can it at least make them less damaging in terms of duration and severity?


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Short-Run Economic Fluctuations

  • Economic activity fluctuates from year to year.

    • Real GDP increases in most years.

    • On average over the past 50 years, real GDP in the U.S. economy has grown by about 3.2 percent per year—see chapter 10

      • Real GDP per person has grown at the rate of about 2 percent per year—see chapter 12

    • In some years normal growth does not occur, causing a recession.


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Short-Run Economic Fluctuations

  • A recession is a period of declining real incomes, and rising unemployment.

    • A depression is a severe recession.

  • An expansion is a period of increasing real incomes, and falling unemployment.



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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

  • Economic fluctuations are irregular and unpredictable.

    • Fluctuations in the economy are often called the business cycle.

  • Most macroeconomic variables fluctuate together.

  • As output falls, unemployment rises.


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Three Key Facts About Economic Fluctuations

  • Fact 1: Economic fluctuations are irregular and unpredictable


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Economic fluctuations are irregular and unpredictable

  • Recessions start at the peak of a business cycle and end at the trough.

  • The length of a business cycle may be measured by the time between one peak and the next or the time between one trough and the next.

    • The peaks and troughs of the US business cycle are officially registered by the NBER.

    • During 1945-2009, there have been 11 cycles in the US.

    • The average recession lasted 11 months and the average expansion lasted 59 months, thereby making the average cycle roughly 70 months long.


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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

  • Fact 2: Most macroeconomic variables fluctuate together.

    • When real GDP falls in a recession, so do many other variables:

      • personal income, corporate profits, consumption spending, investment spending, industrial production, retail sales, home sales, auto sales, etc.

      • However, investment fluctuates a lot more than other variables.

        • Even though investment is about one-seventh of GDP, much of the fall in GDP during recessions is due to the fall in investment spending.


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Three Key Facts About Economic Fluctuations

  • Fact 2: Most macroeconomic variables fluctuate together -- business investment is especially volatile


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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

  • Fact 3: As output falls, unemployment rises.

    • The unemployment rate never approaches zero; instead it fluctuates around its natural rate of about 5 percent.


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Three Key Facts About Economic Fluctuations

  • Fact 3: As Output Falls, Unemployment Rises



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Aggregate Demand and Aggregate Supply

  • Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.


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Aggregate Demand and Aggregate Supply

  • Real GDP (Y)

    • Ch. 5 Measuring a Nation’s Income

  • The Price Level (P)

    • GDP Deflator

      • Ch. 5

    • The CPI

      • Ch 6 Measuring the Cost of Living

  • The theory of aggregate demand and aggregate supply is based on two theoretical links between Y and P.


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Aggregate Demand and Aggregate Supply

  • The aggregate-demand curve shows the total quantity of “Made in USA” goods and services that everybody—households, firms, the government, and foreigners—wants to buy at each price level.

  • The aggregate-supply curve shows the total quantity of “Made in USA” goods and services that US firms would like to produce and sell at each price level.


Figure 2 aggregate demand and aggregate supply l.jpg

Aggregate

supply

Equilibrium

price level

Aggregate

demand

Equilibrium

output

Figure 2 Aggregate Demand and Aggregate Supply

Price

Level

Quantity of

0

Output



Aggregate demand20 l.jpg
AGGREGATE DEMAND

  • The aggregate demand for goods and services has four components:

    Aggregate Demand = C + I + G + NX

  • Aggregate Supply = Y

  • In equilibrium, supply = demand

  • Therefore, in equilibrium Y = C + I + G + NX


Figure 3 the aggregate demand ad curve is downward sloping l.jpg

P

P2

1. A decrease

Aggregate Demand (AD)

in the price

C + I + G + NX

level . . .

Y

Y2

2. . . . increases the quantity of

goods and services demanded.

Figure 3 The Aggregate-Demand (AD) Curve is downward sloping

Price

Level

Quantity of

0

Output


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Bonus slide: why the demand curve for ice cream can’t explain the AD curve

  • The demand curve for an individual commodity is downward sloping because of two effects:

    • Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute)

    • Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice cream

    • Review Chapter 4 The Market Forces of Supply and Demand

  • But the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effect

  • It is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.


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Why the Aggregate-Demand Curve Is Downward Sloping: three reasons

  • The Wealth Effect: a lower price level boosts consumption spending by households

  • The Interest-Rate Effect: a lower price level boosts investment spending by businesses

  • The Exchange-Rate Effect: a lower price level boosts net exports


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Why the Aggregate-Demand Curve Is Downward Sloping: reasonsWealth Effect

  • P↓ causes the purchasing power of consumers’ monetary wealth ↑

  • This causes consumption ↑

    • Besides, if a price decline is perceived to be temporary it makes sense to buy what you need now, while prices are still low

  • C ↑ causes aggregate demand (C+I+G+NX) ↑


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Bonus slide: Wealth Effect Controversy reasons

  • P↓ causes the real burden of the monetary debts of debtors ↑

  • This causes debtors’ consumption↓

  • Therefore, if the decrease in debtors’ consumption exceeds the increase in the consumption of others, it is possible that C↓

  • Therefore, P↓ could cause aggregate demand (C+I+G+NX) ↓

  • For this reason, the economist Paul Krugman has argued that the AD curve may be upward rising!


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Why the Aggregate-Demand Curve Is Downward Sloping: reasonsInterest Rate Effect

  • P↓ causes nominal interest rate ↓

    • See Ch. 16 for more on this.

  • nominal interest rate ↓ encourages greater investment spending by businesses (I ↑)

  • I ↑ means aggregate demand (C+I+G+NX) ↑


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Why the Aggregate-Demand Curve Is Downward Sloping: reasonsExchange-Rate Effect

  • P↓ causes nominal interest rate ↓

    • See Ch. 16 for more on this.

  • Foreigners sell the dollars they had been holding in US banks

  • The value of the dollar ↓

  • As a result, US goods become cheaper relative to foreign goods.

  • This makes U.S. net exports increase (NX ↑)

  • NX↑ means aggregate demand (C+I+G+NX) ↑


Shifts in the aggregate demand curve l.jpg

Price reasons

Level

D2

Aggregate

demand, D1

Y2

Quantity of

Output

Shifts in the Aggregate Demand Curve

We have seen why the AD curve is negatively sloped. We know why aggregate demand would increase from Y1 to Y2 when the price level decreases from P1 to P2.

But what are the reasons why the AD curve might shift? In other words, what are the reasons why aggregate demand might increase to Y2 even if the price level stays put at P1?

P1

P2

0

Y2

Y1


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Why the Aggregate-Demand Curve Might Shift reasons

  • Shifts arising from

    • Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)

    • Investment: technological progress, business confidence, tax rates, money supply

    • Government Purchases

    • Net Exports: foreign GDP, expectations about exchange rates

P

Y


The aggregate demand curve summary a l.jpg

Table 1 reasons

The aggregate-demand curve: summary (a)


The aggregate demand curve summary b l.jpg

Table 1 reasons

The aggregate-demand curve: summary (b)

.



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THE AGGREGATE-SUPPLY CURVE reasons

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

  • In the short run, the aggregate-supply (SRAS) curve is upward sloping.


The aggregate supply curve long run l.jpg
THE AGGREGATE-SUPPLY CURVE: long run reasons

  • An economy’s long-run output of goods and services

    • is also called the natural rate of output or potential output or full-employment output

      • See Chapter 7

  • Long-run output depends on:

    • labor

    • physical capital

    • human capital

    • natural resources

    • Technology

    • Laws, government policies, and their enforcement

  • The price level does not affect these variables in the long run.


Figure 4 the long run aggregate supply curve l.jpg

Long-run reasons

aggregate

supply

P

P2

2. . . . does not affect

1. A change

the quantity of goods

in the price

and services supplied

level . . .

in the long run.

Figure 4 The Long-Run Aggregate-Supply Curve

Price

Level

Quantity of

0

Natural rate

Output

of output


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Why the Long-Run Aggregate-Supply Curve Might Shift reasons

  • Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.

    • Labor: population growth, immigration, natural rate of unemployment

    • Capital, physical or human

    • Natural Resources: price of imported oil

    • Technology

    • Laws, government policies

P

Y


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The Aggregate-Supply Curve Slopes Upward in the Short Run reasons

  • In the short run, an increase in the overall level of prices tends to raise the quantity of goods and services supplied.

  • A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

  • Why?


Figure 6 the short run aggregate supply curve l.jpg

Short-run reasons

aggregate

supply

P

P2

2. . . . reduces the quantity

1. A decrease

of goods and services

in the price

supplied in the short run.

level . . .

Y2

Y

Figure 6 The Short-Run Aggregate-Supply Curve

Price

Level

Quantity of

0

Output


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Why the Aggregate-Supply Curve Slopes Upward in the Short Run: three theories

  • The Sticky-Wage Theory

  • The Sticky-Price Theory

  • The Misperceptions Theory

  • But, they all reach the same conclusion:

Quantity of output supplied

Natural rate of output

Actual price level

Expected price level

=

+

a ✕


The short run aggregate supply curve l.jpg
The Short Run Aggregate-Supply Curve Run: three theories

P

According to the SRAS formula, if the overall price level is equal to the expected price level (P = Pe), then output supplied is equal to the natural rate of output (Y = YN).

AS

140

Pe = 120

Also, if P > Pe, then Y > YN.

That is, the SRAS curve is upward rising.

YN

Y

Quantity of output supplied

Natural rate of output

Actual price level

Expected price level

=

+

a ✕

Y = YN + a✕ (P – Pe)


The short run aggregate supply curve41 l.jpg
The Short Run Aggregate-Supply Curve Run: three theories

We have just seen that if P↑ then Y↑.

AS1

AS2

P

That is, the SRAS curve is upward rising.

But the SRAS equation shows that output supplied can increase (Y↑) even when P is unchanged, as long as Pe↓ or YN↑.

Pe1 = 120

Pe2 = 100

So, if either Pe↓ or YN↑, the AS curve shifts down or to the right

YN1

YN2

Y

Quantity of output supplied

Natural rate of output

Actual price level

Expected price level

=

+

a ✕

Y = YN + a✕ (P – Pe)


The short run aggregate supply curve42 l.jpg
The Short Run Aggregate-Supply Curve Run: three theories

AS1

  • To summarize, the SRAS equation implies that

    • The SRAS curve is upward rising, and

    • The SRAS curve shifts right if

      • The expected price falls, or

      • The natural rate of output increases

AS2

P

Y

Quantity of output supplied

Natural rate of output

Actual price level

Expected price level

=

+

a ✕

Y = YN + a✕ (P – Pe)


The sticky wage theory l.jpg
The Sticky-Wage Theory Run: three theories

  • Suppose wages for 2010 were set in 2009

  • These wage agreements were based on the output prices that were expected to prevail in 2010

  • Suppose actual prices in 2010 fall short of what was expected

  • Wages do not adjust immediately to the unexpectedly low price level.

  • An unexpectedly low price level and an unchanged wage level makes employment and production less profitable.

  • This induces firms to reduce the quantity of goods and services supplied.


Shape of the as curve the sticky wage theory l.jpg
Shape of the Run: three theoriesAS Curve: The Sticky-Wage Theory

  • AS shows the aggregate supply curve for 2010

  • Back in 2009, workers and their bosses had reached an agreement on wages for 2010

  • During the negotiations, they had all expected that prices in 2010 would be Pe = 120

  • If the actual price level in 2010 (P) turns out to be 120, the bosses’ expectations are fulfilled and nobody gets fired.

  • So, output in 2010 is the full-employment output, YN.

  • Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve

  • If the actual price level in 2010 (P) turns out to be 140, production is more profitable than was expected

    • because the prices are higher than expected and the wages are unchanged at the previously agreed level

  • So, production increases beyond the full-employment level (blue dot)

  • In other words, the AS curve is upward rising

P

AS

140

Pe = 120

YN

Y


Shape of the as curve the sticky price theory l.jpg
Shape of the Run: three theoriesAS Curve: The Sticky-Price Theory

  • Prices of some goods and services adjust sluggishly in response to changing economic conditions

    • An unexpected fall in the price level leaves some firms with higher-than-desired prices.

    • This depresses their sales, which induces these firms to reduce the quantity of goods and services they produce.


Shape of the as curve the sticky price theory46 l.jpg
Shape of the Run: three theoriesAS Curve: The Sticky-Price Theory

  • AS shows the aggregate supply curve for 2010

  • Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140

  • Menu costs make frequent price changes impractical. E-type (O-type) firms set prices at the beginning of even-numbered (odd-numbered) months

  • If the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN.

  • Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve

  • If demand falls sharply on Jan. 15, businesses must reduce prices to keep their customers.

  • On Feb. 1, only E-type firms reduce their prices. They keep their customers. They do not layoff any employees.

  • But O-type firms cannot cut their prices. They lose customers and layoff some employees

  • So, production decreases below the full-employment level (blue dot)

    • I am assuming that firms do not produce products that are perfectly substitutable

  • In other words, the AS curve is upward rising

P

AS

Pe = 140

120

YN

Y


Shape of the as curve the misperceptions theory l.jpg
Shape of the Run: three theoriesAS Curve: The Misperceptions Theory

  • Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output

  • A lower price level causes misperceptions about relative prices.

    • These misperceptions induce suppliers to decrease the quantity of goods and services supplied.


Shape of the as curve the misperceptions theory48 l.jpg
Shape of the Run: three theoriesAS Curve: The Misperceptions Theory

  • Suppose an overall decline in demand reduces all prices

  • A wheat farmer, however, sees only that wheat prices have fallen and continues to believe that the prices of the things that she buys (milk, shoes, clothes, etc.) are unchanged at the level she had expected

  • This makes work less attractive and the farmer reduces her production of wheat.

    • I am assuming that the wheat farmer knows only how to produce wheat

  • When this is repeated across the economy, both the overall price level and total output fall


Shape of the as curve the misperceptions theory49 l.jpg
Shape of the Run: three theoriesAS Curve: The Misperceptions Theory

  • AS shows the aggregate supply curve for 2010

  • Back in 2009, businesses had expected that demand would be strong in 2010 and prices would be Pe = 140

  • If the actual price level in 2010 (P) turns out to be 140, the bosses’ expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN.

  • Therefore, the green dot, which represents the expected price level and the full-employment output, must be on the AS curve

  • If the prices fall unexpectedly in 2010 to 120, a wheat farmer becomes aware of a fall in the price of the wheat she sells, but may be unaware that the prices of the stuff she buys have also fallen

  • Disappointed, the wheat farmer chooses to work less and produce less

  • So, production decreases below the full-employment level (blue dot)

  • In other words, the AS curve is upward rising

P

AS

Pe = 140

120

YN

Y


How the as curve shifts l.jpg
How the Run: three theoriesAS curve shifts

AS1

  • AS1 shows the aggregate supply curve for 2010

  • We saw in previous slides that the green dot, which represents the expected price level and the natural rate of output, must be on the AS curve

  • If either Pe↓ or YN↑, the green dot moves down or to the right

  • When the green dot shifts, so must the AS curve

AS2

P

Pe1 = 120

Pe2 = 100

YN1

YN2

Y

So, if either Pe↓ or YN↑, the AS curve shifts down or to the right


The short run aggregate supply curve shifts to the right if l.jpg

Price Level Run: three theories

Quantity of Output

The Short-Run Aggregate-Supply Curve Shifts to the Right if:

  • The natural rate of output increases

    • This happens when there is an increase in:

      • Labor

      • Physical Capital

      • Human capital

      • Natural Resources

      • Technology.

  • The Expected Price Level decreases.


Table 2 the short run aggregate supply curve summary l.jpg
Table 2: Run: three theoriesThe Short-Run Aggregate-Supply Curve: Summary


Table 2 the short run aggregate supply curve summary53 l.jpg
Table 2: Run: three theoriesThe Short-Run Aggregate-Supply Curve: Summary


Recessions caused by decreases in aggregate demand l.jpg

Long-run equilibrium, short-run equilibrium following a disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

Recessions caused by decreases in aggregate demand


Figure 7 the long run equilibrium l.jpg

Long-run disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

aggregate

Short-run

supply

aggregate

supply

A

Equilibrium

price

Aggregate

demand

Natural rate

of output

Figure 7 The Long-Run Equilibrium

Price

Level

Quantity of

0

Output


Figure 8 a contraction in aggregate demand l.jpg

2. . . . causes output to fall in the short run . . . disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

Short-run aggregate

supply,

AS

A

P

B

P2

1. A decrease in

aggregate demand . . .

P3

C

Aggregate

demand,

AD

AD2

Y2

Y

Figure 8 A Contraction in Aggregate Demand

Price

Level

Long-run

aggregate

supply

Quantity of

0

Output

But what if the shock to AD is permanent?

If the shock to AD is temporary, it will soon go back to AD1.


Figure 8 a contraction in aggregate demand57 l.jpg

2. . . . causes output to fall in the short run . . . disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

Short-run aggregate

supply,

AS

A

P

B

P2

1. A decrease in

aggregate demand . . .

P3

C

Aggregate

demand,

AD

AD2

Y2

Y

Figure 8 A Contraction in Aggregate Demand

Price

If the shock to AD is permanent, people will realize that in the long run the economy will end up at C.

Level

Long-run

aggregate

supply

They will expect the price level to fall to P3.

Quantity of

0

Output


Figure 8 a contraction in aggregate demand58 l.jpg

2. . . . causes output to fall in the short run . . . disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

Short-run aggregate

supply,

AS

AS2

3. . . . but over

time, the short-run

A

aggregate-supply

P

curve shifts . . .

B

P2

1. A decrease in

aggregate demand . . .

P3

C

Aggregate

demand,

AD

AD2

Y2

Y

4. . . . and output returns

to its natural rate.

Figure 8 A Contraction in Aggregate Demand

Price

Level

Long-run

aggregate

supply

Quantity of

0

5. The government could also use expansionary monetary/fiscal policies to push AD back to AD1.

Output


Economic fluctuations ad l.jpg
ECONOMIC FLUCTUATIONS: disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibriumAD

  • Contraction (leftward shift) in Aggregate Demand

    • In the short run,

      • output decreases,

      • the overall price level decreases, and

      • the unemployment rate increases

    • In the long run,

      • the overall price level decreases,

      • but output and the unemployment rate remain unchanged at their long-run levels


Policy response to a fall in aggregate demand l.jpg
Policy response to a fall in aggregate demand disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

  • If production and employment take too long to return to their long-run levels, the government could step in to hasten the process

  • The government could push the aggregate demand curve back where it was by:

    • increasing the money supply (expansionary monetary policy)

    • Cutting taxes or increasing government spending (expansionary fiscal policy)


History l.jpg

Great Depression, recession of 2001, Great Recession of 2008 disturbance that throws the economy off the long-run equilibrium, the readjustment to the long-run equilibrium

history


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Two big shifts in aggregate demand: Great Depression and World War II

  • Early 1930s: large drop in real GDP

    • The Great Depression

    • Largest economic downturn in U.S. history

    • From 1929 to 1933

      • Real GDP fell by 27%

      • Unemployment rose from 3 to 25%

      • Price level fell by 22%

    • Cause: decrease in aggregate demand

      • Decline in money supply (by 28%)

      • Decreasing: consumer spending, investment spending


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Two big shifts in aggregate demand: Great Depression and World War II

  • Early 1940s: large increase in real GDP

    • Economic boom

    • World War II

      • More resources to the military

      • Government purchases increased

      • Aggregate demand – increased 1939 - 1944

      • Doubled the economy’s production of goods and services

      • 20% increase in the price level

      • Unemployment fell from 17 to 1%


U s real gdp growth since 1900 l.jpg

Figure 9 World War II

U.S. real GDP growth since 1900

Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of goods and services plummeted. During the early 1940s, the United States entered World War II, and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand.


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The Recession of 2001 World War II

  • 2001: Recession

    • Unemployment rate

      • December 2000: 3.9%

      • August 2001: 4.9%

      • June 2003: 6.3%

      • January 2005: 5.2%

  • Three events – decrease in aggregate demand

    • The end of dot-com bubble in stock market

      • Stock prices fell (25%)

      • Reduced consumer & investment spending

      • Aggregate-demand curve - shifted to left


The recession of 200166 l.jpg
The recession of 2001 World War II

  • Three events – decrease in aggregate demand

    • Terrorist attacks on September 11, 2001

      • Stock market fell (12%) in one week

      • Increased uncertainty about the future

      • Aggregate-demand curve – shifted further to left

    • Series of corporate accounting scandals

      • Enron and WorldCom

      • Stock market fell

      • Aggregate-demand curve – shifted further to left


The recession of 200167 l.jpg
The recession of 2001 World War II

  • 2001: Recession

    • Policymakers - quick to respond

    • The Fed - expansionary monetary policy

      • Interest rates fell; Federal funds rate fell

      • Stimulated spending

    • Congress

      • Tax cut in 2001; Immediate tax rebate; Tax cut in 2003

      • To stimulate consumer & investment spending

    • Aggregate-demand curve – shifted to right

      • Offset the three contractionary shocks


Crisis of 2008 l.jpg
Crisis of World War II2008


Roots of the crisis of 2008 l.jpg
Roots of the Crisis of 2008 World War II

  • The crisis of 2008 may have been caused by the Fed’s overreaction to the recession of 2001

  • The Fed cut interest rates sharply kept them low for too long


Roots of the crisis of 200870 l.jpg
Roots of the Crisis of 2008 World War II

  • Those low interest rates may have fueled a ‘bubble’ in home prices


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The Recession of 2008–2009 World War II

  • Developments in the mortgage market

    • Easier for subprime borrowers to get loans

      • Borrowers with a higher risk of default (income and credit history)

    • Securitization

      • Process by which a financial institution (mortgage originator) makes loan

      • Then (investment bank) bundles them together mortgage-backed securities


The recession of 2008 200972 l.jpg
The Recession of 2008–2009 World War II

  • Developments in the mortgage market

    • Mortgage-backed securities

      • Sold to other institutions, which may not have fully appreciated the risks in these securities

  • Other issues

    • Inadequate regulation for these high-risk loans

    • Misguided government policy

      • Encouraged this high-risk lending


The recession of 2008 200973 l.jpg
The Recession of 2008–2009 World War II

  • 1995-2006

    • Increase in housing demand

    • Increase in housing prices

      • More than doubled

  • 2006-2009, housing prices fell 30%

    • Substantial rise in mortgage defaults and home foreclosures

    • Financial institutions that owned mortgage-backed securities

      • Huge losses, stopped making loans


The recession of 2008 200974 l.jpg
The Recession of 2008–2009 World War II

  • Large contractionary shift in AD

    • Real GDP fell sharply

      • By 4% between the forth quarter of 2007 and the second quarter of 2009

    • Employment fell sharply

      • Unemployment rate rose from 4.4% in May 2007 to 10.1% in October 2009


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The Recession of 2008–2009 World War II

  • Three policy actions - aimed in part at returning AD to its previous level

    • The Fed

      • Cut its target for the federal funds rate

        • From 5.25% in September 2007 to about zero in December 2008

      • Started buying mortgage-backed securities and other private loans

        • In open-market operations

        • Provided banks with additional funds


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The Recession of 2008–2009 World War II

  • Three policy actions

    • October 2008, Wall Street bailout $700 billion

      • For the Treasury to use to rescue the financial system

      • To stem the financial crisis on Wall Street

      • To make loans easier to obtain

      • Equity injections into banks

      • U.S. government – temporarily became a part owner of these banks


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The Recession of 2008–2009 World War II

  • Three policy actions

    • January 2009, President Barack Obama

      • $787 billion stimulus bill, February 17, 2009

        • To be spent over two years

  • Economy

    • Starting to recover from the economic downturn

    • Real GDP - growing again

    • Unemployment – 9.5% in June 2010


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Crisis of 2008: housing bubble pops! World War II

  • This is where it all began


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Crisis of 2008: the stock market tanked World War II

  • This reduced people’s wealth … which reduced consumption … which reduced aggregate demand


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Crisis of 2008: consumption spending tanked World War II

  • This was a major blow to aggregate demand


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Crisis of 2008: consumption spending began tanking early World War II

  • We got hit by the collapse of the housing prices bubble … and by the collapse in share prices


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Crisis of 2008: business investment tanked World War II

  • This was a major blow to aggregate demand

  • Businesses got scared way back in 2006!


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Crisis of 2008: Real GDP fell sharply World War II

  • This was the worst recession since the Great Depression


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Crisis of 2008: Real GDP fell sharply World War II

  • Growth of real GDP turned negative


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Crisis of 2008: unemployment spiked World War II

  • Demand had collapsed … so jobs disappeared


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Crisis of 2008: prices actually fell World War II

  • … for a while


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Crisis of 2008: no inflation World War II

  • We had deflation, for a while


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Crisis of 2008: our net exports improved World War II

  • This was a consequence of our falling incomes

  • But this did not help aggregate demand all that much


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Crisis of 2008: government spending rose World War II

  • This helped aggregate demand


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Crisis of 2008: government spending rose sharply as a percentage of GDP

  • But it wasn’t enough


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Crisis of 2008: government receipts tanked percentage of GDP

  • Incomes fell … so tax payments fell too … automatic stabilizers in action!


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Crisis of 2008: fiscal policy stimulus percentage of GDP

  • The government went on a borrowing binge to stimulate the economy


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Crisis of 2008: fiscal policy stimulus percentage of GDP

  • The government went on a borrowing binge to stimulate the economy


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Crisis of 2008: monetary stimulus percentage of GDP

  • Real money supply kept rising at a slightly faster than usual pace


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Crisis of 2008: monetary stimulus percentage of GDP

  • The Federal Reserve did all it could

  • But the Federal Funds Rate could not be reduced below zero!



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ECONOMIC FLUCTUATIONS: percentage of GDPAS

  • A leftward shift in Short-Run Aggregate Supply

    • Output falls below the natural rate of employment

    • Unemployment rises

    • The price level rises

  • If the government does nothing, the SRAS will shift back to where it was.

    • The price level, total production and unemployment will be unaffected in the long run.

Stagflation!


Figure 10 an adverse shift in aggregate supply l.jpg

1. An adverse shift in the short- percentage of GDP

run aggregate-supply curve . . .

Short-run

AS2

aggregate

supply,

AS

B

P2

A

P

3. . . . and

the price

level to rise.

Aggregate demand

Y2

Y

2. . . . causes output to fall . . .

Figure 10 AnAdverse Shift in Aggregate Supply

Price

Level

Long-run

aggregate

supply

Quantity of

0

Output


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Stagflation percentage of GDP

  • Adverse shifts in aggregate supply cause stagflation—a period of recession and inflation.

    • Output falls and prices rise.

    • Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.


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The Effects of a Shift in Aggregate Supply percentage of GDP

  • Policy Responses to Recession

    • Policymakers may respond to a recession in one of the following ways:

      • Do nothing and wait for prices and wages to adjust.

      • Take action to increase aggregate demand by using (expansionary) monetary and fiscal policy.


Figure 11 accommodating an adverse shift in aggregate supply l.jpg

1. When short-run aggregate percentage of GDP

supply falls . . .

Short-run

AS2

aggregate

supply,

AS

P3

C

2. . . . policymakers can

accommodate the shift

P2

by expanding aggregate

A

3. . . . which

demand . . .

P

causes the

price level

AD2

to rise

4. . . . but keeps output

further . . .

at its natural rate.

Figure 11 Accommodating an Adverse Shift in Aggregate Supply

Price

Level

Long-run

aggregate

supply

Aggregate demand,

AD

Quantity of

0

Natural rate

Output

of output


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Oil and the economy percentage of GDP

  • Economic fluctuations in the U.S. economy

    • Since 1970

    • Some: originated in the oil fields of the Middle East

  • Some event - reduces the supply of crude oil flowing from Middle East

    • Price of oil - rises around the world

    • Aggregate-supply curve – shifts left

    • Stagflation

      • Mid-1970s

      • Late-1970s


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Oil and the economy percentage of GDP

  • Some event – increases the supply of crude oil from Middle East

    • Price of oil decreases

    • Aggregate-supply curve – shifts right

      • Output – rapid growth

      • Unemployment – falls

      • Inflation rate – falls


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Oil and the economy percentage of GDP

  • Recent years: World market for oil – not an important source of economic fluctuations

    • Conservation efforts

    • Changes in technology

  • 2008 - world oil prices – rising significantly

    • Increased demand from a rapidly growing China


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John Maynard Keynes (1883-1946) percentage of GDP

  • Our understanding of the short-run behavior of the economy grew out of economists’ attempts to understand why the Great Depression happened

  • Published in 1936, Keynes’s The General Theory of Employment, Interest and Money laid the foundations

TIME Cover, December 31, 1965


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John Maynard Keynes (1883-1946) percentage of GDP

  • “The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.”

    • A Tract on Monetary Reform (1923)


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Summary percentage of GDP

  • All societies experience short-run economic fluctuations around long-run trends.

  • These fluctuations are irregular and largely unpredictable.

  • When recessions occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.


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Summary percentage of GDP

  • Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply model.

  • According to the model of aggregate demand and aggregate supply, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.


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Summary percentage of GDP

  • The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an exchange rate effect.

  • Any event or policy that changes consumption, investment, government purchases, or net exports at a given price level will shift the aggregate-demand curve.


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Summary percentage of GDP

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

  • The short-run, the aggregate supply curve is upward sloping.

  • The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory.


Summary111 l.jpg
Summary percentage of GDP

  • Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve.

  • Also, the position of the short-run aggregate-supply curve depends on the expected price level.

  • One possible cause of economic fluctuations is a shift in aggregate demand.


Summary112 l.jpg
Summary percentage of GDP

  • A second possible cause of economic fluctuations is a shift in aggregate supply.

  • Stagflation is a period of falling output and rising prices.


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