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Economic fluctuations are irregular, recurring movements of GDP away from potential output, also called business cycles.
Aggregate supply and aggregate demand curves are tools of analysis used for understanding key aspects of economic fluctuations in both the short run and the long run.
A depression is a prolonged period of decline in output, or a severe recession. During the Great Depression, 1929 through 1933, real GDP fell by over 33%, and unemployment rose to 25%.
In the U.S., there were 20 recessions prior to World War II, including two severe episodes in 1893 and 1929. After WWII the U.S. has had nine recessions.
A recession is a period when real GDP falls for two consecutive quarters. It starts at the peak of an increase in output, and ends at a trough.
The relationship between changes in real GDP and the corresponding changes in unemployment is called Okun’s Law.
According to Okun’s law, for every percentage point that real GDP grows faster than the normal rate of increase in potential output, the unemployment rate falls by one-half of a percentage point.
The Unemployment Rate During The Unemployment Rate During RecessionsRecessionsThe Unemployment Rate During The Unemployment Rate During RecessionsRecessions
During periods of recession, marked by the shaded bars, unemployment rises sharply.
Procyclical and Countercyclical MeasuresProcyclical and Countercyclical MeasuresProcyclical and Countercyclical MeasuresProcyclical and Countercyclical Measures
ProcyclicalProcyclical economic measures move in conjunction with real GDP. Investment spending, consumption spending and prices of stocks are all procyclical. The stock market always plunges sharply during recessions.
Economic measures that fall as real GDP rises are countercyclicalcountercyclical. Unemployment is countercyclical.
Recessions are unpredictable and can arise as a result of external shocks or changes in economic policy.
Wages are sticky because workers often have long-term contracts or are protected from wage decreases by minimum wage laws.
If wages are sticky, then firms’ costs and their prices will be sticky as well. Sticky prices get in the way of the economy’s ability to coordinate economic activity, and to bring demand and supply into balance.
Typically, firms let demand determine the level of output in the short run. In the long run, prices fully adjust to changes in demand.
In the short run, firms have negotiated contracts that keep input prices fixed. Sudden changes in demand will be met by changes in production with only small changes in prices.
Keynesian economics refers to the determination of output in the short run based strictly on changes in demand.
Aggregate demand slopes downward for several reasons. Among them are:
Reality PRINCIPLE What matters to people is the real value or purchasing power of money or income, not its face value.
The wealth effect: as the price level falls, the real value of money increases and people find that they are wealthier. This concept is associated with the reality principle.
Aggregate demand slopes downward for several reasons. Among them are:
The interest rate effect: with a given money supply, a lower price level will lead to lower interest rates and higher consumption and investment spending.
Aggregate demand slopes downward for several reasons. Among them are:
The impact of international trade: a lower price level makes domestic goods cheaper relative to foreign goods; and a lower U.S. interest rate leads to a lower U.S. exchange rate which also makes domestic goods relatively cheaper than foreign goods.
The aggregate supply curveaggregate supply curve depicts the relationship between the level of prices and real GDP.
We will consider two aggregate supply curves, one corresponding to the long run (the long run the long run aggregate supply curveaggregate supply curve), and one to the short run (the short run the short run aggregate supply curveaggregate supply curve).
The Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply Curve
The classical aggregate supply curve is the supply curve for the long run—when the economy is at full employment.
The level of full- employment output does not depend on the level of prices, but on supply factors—capital, labor and technology. This is why the classical AS curve is vertical.
The Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply Curve
Combined with the aggregate demand curve, the intersection of the classical AS curve and the AD curve determines the price level and the full-employment level of output.
The position of the AD curve depends on the level of taxes, government spending, and the supply of money.
The Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply CurveThe Long Run Aggregate Supply Curve
An increase in aggregate demand does not change the level of output in the economy but only the level of prices.
The main result from the classical model is that, in the long run, output is determined solely by the supply of capital and labor—not by changes in demand.
If the level of output remains the same but government spending increases, some other component of demand (consumption, investment, or net exports) must decrease.
As we have seen, higher aggregate demand (i.e. higher government spending) in the classical model does not change the level of output.
The Short Run Aggregate Supply CurveThe Short Run Aggregate Supply CurveThe Short Run Aggregate Supply CurveThe Short Run Aggregate Supply Curve
The Keynesian AS curve is relatively flat because, in the short run, firms adjust output more than they adjust prices.
Since an increase in demand is met mostly by an increase in output, we say that aggregate demand primarily determines the level of output in the short run.
From Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run Equilibrium
As firms compete for labor and raw materials, wages and prices will tend to rise over time.
This will cause the Keynesian aggregate supply curve to shift upward.
This situation will continue as long as output exceeds potential.
From Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run EquilibriumFrom Short-run to Long-run Equilibrium
The Keynesian aggregate supply will keep rising upward until it intersects the aggregate demand curve at full employment.
Adjustments in wages and prices eventually take the economy from short-run Keynesian equilibrium to long-run classical equilibrium.