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In most years production of goods and services rises. On average over the past 50 years, production in the U.S. economy has grown by about 3 percent per year. In some years normal growth does not occur, causing a recession.
A recession is a period of declining real incomes, and rising unemployment. Since 1965, the U.S. economy has suffered six recessions. A depression is a severe recession. The Great Depression occurred in 1929-1941 when output fell by about 30 percent and unemployment rose to 25 percent.
THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Economic fluctuations are irregular and unpredictable.
Fluctuations in the economy are often called the business cycle. Stylized model of the business cycle.
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SR: Most economists believe that prices do not adjust fully in the short-run and therefore output will change.
Therefore, aggregate demand as well as aggregate supply are important in determining output and prices in the short-run.
Aggregate supply
Aggregate demand
Equilibrium output
Quantity of Output
Copyright 2004 South-Western
Level
P1
D2 Aggregate demand, D 1
0
Y1
Y2
Quantity of Output
2. . . . does not affect the quantity of goods and services supplied in the long run. Quantity of Output
P2 1. A decrease in the price level . . . 2. . . . reduces the quantity of goods and services supplied in the short run.
Y2
Quantity of Output
Copyright 2004 South-Western
The expected price level Pe is the link between aggregate supply in the short-run and in the long-run. In the long-run P=Pe, people cant be fooled, but in the short-run P can be less than, equal to, or more than Pe. Three theories of upward-sloping short-run aggregate supply:
The Misperceptions Theory The Sticky-Wage Theory The Sticky-Price Theory
An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and
Equilibrium price
P P2 P3 B
B A
C A
2. . . . policymakers can accommodate the shift by expanding aggregate demand . . . AD2 Aggregate demand, AD Quantity of Output
Copyright 2004 South-Western
If Yactual> YFE, Uactual<UNR, this will cause nominal wages (W) to rise in the long-run and the AS will decrease or shift up and to the left. If Yactual< YFE, Uactual>UNR, this will cause nominal wages (W) to fall in the long-run and the AS will increase or shift down and to the right. In both cases, nominal wages will continue to adjust until we return to the UNR and YFE is restored.
Summary
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.
Summary
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.
Summary
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.
Summary
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.
Summary
Events that alter the economys 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.
Summary
A second possible cause of economic fluctuations is a shift in aggregate supply. Stagflation is a period of falling output and rising prices.