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? 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?

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.

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.

FACTS

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

1. Economic fluctuations are irregular and unpredictable.
Fluctuations in the economy are often called the business cycle.

2. Most macroeconomic variables fluctuate together. 3. As output falls, unemployment rises.

Three Key Facts About Economic Fluctuations

Fact 1: Economic fluctuations are irregular and unpredictable

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.

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.

Three Key Facts About Economic Fluctuations

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

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.

Three Key Facts About Economic Fluctuations

Fact 3: As Output Falls, Unemployment Rises

THEORY

Recap: long-run theory

Chapter 7: GDP depends on
number of workers physical capital per worker human capital per worker natural resources per worker technological knowledge laws, government policies, and their enforcement

Chapter 8: saving, investment, and the real interest rate depend on the supply and demand for loanable funds Chapter 10: unemployment depends on
how well the labor market matches unemployed workers to job vacancies, and how close the wage is to the equilibrium wage

Chapter 12: the price level depends on the quantity of money, and the rate of inflation depends on the growth rate of the quantity of money The factors that affect the real interest rate (Ch. 8) and the inflation rate (Ch. 12) together determine the nominal interest rate

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

Most economists believe that the long run theory we ve studied in previous chapters does not explain short run fluctuations
in the long run, changes in the money supply affect nominal variables but not real variables.
This is monetary neutrality; see chapter 12.

But monetary neutrality is not true in the short run

Aggregate Demand and Aggregate Supply

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

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.

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

Price Level

Aggregate supply

Equilibrium price level

Aggregate demand

Equilibrium output

Quantity of Output

AGGREGATE DEMAND

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

Price Level

P2 1. A decrease in the price level . . . 0 Y Y2 Aggregate Demand (AD) C + I + G + NX Quantity of Output

2. . . . increases the quantity of goods and services demanded.

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.

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

Why the Aggregate-Demand Curve Is Downward Sloping: Wealth 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

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

Bonus slide: Wealth Effect Controversy

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!

Why the Aggregate-Demand Curve Is Downward Sloping: Interest 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)

Why the Aggregate-Demand Curve Is Downward Sloping: Exchange-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 CurveAD We have seen why the

Price Level
curve is negatively sloped. We know why aggregate But what are the reasons demand would increase why the AD curve might from Y1 to Y2 when the shift? In other words, what price level decreases from are the reasons why P1 to P2. aggregate demand might increase to Y2 even if the price level stays put at P1?

P1 P2 D2 Aggregate demand, D1 0 Y1 Y2 Quantity of Output

Why the Aggregate-Demand Curve Might Shift P causes C+I+G+NX

This explains the downward slope of the aggregate demand curve

Many other factors can affect C+I+G+NX even when the price level stays unchanged. When these factors change, the aggregate demand curve shifts.
P

AD C + I + G + NX

Why the Aggregate-Demand Curve Might Shift 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

Table 1 The aggregate-demand curve: summary (a)

Why Does the Aggregate-Demand Curve Slope Downward? 1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption. 2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on investment. 3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports

Table 1 The aggregate-demand curve: summary (b)

Why Might the Aggregate-Demand Curve Shift? 1. Shifts Arising from Consumption: An event that makes consumers spend more at a given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to the right. An event that makes consumers spend less at a given price level (a tax hike, a stock-market decline) shifts the aggregate-demand curve to the left. 2. Shifts Arising from Investment: An event that makes firms invest more at a given price . level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that makes firms invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left. 3. Shifts Arising from Government Purchases: An increase in government purchases of goods and services (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left. 4. Shifts Arising from Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes an exchange-rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left

AGGREGATE SUPPLY

THE AGGREGATE-SUPPLY CURVE

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

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

Price Level Long-run aggregate supply P

P2 1. A change in the price level . . . 0 Natural rate of output

2. . . . does not affect the quantity of goods and services supplied in the long run. Quantity of Output

Why the Long-Run Aggregate-Supply Curve Might Shift 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 P Technology Laws, government policies
Y

Figure 5 Long-Run Growth and Inflation

2. . . . and growth in the money supply shifts aggregate demand . . . Price Level Long-run aggregate supply, LRAS1980 LRAS1990 LRAS2000

P2000 4. . . . and ongoing inflation. P1990

1. In the long run, technological progress shifts long-run aggregate supply . . .

Aggregate Demand, AD2000 P1980 AD1990

AD1980 0 Y1980 Y1990 Y2000 Quantity of Output 3. . . . leading to growth in output . . .

A New Way to Depict Long-Run Growth and Inflation Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

The Aggregate-Supply Curve Slopes Upward in the Short Run 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

Price Level Short-run aggregate supply P

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

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 Expected price price level level

The Short Run Aggregate-Supply Curve

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). Also, if P > Pe, then Y > YN. That is, the SRAS curve is upward rising. Quantity of output supplied Natural rate of + output Y = YN + a
YN Y P 140 Pe = 120 AS

a (P

Actual Expected price price level level Pe)

The Short Run Aggregate-Supply Curve

We have just seen that if P then Y .
P AS1 AS2

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 .
So, if either Pe or YN , the AS curve shifts down or to the right
Pe1 = 120

Pe2 = 100 YN1 YN2 Y

Quantity of output supplied

Natural rate of + output Y = YN + a

a (P

Actual Expected price price level level Pe)

The Short Run Aggregate-Supply Curve 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 Quantity of output supplied Natural rate of + output Y = YN + a Actual Expected price price level level Pe)
Y P AS1 AS2

a (P

The Sticky-Wage Theory

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 StickyWage 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 P If the actual price level in 2010 (P) turns out to be 120, the bosses expectations are fulfilled and nobody gets fired. 140 So, output in 2010 is the full-employment output, YN. Pe = 120 Therefore, the green dot, which represents the expected price level and the fullemployment 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

AS

YN

So, production increases beyond the fullemployment level (blue dot) In other words, the AS curve is upward rising

Shape of the AS 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 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) P months If the actual price level in 2010 (P) turns out to be 140, the bosses expectations are fulfilled. Nobody Pe = 140 gets fired. So, output in 2010 is the natural rate of output, YN. Therefore, the green dot, which represents the 120 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 fullemployment level (blue dot)
I am assuming that firms do not produce products that are perfectly substitutable

AS

YN

In other words, the AS curve is upward rising

Shape of the AS 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 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 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 P be 140, the bosses expectations are fulfilled. Nobody gets fired. So, output in 2010 is the natural rate of output, YN. Pe = 140 Therefore, the green dot, which represents the expected price level and the full120 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 fullemployment level (blue dot) In other words, the AS curve is upward rising

AS

YN

How the AS curve shifts

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
P AS1 AS2

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: The natural rate of output increases
This happens when there is an increase in:
Labor Physical Capital Human capital Natural Resources Technology.
Price Level

The Expected Price Level decreases.

Quantity of Output

Table 2: The Short-Run AggregateSupply Curve: Summary

57

Table 2: The Short-Run AggregateSupply Curve: Summary

58

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

Price Level Long-run aggregate supply

Short-run aggregate supply

Equilibrium price

Aggregate demand 0 Natural rate of output Quantity of Output

Figure 8 A Contraction in Aggregate Demand

2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply Short-run aggregate supply, AS

P P2 P3 B

1. A decrease in aggregate demand . . . Aggregate demand, AD AD2

Y2

Y But what if the shock to AD is permanent?

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

Quantity of Output

Figure 8 A Contraction in Aggregate Demand

2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply Short-run aggregate supply, AS If the shock to AD is permanent, people will realize that in the long run the economy will end up at C. They will expect the price level to fall to P3. P P2 P3 B C 1. A decrease in aggregate demand . . . Aggregate demand, AD AD2 0 Y2 Y Quantity of Output A

Figure 8 A Contraction in Aggregate Demand

2. . . . causes output to fall in the short run . . . Price Level Long-run aggregate supply Short-run aggregate supply, AS AS2 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 1. A decrease in aggregate demand . . . Aggregate demand, AD AD2 0 Y2 5. The government could also use expansionary monetary/fiscal policies to push AD back to AD1. Y 4. . . . and output returns to its natural rate. Quantity of Output

P P2 P3 B

ECONOMIC FLUCTUATIONS: AD
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

ECONOMIC FLUCTUATIONS: AD (bonus slide)

Note that the decrease in demand could be caused by
A decrease in the quantity of money (M), or Some other (non-monetary) reason

Either way, the long run effect is that P and Y stays unchanged. Therefore, P Y . But in the long run, the quantity equation of chapter 17 is assumed to be true: M V = P Y. Therefore, M V must fall. If M is unchanged, then V must fall So, the theory predicts that any non-monetary decrease in AD must cause V to fall in the long run

Policy response to a fall in aggregate demand

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)

Great Depression, recession of 2001, Great Recession of 2008

HISTORY

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 68

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% 69

Figure 9 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.

70

The Recession of 2001

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

1.The end of dot-com bubble in stock market
Stock prices fell (25%) Reduced consumer & investment spending Aggregate-demand curve - shifted to left

71

The recession of 2001

Three events decrease in aggregate demand
2. 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

3. Series of corporate accounting scandals

Enron and WorldCom Stock market fell Aggregate-demand curve shifted further to left

72

The recession of 2001

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 73

CRISIS OF 2008

Roots of the Crisis of 2008

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 2008

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

The Recession of 2008 2009

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

77

The Recession of 2008 2009

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

78

The Recession of 2008 2009

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
79

The Recession of 2008 2009

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

80

The Recession of 2008 2009

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

81

The Recession of 2008 2009

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

82

The Recession of 2008 2009

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

83

Crisis of 2008: housing bubble pops!

This is where it all began

Crisis of 2008: the stock market tanked

This reduced people s wealth which reduced consumption which reduced aggregate demand

Crisis of 2008: consumption spending tanked

This was a major blow to aggregate demand

Crisis of 2008: consumption spending began tanking early

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

Crisis of 2008: business investment tanked

This was a major blow to aggregate demand Businesses got scared way back in 2006!

Crisis of 2008: business investment tanked

Businesses got scared way back in 2006!

Crisis of 2008: Real GDP fell sharply

This was the worst recession since the Great Depression

Crisis of 2008: Real GDP fell sharply

Growth of real GDP turned negative

Crisis of 2008: unemployment spiked

Demand had collapsed so jobs disappeared

Crisis of 2008: prices actually fell

for a while

Crisis of 2008: no inflation

We had deflation, for a while

Crisis of 2008: our net exports improved

This was a consequence of our falling incomes But this did not help aggregate demand all that much

Crisis of 2008: government spending rose

This helped aggregate demand

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

But it wasn t enough

Crisis of 2008: government receipts tanked

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

Crisis of 2008: fiscal policy stimulus

Crisis of 2008: fiscal policy stimulus

The government went on a borrowing binge to stimulate the economy

Crisis of 2008: fiscal policy stimulus

The government went on a borrowing binge to stimulate the economy

Crisis of 2008: monetary stimulus

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

Crisis of 2008: monetary stimulus

The Federal Reserve did all it could But the Federal Funds Rate could not be reduced below zero!

RECESSIONS CAUSED BY DECREASES IN AGGREGATE SUPPLY

ECONOMIC FLUCTUATIONS: AS
A leftward shift in Short-Run Aggregate Supply
Output falls below the natural rate of employment Unemployment rises Stagflation! 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.

Figure 10 An Adverse Shift in Aggregate Supply

1. An adverse shift in the shortrun aggregate-supply curve . . . Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS

B P2 A P 3. . . . and the price level to rise. Aggregate demand 0 Y2 Y Quantity of Output

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

Stagflation
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.

The Effects of a Shift in Aggregate Supply 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

1. When short-run aggregate supply falls . . . Price Level Long-run aggregate supply AS2 Short-run aggregate supply, AS

P3 P2 A 3. . . . which P causes the price level to rise further . . . 0

2. . . . policymakers can accommodate the shift by expanding aggregate demand . . .

4. . . . but keeps output at its natural rate. Natural rate of output

AD2 Aggregate demand, AD

Quantity of Output

Oil and the economy 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

Oil and the economy 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

Oil and the economy 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

John Maynard Keynes (1883-1946)

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

John Maynard Keynes (1883-1946)

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)

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 economy s ability to produce output will shift the short-run aggregate-supply curve. Also, the position of the short-run aggregatesupply 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.