Economic Fluctuations

Sherif Khalifa Sherif Khalifa () Economic Fluctuations 1 / 39

Economy s output experiences short run fluctuations around the long run upward trend. Fluctuations in the economy s output are closely associated with fluctuations in employment. Economists call the short run fluctuations in output and employment the business cycle. When the economy experiences a period of falling output and increasing unemployment, the economy is in a recession. Sherif Khalifa () Economic Fluctuations 2 / 39

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Economic Fluctuations Sherif Khalifa () Economic Fluctuations 6 / 39

12 10 8 Unemployment rate, percent of of labor force 6 4 2 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 Sherif Khalifa () Economic Fluctuations 7 / 39

Economic Fluctuations Sherif Khalifa () Economic Fluctuations 8 / 39

AS/AD is the model that explains short run fluctuations in economic activity around its long run trend. The aggregate demand curve is a curve that shows the quantity of goods and services that households, firms, the government, and foreigners want to buy at each price level. The aggregate supply curve is a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. The price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. Sherif Khalifa () Economic Fluctuations 9 / 39

Aggregate Demand Definition Aggregate demand is the relationship between the quantity of output demanded and the aggregate price level. Definition The aggregate demand curve tells us the quantity demanded of goods and service people want to buy at any given level of prices. Sherif Khalifa () Economic Fluctuations 10 / 39

Aggregate Demand MxV = PxY If the price level increases, each transaction requires more dollars. The number of transactions and thus the quantity of goods and services purchases must fall. Sherif Khalifa () Economic Fluctuations 11 / 39

Aggregate Demand Wealth Effect A decrease in the price level increases the value of money and makes consumers wealthier. This in turn encourages them to spend more, which means larger quantity of goods and services demanded. An increase in the price level decreases the value of money, and makes consumers less wealthy. This in turn discourages them from spending, which means smaller quantity of goods and services demanded. Sherif Khalifa () Economic Fluctuations 12 / 39

Aggregate Demand Interest Rate Effect The lower the price level, the less money households need to hold to buy the goods and services they want. As households try to convert some of their excess money into interest bearing assets, they decrease interest rates. The decrease in the interest rate, encourages spending on investment goods and increases the quantity of goods and services demanded. The higher the price level, the more money households need to hold to buy the goods and services they want. As households try to withdraw some of their money in interest bearing assets, they increase interest rates. The increase in the interest rate, discourages spending on investment goods and decreases the quantity of goods and services demanded. Sherif Khalifa () Economic Fluctuations 13 / 39

Aggregate Demand Exchange Rate Effect When a decrease in the U.S. price level causes U.S. interest rates to decrease, the value of the dollar decreases. This depreciation increases U.S. net exports and the quantity of goods and services demanded. When an increase in the U.S. price level causes U.S. interest rates to increase, the value of the dollar increases. This appreciation decreases U.S. net exports and the quantity of goods and services demanded. Sherif Khalifa () Economic Fluctuations 14 / 39

Aggregate Demand P P 1 P 2 AD Y Y 1 Y 2 Sherif Khalifa () Economic Fluctuations 15 / 39

P P 1 AD 2 Y 1 Y 2 AD 1 Y Sherif Khalifa () Economic Fluctuations 16 / 39

Aggregate Demand P P 1 Y 2 Y 1 AD 2 AD 1 Y Sherif Khalifa () Economic Fluctuations 17 / 39

Aggregate Supply Definition Aggregate supply is the relationship between the quantity of goods and services supplied and the price level. Firms have flexible prices in the long run, but sticky prices in the short run. The aggregate supply relationship depends on the time horizon. There is a long run aggregate supply curve and a short run aggregate supply curve. Sherif Khalifa () Economic Fluctuations 18 / 39

Aggregate Supply Natural rate of output is the production of goods and services in the long run when unemployment is at its natural rate. Natural rate of output depends on the economy s stock of labor, capital, natural resources, and technology. An increase in the price level does not affect any of these factors, so it does not affect the natural rate of output. Any event that changes any of the determinants of the natural rate of output will shift LRAS. Sherif Khalifa () Economic Fluctuations 19 / 39

Aggregate Supply P LRAS P 1 P 2 Y N Sherif Khalifa () Economic Fluctuations 20 / 39 Y

Aggregate Supply P SRAS Y Sherif Khalifa () Economic Fluctuations 21 / 39

Aggregate Supply The quantity of output supplied deviates from its long run, or natural level, when the actual price level in the economy deviates from the price level that people expected to prevail. Y = Y + a (P EP) P When P > P E SRAS the expected price level P E When P < P E Y N Sherif Khalifa () Economic Fluctuations 22 / 39 Y

Aggregate Supply P SRAS P 1 P 2 Y 2 Y 1 Y Sherif Khalifa () Economic Fluctuations 23 / 39

Aggregate Supply The Sticky Wage Theory Nominal wages are slow to adjust to changing economic conditions, due to long term contracts between workers and firms. A firm expects the price level to be high, and signs a contract with its workers to pay them a high wage. The price level turns out to be lower than expected, but the cost of labor is stuck at the contracted level. Production is now less profitable, so the firm hires fewer workers and decreases the quantities of output supplied. Sherif Khalifa () Economic Fluctuations 24 / 39

Aggregate Supply The Sticky Price Theory The prices of some goods and services adjust sluggishly due to menu costs. Firms announce their prices in advance based on economic conditions it expects to prevail over the coming year. The economy experiences an unexpected contraction of money supply, which decreases the overall price level. Although some firms can decrease their prices immediately, others may not want to incur menu costs. Because these firms have prices that are too high, their sales decline. Declining sales cause these firms to cut back on production and employment. Sherif Khalifa () Economic Fluctuations 25 / 39

P LRAS P 1 SRAS AD Y N Y Sherif Khalifa () Economic Fluctuations 26 / 39

Event: A wave of pessimism overtakes the economy. P LRAS 1 P 1 B A SRAS 1 C Y 2 Y N AD 2 AD 1 Y Sherif Khalifa () Economic Fluctuations 27 / 39

Event: An increase in investment tax credits. P LRAS 1 C P 1 A B SRAS 1 AD 2 AD 1 Y N Y 2 Y Sherif Khalifa () Economic Fluctuations 28 / 39

Event: An oil price shock. P LRAS 1 P 2 B SRAS 2 P 1 A SRAS 1 AD 1 Y 2 Y N Y Sherif Khalifa () Economic Fluctuations 29 / 39

P LRAS 1 P 2 B SRAS 2 P 1 A SRAS 1 AD 2 AD 1 Y 2 Y N Y Sherif Khalifa () Economic Fluctuations 30 / 39

P LRAS 1 SRAS 1 P 1 Y N AD 1 Y Sherif Khalifa () Economic Fluctuations 31 / 39

Event: a wave of pessimism overtakes the economy. P LRAS 1 SRAS 1 P 1 P 2 AD 1 Y 2 Y N AD 2 Y Sherif Khalifa () Economic Fluctuations 32 / 39

The wave of pessimism affect spending plans, and shifts the aggregate demand curve to the left causing a recession and a decline in prices. Pessimism about the future is self fulfilling,and leads to falling incomes and increasing unemployment. The price level is below the level that people had come to expect before the sudden fall in aggregate demand. Overtime, expectations catch up with this new reality, and the fall in the expected price alters wages, prices and perceptions. Workers and firms bargain for lower wages, which encourages more hiring and expands production which shifts the SRAS to the right. Sherif Khalifa () Economic Fluctuations 33 / 39

P LRAS 1 SRAS 1 SRAS 2 P 1 P 2 AD 1 Y 2 Y N AD 2 Y Sherif Khalifa () Economic Fluctuations 34 / 39

P LRAS 1 SRAS 1 P 1 P 2 AD 1 Y 2 Y N AD 2 Y Sherif Khalifa () Economic Fluctuations 35 / 39

Event: a war interrupting the shipping of crude oil. P LRAS 1 SRAS 2 SRAS 1 P 2 P 1 Y 2 Y N AD 1 Y Sherif Khalifa () Economic Fluctuations 36 / 39

Because higher production costs make selling goods and services less profitable, firms supply a smaller quantity of output for any given price level. This causes a stagflation, which is a period of falling output and increasing prices. Stagflation is a combination of stagnation and inflation. The low level of output and employment will put downward pressure on workers wages because workers have less bargaining power when unemployment is high. As nominal wages fall, producing goods and services become profitable, and the SRAS shifts to the right. Sherif Khalifa () Economic Fluctuations 37 / 39

P LRAS 1 SRAS 2 SRAS 1 P 2 P 1 AD 1 Y 2 Y N Y Sherif Khalifa () Economic Fluctuations 38 / 39

P LRAS 1 SRAS 2 SRAS 1 P 3 P 2 P 1 AD 2 AD 1 Y 2 Y N Y Sherif Khalifa () Economic Fluctuations 39 / 39