Sherif Khalifa Sherif Khalifa () Economic Fluctuations 1 / 29
Definition The business cycle describes the fluctuations in the production output of goods and services in an economy. The business cycle is the downward and upward movement of gross domestic product about its long term growth trend. Short-run economic fluctuations are often called business cycles. During periods of economic expansion, firms find that customers are plentiful and profits are increasing. During periods of economic contraction, firms experience declining sales and diminishing profits. Economic fluctuations do not follow a predictable pattern. Sherif Khalifa () Economic Fluctuations 2 / 29
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Economic Fluctuations Sherif Khalifa () Economic Fluctuations 6 / 29
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 / 29
Economic Fluctuations Sherif Khalifa () Economic Fluctuations 8 / 29
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 / 29
Aggregate Demand P P 1 P 2 AD Y Y 1 Y 2 Sherif Khalifa () Economic Fluctuations 10 / 29
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 lhigher 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 lower quantity of goods and services demanded. Sherif Khalifa () Economic Fluctuations 11 / 29
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 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 and decreases the quantity of goods and services demanded. Sherif Khalifa () Economic Fluctuations 12 / 29
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 13 / 29
Aggregate Demand Any event that changes how much people want to consume at a given price level shifts the aggregate demand curve. Examples change in consumer confidence, change in credit availability, change in consumer wealth. Any event that changes how much firms want to invest at a given price level shifts the aggregate demand curve. Examples changes in investment taxes, changes in the cost of borrowing, uncertainty and risk. Sherif Khalifa () Economic Fluctuations 14 / 29
Aggregate Demand The most direct way that policymakers shift the aggregate demand curve is through government spending. Examples changes in budget deficit, changes in fiscal policy. Any event that changes net exports for a given price level shifts the aggregate demand curve. Examples changes in trade policy, changes in the exchange rate. Sherif Khalifa () Economic Fluctuations 15 / 29
Aggregate Supply In the long run, an economy s production of goods and services depends on its supplies of labor, capital, natural andowment and technology. Natural rate of output is the production of goods and services that an economy achieves in the long run when unemployment is at its natural rate. Natural rate of output depends on the economy s stocks of labor, capital, natural endowments, and the level of 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 the long run aggregate supply curve. Sherif Khalifa () Economic Fluctuations 16 / 29
Aggregate Supply P LRAS P 1 P 2 Y N Sherif Khalifa () Economic Fluctuations 17 / 29 Y
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 18 / 29 Y
Aggregate Supply P SRAS P 2 P 1 Y 1 Y 2 Y Sherif Khalifa () Economic Fluctuations 19 / 29
Aggregate Supply Definition Sticky wages are wages that are predetermined by long term contracts. 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. Sherif Khalifa () Economic Fluctuations 20 / 29
Aggregate Supply Definition Sticky prices are prices that adjust sluggishly not to incur costs of changing prices. 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 21 / 29
Aggregate Supply All the variables that shift the LRAS causes a shift in the SRAS plus the price level that people expect to prevail. An increase in the expected price level decreases the quantity of goods and services supplied and shifts the SRAS to the left. A decrease in the expected price level increases the quantity of goods and services supplied and shifts the SRAS to the right. Sherif Khalifa () Economic Fluctuations 22 / 29
P LRAS 1 SRAS 1 P 1 Y N AD 1 Y Sherif Khalifa () Economic Fluctuations 23 / 29
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 24 / 29
The wave of pessimism affect spending plans, 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. 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. Policy makers can interfere in the recession by adopting expansionary monetary or fiscal policy to shift the aggregate demand curve back. Sherif Khalifa () Economic Fluctuations 25 / 29
P LRAS 1 SRAS 1 SRAS 2 P 1 P 2 AD 1 Y 2 Y N AD 2 Y Sherif Khalifa () Economic Fluctuations 26 / 29
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 27 / 29
Definition Stagflation is a combination of stagnation and inflation. Higher production costs make selling goods and services less profitable, firms supply a smaller quantity of output for any given price level. This causes stagflation, which is a period of falling output or stangation and increasing prices and inflation. The low level of output and employment will put downward pressure on 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. Policy makers can interfere by adopting expansionary monetary or fiscal policy to shift the aggregate demand curve back. Sherif Khalifa () Economic Fluctuations 28 / 29
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 29 / 29