ShortRun Economic Fluctuations

1
Short-Run Economic Fluctuations

• Aggregate Demand and Aggregate Supply

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Outline

• What causes SR fluctuations in an economy?
• Analysis of SR fluctuations around its LR trend
• Model of aggregate demand and aggregate supply

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Properties of economic fluctuations

• Economic fluctuations are irregular and
  unpredictable
• Most macroeconomic quantities fluctuate together
• Unemployment rises with fall in output

4
Difference between SR and LR

• Classical economics examines the determinants of
  real macroeconomic variables in the LR without
  introducing nominal variables.
• Classical economics is based on two relate ideas-
  classical dichotomy and monetary neutrality.
• In the SR, both real and nominal variables are
  intertwined.
• Changes in nominal variables explain SR
  fluctuations around the LR trend.

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Basic model of economic fluctuations

• Examines the relationship between real GDP and
  the price level.
• Model of aggregate demand and aggregate supply
  explains the SR fluctuations in economic activity
  around its LR trend.
• Aggregate demand shows the quantity of goods and
  services that households, firms, and the
  government want to buy at each price level.
• Aggregate supply curve shows the quantity of
  goods and services that firms choose to produce
  and sell at each price level.

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Why the aggregate demand slopes downward?

• A fall in the price level results in the
• wealth effect, which stimulates demand for
  consumption goods
• interest rate effect which stimulates the demand
  for investment goods
• Real Exchange Rate (RER) effect, which stimulates
  demand for Net exports (NX)
• Remember that Money supply is constant

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Why the aggregate demand curve may shift?

• Aggregate demand curve shifts when the demand for
  quantity of goods and services changes at a given
  price level.
• Shifts may occur due to the following factors
• Shifts arising from consumption
• Shifts arising from investment
• Shifts arising from government purchases
• Shifts arising from NX

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Aggregate Supply Curve LR and SR

• In the LR aggregate supply is vertical.
• In the SR aggregate supply is downward sloping.

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Why the aggregate supply curve is vertical in the
LR?

• LR level of production is called as the natural
  level output or full employment or potential
  output.
• Real GDP, in the LR, is a function of factor
  inputs and available technology.
• Nominal variables (p level) has no impact on real
  GDP in the LR.
• Supply curves for specific goods slope upwards as
  they depend on relative prices.
• Economys supply of output is limited by factor
  inputs and technology. Thus an increase in the
  overall price does not alter the output supplied.

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Why the LR aggregate supply curve may shift?

• Any economic change that alters the natural level
  of output shifts the aggregate supply curve.
• Sources of shifts
• Changes in labour supply
• Changes in capital (physical and human) stock
• Changes in the availability of natural resources
  
• Changes in technological knowledge

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Relation between LR growth and inflation

• In the LR, technological changes shift the LR
  aggregate supply curve
• In the LR, growth in money supply shifts the LR
  aggregate demand curve
• The intersection in aggregate demand and
  aggregate supply curves shows the trend growth in
  output and inflation

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Why the aggregate supply curve slopes upward in
the SR?

• Specific market imperfections cause deviation in
  the SR quantity of output from its natural (LR)
  level, when the price level deviates from its
  expected level.
• Theories explaining market imperfections
• The misperceptions theory
• The sticky-wage theory
• The sticky-price theory

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Why the SR aggregate supply curve may shift?

• The misperceptions theory
• The sticky-wage theory
• The sticky-price theory
• Peoples expectations of price level

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Why the SR aggregate supply curve may shift?
(conclusion)

• An increase in the expected price level reduces
  quantity of goods and services supplied and
  shifts the SR aggregate supply curve to the left.
  
• A decrease in the expected price level increases
  quantity of goods and services supplied and
  shifts the SR aggregate supply curve to the
  right.
• In the SR, expectations are fixed
• In the LR, expectations adjust and SR aggregate
  supply curve shifts.

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Economic fluctuations Shifts in aggregate demand

• In the SR, shifts in aggregate demand cause
  fluctuations in the economys output of goods and
  services.
• In the LR, shifts in aggregate demand affect the
  overall price level but do not affect output.
• Policy makers can offset shifts in aggregate
  demand through changes in government exp or
  changes in money supply.

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Economic fluctuations Shifts in aggregate supply

• Shifts in aggregate supply can cause stagflation
• Policy makers can influence aggregate demand in
  order to maintain output at its natural level.
  But this leads to a permanent increase in prices.
  
• Policy makers may chose not to intervene and let
  the economy adjust itself. This approach will see
  a low price level but temporary rise in
  unemployment and fall in output.