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Short-Term
Economic Fluctuations:
An Introduction
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
Closed in
South Bend,
February
2001
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Posted: 02/01/2001 12:24 am
Last Updated: 2001-02-01 10:49:5405
The Federal Reserve has cut interest
rates for the second time this month.
With so many area businesses
closing, Michiana residents worry it
may be too late to save the economy
from slipping into recession.
Mark Eagen, the president and CEO
of St. Joseph County's chamber of
commerce, is watching Michiana's
economy closely and says it is slowing
down. While consumer spending has
obviously decreased, companies are
feeling the effect.
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
2
Closed in
South Bend,
February
2001
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Local effects
Plant closings like Bayer in
Elkhart, bankruptcies like OMC
Boats in Syracuse, along with
the shutdown of Montgomery
Ward, L.S. Ayers and
Thermoplastics, as well as the
downsizing of Whirlpool have all
taken a major toll on the area.
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
3
According to Tyler Glynn of Edwards Jones
Investments, “We feel a recession, or the
effects of a possible oncoming of a recession,
more than other parts of the country because
we have so much of a base in manufacturing.”
Closed in
South Bend,
February
2001
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Ray of hope
While all the closings have left many people
jobless, a ray of hope is on the horizon. AMGeneral, an auto plant opening in Mishawaka,
will manufacture a new generation of the
Hummer 4-wheel drive sport utility. The
additional 1500 jobs should make up for the
recent loss in Michiana, but experts continue
to watch the economy closely.
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
4
Recessions and Expansions
Recession (or contraction)
 A period in which the economy is growing at a rate
significantly below normal
The NBER does not define a recession in terms of two
consecutive quarters of decline in real GDP. Rather, a
recession is a significant decline in economic activity spread
across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment,
industrial production, and wholesale-retail sales.
• For more information, see the latest announcement on how the
NBER's Business Cycle Dating Committee chooses turning
points in the Economy and its latest memo, dated 07/17/03.
Depression
 A particularly severe or protracted recession
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
5
Fluctuations in U.S.
Real GDP, 1920-2001
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
6
Figure 2. Real Personal Income Less Transfers
The dark line shows the movement of income from May 2000 to the present and the shaded line the average over the
previous 6 recessions. Source: Bureau of Economic Analysis, U.S. Department of Commerce
Source: The Conference Board (http://www.globalindicators.org)
Copyright c 2004 by The McGraw-Hill
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
7
Figure 3. Payroll Employment
The dark line shows the movement of employment from May 2000 to the present and the shaded
line the average over the previous 6 recessions. Source: Bureau of Labor Statistics, U.S.
Department of Labor
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
8
U.S. Recessions Since 1929
Peak date
(beginning)
Trough date
(end)
Duration
(months)
Aug. 1929
Mar. 1933
43
May 1937
June 1938
Feb. 1945
Change in real
GDP (%)
Duration of
subsequent expansion
(months)
24.9
-28.8
50
13
19.0
-5.5
80
Oct. 1945
8
3.9
-8.5
37
Nov. 1948
Oct. 1949
11
5.9
-1.4
45
July 1953
May 1954
10
5.5
-1.2
39
Aug. 1957
Apr. 1958
8
6.8
-1.7
24
Apr. 1960
Feb. 1961
10
6.7
2.3
106
Dec. 1969
Nov. 1970
11
5.9
0.1
36
Nov. 1973
Mar. 1975
16
8.5
-1.1
58
Jan. 1980
July 1980
6
7.6
-0.3
12
July 1981
Nov. 1982
16
9.7
-2.1
92
July 1990
Mar. 1991
8
7.5
-0.9
120
Mar. 2001
Dec. 2001*
9*
6.0*
*Unofficial
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Highest
unemployment
rate (%)
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
0.2*
9
Recessions and Expansions
Peak
 The beginning of a recession, the high point
of economic activity prior to a downturn
Trough
 The end of a recession, the low point of
economic activity prior to a recovery
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
10
Recessions and Expansions
Expansion
 A period in which the economy is growing at a
rate significantly above normal
Boom
 A particularly strong and protracted expansion
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
11
The Phases of the Business
Cycle
Why does this matter?
Expansion
Recession
Expansion
Total Output
Peak
0
Trough
Secular
growth
trend
Jan.- Apr.- July- Oct.- Jan.- Apr.- July- Oct.- Jan.- Apr.Mar June Sept. Dec. Mar June Sept. Dec. Mar June
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
12
Business Cycles
Although we call them “cycles”, they are
not perfectly regular.
Business fluctuations are irregular and
difficult to predict.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
13
U. S. Business Cycles
20
Recovery
of 1895
Civil
10 War
World War I
World War II
Korean
War Vietnam War
0
Panic
of 1893
–10
Panic
of 1907
Great
Depression
–20
1860 ‘70
‘80
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‘90
1900
‘10
‘20
‘30 ‘40 ‘50 ‘60
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
‘70 ‘80 ‘90 2000 ‘10
14
Recessions and Expansions
Economic Naturalist
 Calling the 2001 recession
Business cycle dating committee of the National
Bureau of Economic Research
March 2001
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
15
Recessions and Expansions
Economic Naturalist
 Calling the 2001 recession
Indicators of the business cycle
• Industrial production
• Total sales in manufacturing, wholesale trade, and retail
trade
• Nonfarm employment
• Real after-tax income of households excluding transfers
Recessions are felt throughout the economy
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
16
Some Facts About Short-term
Economic Fluctuations
Economic fluctuations are irregular in
length and severity
Economic fluctuations are felt throughout
the economy and may have a global effect
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
17
Real GDP Growth in Five Major
Countries, 1999-2002
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
18
Some Facts About Short-term
Economic Fluctuations
Unemployment is a key indicator of shortterm economic fluctuations.
Industries that produce durable goods are
more affected than nondurable & service
industries.
 People give up buying refrigerators before
they cut food expenditures.
 Businesses stop making capital investments
when their sales fall.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
19
U.S. Inflation, 1960-2001
Recessions are usually followed by a decline in inflation
Many have been preceded by an increase in inflation.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
20
U.S. Unemployment Rate
Recessions are usually accompanied by high unemployment.
Unemployment tends to remain high for a long time after the recession is
Chapter 25: Short-Term Economic
over.
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Fluctuations: An Introduction
21
Output Gaps and
Cyclical Unemployment
Output Gaps and
Cyclical Unemployment
Potential Output, Y* (or potential real GDP
or full-employment output)
 The amount of output (real GDP) that an
economy can produce when using its
resources, such as capital and labor, at
normal rates.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
23
Output Gaps and
Cyclical Unemployment
For example,
 You may be able to study for 8 hours a day,
normally.
8 hours of study is your “normal” rate.
 Right before finals, maybe you are putting in
12 hours a day.
You are studying above your normal rate.
 But you may not be able to study 12 hours a
day all the time.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
24
Output Gaps and
Cyclical Unemployment
Notice that potential output is not the same
as “maximum output”.
Because capital and labor can be utilized
at greater-than-normal rates, at least for a
time, a country’s actual output Y can
exceed potential output Y*.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
25
Potential Output
Potential Output
Maximum output
(water at normal
capacity)
(water above
normal capacity)
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
26
Output Gaps and
Cyclical Unemployment
Potential output is often designated with
Y*
 (pronounced as “Y-star”).
Actual output designated as Y, is the
level of GDP that is actually counted using
methods specified in chapters 18.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
27
Output Gaps and
Cyclical Unemployment
Potential output is the GDP that can be
produced if the factors of production are
used at their “normal” rates.
 The normal rate is generally not 100 percent
or maximum utilization.
 Workers must rest and machines must be
maintained. Factories must be remodeled
and new computers must be installed, which
takes time. Y* takes this planned downtime
into account.
Copyright c 2004 by The McGraw-Hill
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
28
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
29
Actual Output
Below Potential
Output
(water below
normal capacity)
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At Potential Output
(water at normal
capacity)
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
Above Potential
Output
(water above
capacity)
30
Output Gaps and
Cyclical Unemployment
Potential output is defined as “full
employment” even though some factors
are idle.
Potential output = normal output = fullemployment output
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
31
Output Gaps and
Cyclical Unemployment
Why the output growth rate varies:
 There may be changes in the rate at which
the country’s potential output, Y*, is
increasing.
We often study this as part of “long-run” or
“growth” economics.
 Actual output, Y, does not always equal
potential output, Y*.
We study this as part of “short-run” or
“business-cycle” economics.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
32
Output Gaps and
Cyclical Unemployment
Y* reflects the number and the productivity of
factors of production that are available in an
economy.
Increasing the number or quality (productivity) of
these factors will increase potential output.
 Potential output in the U.S. economy has grown
demonstrably in response to increases in the labor
supply, increased endowments of human capital,
advances in technology, expansions in the
infrastructure, improved institutions, protection of
several categories of natural resources, and other
changes.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
33
Output Gaps and
Cyclical Unemployment
Output Gap
 Y* – Y
 potential output – actual output
Recessionary Gap
 Y* > Y

Y* – Y > 0
Expansionary Gap
 Y* < Y
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
Y* – Y < 0
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
34
Output Gaps and
Cyclical Unemployment
$
Recessionary
Gap
Y* - Y > 0
How Y
moves
over time
How Y*
grows
over
time
Expansionary
Gap
Y* - Y < 0
time
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
35
Output Gaps and
Cyclical Unemployment
When Y* = Y,
factors are working at the normal level and
expectations are realized. The
macroeconomy is producing according to
plan. Just the right quantity of goods and
services are being produced.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
36
Output Gaps and
Cyclical Unemployment
Recessionary Gap: Y* - Y > 0
 Capital and labor resources are not fully
utilized
 Output and employment are below normal
levels
Factors of production are idle or working at less
than normal rates. Goods pile up and factors are
laid off. The economy falls into a recession.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
37
Output Gaps and
Cyclical Unemployment
Recessionary Gap:
Y* - Y > 0
 Capital and labor
resources are not fully
utilized
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
38
Output Gaps and
Cyclical Unemployment
Expansionary Gap: Y* - Y < 0
 Higher output and employment than normal, more
than it usually wants to produce.
This above-normal level of output cannot be sustained
forever. Machines are running too fast and
workers are working too many hours. In this
case, the economy is struggling to expand,
but since output generally cannot expand fast
enough, prices must rise.
 Demand for goods exceed the capacity
to produce them and prices rise.
 High inflation reduces economic
efficiency.
Chapter 25: Short-Term Economic
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Fluctuations: An Introduction
39
The Rate of Unemployment
“Recessionary output gaps are particularly
frustrating for policymakers…because they
imply that the economy has the capacity to
produce more, but for some reason
available resources are not being fully
utilized.”
 Frank and Bernanke.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
40
The Rate of Unemployment
The Natural Rate of Unemployment
 Recessionary gaps are characterized by high
unemployment.
 Expansionary gaps are characterized by
unusually low unemployment.
 When Y=Y*, there is some unemployment,
called the natural rate of unemployment.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
41
The Natural Rate of Unemployment
The Natural Rate of Unemployment and
Cyclical Unemployment
 Types of unemployment (revisited)
Frictional
Structural
Cyclical
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
42
The Natural Rate of Unemployment
The Natural Rate of Unemployment and
Cyclical Unemployment
 Natural rate of unemployment, u*
Attributable to frictional and structural
unemployment
Natural Rate of Unemployment
=
Frictional Unemployment + Structural Unemployment
Cyclical unemployment equals zero
No recessionary or expansionary gap
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
43
The Rate of Unemployment
Cyclical Unemployment
 During recessionary gaps (Y* - Y > 0):
u > u*
cyclical unemployment is positive = u - u* > 0
 During expansionary gaps (Y* - Y < 0):
u < u*
cyclical unemployment is negative = u - u* < 0
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
44
The Natural Rate of Unemployment
Economists almost always talk about an
unemployment rate.
 Unemployment refers to something that is not
happening: workers are not going to work.
An increase in the unemployment rate is looked
upon with dismay.
 An increase in GDP is good. An increase in the rate
of growth of GDP is good. However, an increase in
the rate of unemployment is at best unfortunate and
at worst, it is devastating for the economy.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
45
Output Gaps and
Cyclical Unemployment
Economic Naturalist
 It seems that the natural rate of
unemployment in the United States has
declined. Why?
Aging labor force
More efficient labor market
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
46
Output Gaps and
Cyclical Unemployment
Economic Naturalist
 Since there is no easy way to tell for sure how many
people are frictionally or structurally unemployed, we
must depend on careful and educated hypotheses
and plausible explanations about the changes in the
workforce.
 The average age of the workforce has increased, and
older workers are more likely to remain in the jobs
that they have. Therefore, frictional unemployment is
reduced. If this is the case, then cyclical forces must
explain a greater proportion of total unemployment.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
47
Okun’s Law
Arthur Okun was a famous economist
and a policy adviser to Kennedy.
Being an economist, he combed the
economic data for regularities and
patterns between different variables.
He found one such regularity between
Y* – Y
and
u – u*
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
48
Okun’s Law
Okun’s Law
 Each extra percentage point of cyclical
unemployment (u-u*) is associated with
about a 2 percentage point increase in the
output gap (Y* – Y), measured in relation to
potential output.
Y * Y
 2  u  u *
Y*
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
49
Example 12.1
Year
u
1982
9.7%
6.1%
3,433
1991
6.8
5.8
6,093
1998
4.5
5.2
8,563
1982
•u - u* = cyclical unemployment
•9.7 - 6.1 = 3.6%
•Output gap = 2 x 3.6 = 7.2%
•Output gap = 3,433 x .072
= $247 billion
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u*
Y*
1991
•6.8 - 5.8 = 1%
•Output gap = 6,093 x .02 = $122 billion
1998
•4.5 - 5.2 = -0.7
•Output gap = 8,563 x -0.14 = -$120 billion
Chapter 25: Short-Term Economic
Fluctuations: An Introduction
50
Output Gaps and
Cyclical Unemployment
Okun’s Law
 The 1982 output gap per capita
$247 billion/230 million = $1,074
• Or $4,300 for a family of four
In 2001 dollars it equals $7,100 for a family of four
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
51
Plain English Economics
The relationships mentioned in this section
will become very important in the following
chapters, so you may want to have a
“plain English” version of the material.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
52
Plain English Economics
When economic activity speeds, actual output
(Y) exceeds the potential or normal level of
economic activity and a negative output gap
appears (Y* – Y is negative).
In this case, the economy is operating at
greater-than-normal levels, so unemployment
levels will be very low. Everyone who can work
will be working and actual unemployment (u) will
be less than the normal rate of unemployment
(u*). The indicator (u – u*) will be negative.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
53
Plain English Economics
In symbols:
When Y* – Y < 0, u – u* < 0, an output gap
indicates an expansionary economy.
When Y* – Y > 0, u – u* > 0, indicating that
unemployment is above normal.
The recap on page 656 is very good. You may
want to write it out without symbols, read the
section, and after reading it, put the symbols back
in and work through the recap one more time.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
54
Output Gaps and
Cyclical Unemployment
Economic Naturalist
 Why did the Federal Reserve take measures
to slow down the economy in 1999 and 2000?
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
55
Why Do Short-Term
Fluctuations Occur? A Preview
and a Parable
Why Do Short-Term Fluctuations
Occur? A Preview
GDP fluctuates because


Y* grows, due to changes in the availability
of capital and labor and changes in
technology.
Y fluctuates, generating expansionary and
recessionary gaps.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
57
Why Do Short-Term Fluctuations
Occur? A Preview
If prices were absolutely flexible, demand
would meet supply.

Markets would clear and no gaps would
occur.
If prices take time to adjust, firms will
“meet the demand” by changing quantity
at constant prices.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
58
Why Do Short-Term Fluctuations
Occur? A Preview
Because firms meet consumers’
demand, changes in the amount
consumers decide to spend affect output.
Changes in economywide spending are
the primary cause of output gaps.
Government can eliminate output gaps
by changing its own spending

…or influencing the private sector’s
spending.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
59
Why Do Short-Term Fluctuations
Occur? A Preview
But eventually prices do adjust.
Expansionary gaps lead to higher
inflation, recessionary gaps lead to lower
inflation.

If consumer demand is higher than potential
output, eventually firms will react by raising
prices aggressively.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
60
Why Do Short-Term Fluctuations
Occur? A Preview
Over a long period of time, firms will
change prices so that output gaps will
disappear.
The economy “self-corrects” in the long
run, so that Y = Y*.

In the long run, changes in spending only
affect inflation.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
61
Why Do Short-Term Fluctuations
Occur? A Parable
Al’s Ice Cream shop



Potential output varies little, but there are
many fluctuations in sales.
Some fluctuations are regular and
predictable, some are not.
Al could not possibly change his prices in
response to every single event (higher
prices on Saturday afternoons than
mornings?)
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
62
Why Do Short-Term Fluctuations
Occur? A Parable
Al’s Ice Cream shop



Al posts fixed prices and “meets the
demand” at those prices.
He adjusts them if, after a while, it’s clear
that he’s made a mistake in forecasting the
demand.
If, for example, he keeps running out of ice
cream, he’ll eventually raise prices.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
63
Why Do Short-Term Fluctuations
Occur? A Preview and a Parable
Economic Naturalist
 Why did the Coca-Cola Company test a
vending machine that “knows” when the
weather is hot?
Hot weather increases demand for Coke, so it
would be profitable to raise prices.
It provoked consumer complaints about fairness.
And the weather-sensitive chip might be
expensive.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
64
The Historical Development
of Modern Macroeconomics
The Historical Development of
Modern Macroeconomics
The Great Depression of the 1930s led to
the development of macroeconomics and
aggregate demand tools to deal with
recessions.
 During the Depression, output fell by 30
percent and unemployment rose to 25
percent.
 It seemed clear that the market was not
functioning.
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Chapter 25: Short-Term Economic
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From Classical to Keynesian
Economics
Classical economists had focused on longrun issues such as growth.
 Followers of Adam Smith, David Ricardo,
John Stuart Mill, etc.
Keynesians are called so after economist
John Maynard Keynes.
 Focus on short-run economic issues.
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Chapter 25: Short-Term Economic
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Classical Economics
The Classical approach was laissez-faire
 Markets are perfect if they are just left alone.
 The market is self-adjusting (Say’s Law), so
we should concentrate on the long-run and
largely ignore the short-run.
 Their solution to the high unemployment was
to eliminate labor unions and government
policies that kept wages too high.
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Chapter 25: Short-Term Economic
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Classical Economics
Classical economists opposed deficit
spending by the government
 Deficits are financed by borrowing
 These funds would have financed private
economic activity and jobs, so everything
would cancel out.
 And economic freedom would be limited by
government’s decisions.
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Chapter 25: Short-Term Economic
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Say’s Law and Potential Output
Say’s Law: supply creates its own
demand
 Y = Spending, therefore, Y= C + S = C + I
Therefore, S = I
Therefore, the economy is always at
Potential Output
 Households and firms always buy up all the
production.
Potential Output changes only with
Economic Growth.
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Chapter 25: Short-Term Economic
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Say’s Law and Potential Output
Classical economists argued that the
economy adjusts so quickly the long run
happens very quickly.
 If the economy adjusts quickly to any
disturbance, returning to Y = Y*, government
policy is unnecessary / destabilizing.
The quantity theory of money, which assumed Y
was constant, is a classical theory.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
71
The Possibility of
Unemployment
However:
Suppose a large number of people in the
economy decide to spend less.
And suppose that saving does not become
investment
Total spending would fall and unemployment
would rise.
Incomes, consumption, and saving 
The economy reaches a new equilibrium which
could be at an almost permanent recession.
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Chapter 25: Short-Term Economic
Fluctuations: An Introduction
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The Paradox of Thrift
A decrease in expenditures may cause
decreasing output and a recession.
 So the government may need to intervene.
Notice that the key is that saving does not become
investment (which was assumed by Say’s Law).
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Chapter 25: Short-Term Economic
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The Essence of Keynesian
Economics
Keynes concentrated on the short run
rather than the long run.
 This created the macroeconomic framework
focused on stabilization policy.
Keynes thought that the economy could
get stuck in a rut.
 Then “laissez-faire” would be
counterproductive.
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Chapter 25: Short-Term Economic
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The Essence of Keynesian
Economics
He believed that the economy adjusted
very, very slowly.
Particularly, he argued that prices are
pretty much fixed for long periods of time
and change very slowly.
 Sure, the actual output may go back to
potential output in the long run.
 But he thought the long run is so long that “in
the long run we are all dead.”
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Chapter 25: Short-Term Economic
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The Essence of Keynesian
Economics
According to Keynes:
If investment demand  
job layoffs  consumer demand  
production and investment  
more job layoffs 
consumer demand , and so forth
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Chapter 25: Short-Term Economic
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Equilibrium Income Fluctuates
Keynes:
 Market forces do not work fast enough
Prices and wages are inflexible (or “sticky”) for a
large number of reasons
 Supply and Demand may not be strong
enough to get the economy out of a recession
 Therefore, at certain times the economy
needs help to reach its potential income.
Government expenditures or interest-rate changes
may be necessary and useful
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Chapter 25: Short-Term Economic
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Keynes
John Maynard Keynes
 Economist, diplomat, financier,
journalist, and patron of the arts.
 Publications include:
Keynes
The Economic Consequences of the Peace Pronounced
“canes”
A Treatise on Money
The General Theory of Employment, Interest, and
Money
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Chapter 25: Short-Term Economic
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Keynes
John Maynard Keynes
 The General Theory of Employment, Interest,
and Money (1936):
Revolutionized economic policy
Predicted that a decrease in
aggregate spending could create a
recessionary gap
Suggested that government policy
could be used to restore full
employment
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Chapter 25: Short-Term Economic
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Keynes
John Maynard Keynes
 The General Theory of Employment, Interest,
and Money (1936):
Published in the trough of the
Great Depression, and as a
response to it.
Was (and is) tremendously
controversial and influential.
Is the basis for much of what we
study today as short-run economics.
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