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Introduction to Economic
Fluctuations
Sections 1 and 2
Chapter 10, 8th and 9th edition
Chapter 9, 7th edition
IN THIS CHAPTER:




facts about the business cycle
how the short run differs from the long run
an introduction to aggregate demand
an introduction to aggregate supply in the short
run and long run
 how the model of aggregate demand and
aggregate supply can be used to analyze the
short-run and long-run effects of “shocks.”
1
Facts about the business cycle
 GDP growth averages 3–3.5 percent per year
over the long run with large fluctuations in the
short run.
 Consumption and investment fluctuate with
GDP, but consumption tends to be less volatile
and investment more volatile than GDP.
 Unemployment rises during recessions and falls
during expansions.
 Okun’s law: the negative relationship between
GDP and unemployment.
Growth rates of real GDP, consumption
Percent 10
change
from 4 8
quarters
earlier
Real GDP
growth rate
Consumption
growth rate
6
Average 4
growth
rate 2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Growth rates of real GDP, consump., investment
Percent
change 40
from 4
quarters 30
earlier
Investment
growth rate
20
Real GDP
growth rate
10
0
Consumption
growth rate
-10
-20
-30
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Unemployment
Percent 12
of labor
force
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Okun’s Law: Growth Rate Version
Percentage 10
change in
real GDP 8
1951
Y
 3  2 u
Y
1966
1984
6
2003
1971
4
1987
2
1975
2001
0
2009
2008
-2
1991
1982
-4
-3
-2
-1
0
1
2
3
Change in unemployment rate
4
Index of Leading Economic Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
6-9 months into the future.
 Used in planning by businesses and govt,
despite not being a perfect predictor.
Components of the LEI index










Average workweek in manufacturing
Initial weekly claims for unemployment insurance
New orders for consumer goods and materials
New orders, nondefense capital goods
Vendor performance
New building permits issued
Index of stock prices
M2
Yield spread (10-year minus 3-month) on Treasuries
Index of consumer expectations
Index of Leading Economic Indicators,
1970-2012
120
110
2004 = 100
100
90
The index turns downward a few months to
a year before almost every recession. It
also turns upward just prior to the end of
almost every recession.
80
70
60
50
40
30
20
10
Source:
0
Conference
1970
Board
1975
1980
1985
1990
1995
2000
2005
2010
Time horizons in macroeconomics
 Long run
Prices are flexible, respond to changes in supply
or demand.
 Short run
Many prices are “sticky” at a predetermined
level.
The economy behaves much
differently when prices are sticky.
Recap of classical macro theory
 Output is determined by the supply side:
 supplies of capital, labor
 technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.
When prices are sticky…
…output and employment determined bydemand,
which is affected by:
 fiscal policy (G and T )
 monetary policy (M )
 other factors, like exogenous changes in
C or I
Aggregate supply in the long run
 Recall from Chap. 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
•
“Full employment” means that unemployment equals its
natural rate (not zero).
•
Some textbooks also use the term “potential GDP” to
mean the full-employment level of output.
The long-run aggregate supply curve
P
LRAS
Y does not
depend on P,
so LRAS is
vertical.
Y
 F (K , L )
Y
The short-run aggregate supply curve
The SRAS
curve is
horizontal:
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
P
P
SRAS
Y