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Economics 3307 · Main Points of Chapter 9: Economic Fluctuations
1.
Chapters 7-8 explained that the long-term upward trend in Real GDP is due to population growth and technological progress. This
chapter explains short-term fluctuations in Real GDP -- i.e., the temporary movements in actual Real GDP around its trend line.
2.
Economists refer to these short-term fluctuations in Real GDP as the business cycle. During periods when Real GDP is rising (i.e.,
has a positive growth rate), the economy is said to be in a business cycle expansion. During periods when Real GDP is falling
(i.e., has a negative growth rate), the economy is said to be in a business cycle contraction or recession. The economy is said to
reach a business cycle peak when it moves from expansion to recession. The economy is said to reach a business cycle trough
when it moves from recession to expansion. The generic term for business cycle peaks and troughs is business cycle turning
point.
3.
In the U.S., business cycle turning points are determined after the fact by the business cycle dating committee of the National
Bureau of Economic Research (NBER). A general rule of thumb is that the NBER will not declare a recession until Real GDP has
fallen (i.e., had negative growth) for two or more consecutive quarters.
4.
An especially long and deep recession is called a depression. An especially rapid expansion is called a boom. These terms have
no formal definition, and uses of the term are sometimes associated with political orientation.
5.
The conventional theory of the business cycle, which might be called New Keynesian and which is implicitly assumed in virtually
all discussions of the business cycle in the news media, has the following elements:
- Total desired purchases of GDP goods and services (aggregate demand, or AD) fluctuates considerably for a number of
reasons (more on this point below).
- The overall price level in the economy (P) is slow to adjust to equate aggregate demand to the total equilibrium desired
production of goods and services (long-run aggregate supply, or LRAS)
- When the economy is not in equilibrium (which can occur if P is “too high” so that AD < LRAS or if P is “too low” so that
AD > LRAS), firms are assumed to produce at a level that meets AD. That is, actual output Y is equal to AD when P is such
that AD is not equal to LRAS. We can show this point on the graph by introducing the short-run aggregate supply
(SRAS)curve, which is a horizontal line at the prevailing price level. By definition, P and Y in the short-run are determined
as the intersection point of the AD and SRAS curves.
6.
Like any other supply & demand model the AS/AD model is a graph with quantity (Real GDP) on the horizontal axis and price
(the GDP deflator) on the vertical axis.
7.
The AD curve slopes downward, as a lower price level increases total desired purchases. The AD curve shifts with any event that
causes a change in total desired purchases.2
8.
The LRAS curve is vertical at the level of Y implied by full employment of capital and labor. That is, the LRAS curve is vertical
at Y = F(K,L). NOTE: Be sure to put “bars” over K and L. The LRAS curve shifts with changes in K, L, and productivity
(efficiency). The level of Y at which the LRAS curve is vertical is the trend level of output.
9.
Given that P adjusts fully in the "long-run" to equate AD and LRAS, we can explain long-run trends in the economy by examining
the intersection point of the AD and LRAS curves. Chapters 3 and 4 explained why the LRAS curve shifts right on average over
time: Y increases at rate (n+g), where increases in the labor force and technological progress bring forth additional capital (K) to
keep capital per efficiency unit of labor (k) constant in steady-state equilibrium. The rightward LRAS shift explains the upward
trend in Y.
1
1
If you have taken a principles of economics class, or if you have read anything at all about macroeconomics, then you may be
vaguely familiar with the debate between Keynesians and Monetarists. Beginning in the early 1960s, this debate went through
several stages and was ultimately resolved -- or at least became irrelevant -- in the early 1980s, with each side admitting that the other
had some valid points.
2
One important difference in this model from the supply & demand model of a single market is that changes in total income do not
shift the AD curve. The reason is that total income in the AS/AD model is national income, which is equal to Real GDP = Y, which
is the quantity variable the model is designed to explain. Changes in Y cannot shift the AD curve any more than changes in the
quantity traded of oranges can shift the demand curve for oranges.
Main Points of Chapter 9, Page 2
10. In the "short-run," actual output (Y) can differ from the level of Y at which the LRAS curve is vertical. Economists call the level
of output at which the LRAS curve is vertical by various names, all of which mean the same thing: (i) the full-employment level of
output, (ii) capacity output, (iii) the trend level of output, (iv) potential output, (v) the natural level of output. You could also
substitute "Real GDP" for "output" in any of the above expressions.
11. At any given time, actual output (Y) is equal to AD, because we assume that in the short-run firms will produce to meet demand.
If Y = AD > LRAS, then input markets are very tight. Eventually (but in most cases not immediately), input prices will be driven
up, which will lead to higher output prices (P). As P rises, the SRAS curve shifts upward and the economy moves up and left
along the AD curve until AD = LRAS, so that actual output (Y) moves back to its trend line.
12. If Y = AD < LRAS, then input markets are slack (the economy has a lot of cyclical unemployment). Eventually (but in most cases
not immediately), input prices will decrease, which will be passed on by firms in the form of lower output prices (P). This makes
the SRAS curve shift downward. As P falls, the economy moves down and right along the AD curve until AD=LRAS, so that
actual output (Y) moves back to its trend line.
13. The AD curve shifts right over time due primarily to ongoing increases in the money supply (M). The AD shift is bigger on
average than the LRAS shift, so the price level (P) increases over time.
14. Given that AD = LRAS initially, if AD falls (because of a collapse in consumer confidence, a tax increase, a tightening of
monetary policy, a recession in another country that buys our exports, or whatever), Y initially falls as the AD curve shifts left.
With AD < LRAS, P will eventually begin to fall and SRAS will shift downward until AD = LRAS is restored. In the short-run, a
decrease in AD causes a decrease in Y to the extent that P is slow to adjust. In the long-run, when P adjusts fully by definition, a
decrease in AD has no effect on Y (causing only a decrease in P). To make this applicable to the "real world," we need to
superimpose the AD and SRAS shifts on top of the long-run trends described in points 8 and 9 above.
15. Given that AD = LRAS initially, if AD rises (because of an investment tax credit, an increase in the money supply, a depreciation
of the currency, or whatever) Y initially rises as the AD curve shifts right. With AD>LRAS, P will eventually begin to rise, and
hence the SRAS curve will shift upward, until AD = LRAS is restored. In the short-run, an increase in AD causes an increase in Y
to the extent that P is slow to adjust. In the long-run, when P adjusts fully by definition, an increase in AD has no effect on Y
(causing only an increase in P). To make this applicable to the "real world," we need to superimpose the AD and SRAS shifts on
top of the long-run trends described in points 8 and 9 above.
16. A supply shock is an event that causes P to change for some reason other than as an adjustment to a difference between AD and
LRAS. An adverse supply shock increases P and shifts SRAS upward, while a favorable supply shock decreases P and shifts
SRAS downward. (To make this applicable to the "real world," we need to superimpose the SRAS shift on top of the long-run
trends described in points 8 and 9 above.) The most common supply shocks involve changes in the world price of crude oil. Other
supply shocks might involve a drought that increases food prices, or a strike threat resolved by a large rise in wages.
17. Mankiw assumes that supply shocks shift only the SRAS curve and not the LRAS curve. It is possible, however, that a supply
shock can permanently change output by changing K, L, or productivity. (One might argue, for example, that a permanent
increase in the scarcity of energy and the resulting higher real energy prices make capital and labor less productive than they
otherwise would have been. This would shift the LRAS curve to the left as well as shifting the SRAS curve upward.) To make
this applicable to the "real world," we need to superimpose the LRAS and SRAS shifts on top of the long-run trends described in
points 8 and 9 above.
18. When a supply shock shifts the LRAS curve as well as the SRAS curve, the SRAS curve tends to shift "too much," -- that is, the
price level rises initially by more than the amount necessary to make LRAS equal to AD. We know this because real-world
adverse supply shocks such as the large oil price increases in 1974 and 1980 were associated with large increases in
unemployment. When unemployment rises, this suggests that actual output is to the left of the LRAS curve, because the LRAS
curve is vertical at the "full employment" output level.
19. Stabilization policy is the term used to describe actions designed by the government to offset the output effects of changes in AD
that originate in the private sector. Stabilization policies can involve fiscal policy, monetary policy, or both. The tools of fiscal
policy are taxes (T) and government purchases (G). AD increases with lower T and higher G. AD decreases with higher T and
lower G. The main tool of monetary policy is the money supply (M). AD increases with higher M and decreases with lower M.
20. Stabilization policy is tricky for several reasons. First, policymakers cannot know for sure where the economy is relative to trend
at any given time. (Statistics are available only with a time lag, and are subject to revision long after the fact.) Second,
Main Points of Chapter 9, Page 3
policymakers cannot know for sure the prevailing tendency of AD in the absence of policy. Third, policymakers are unsure about
the exact effects on AD of any given monetary or fiscal policy action, including the size of the effect on AD and how long it takes
for the full effect to be felt.
21. Economists still disagree about the ability of policy actions to stabilize the economy. Some think that stabilization policy helps
the economy on average even with an occasional mistake. Others think that attempts to stabilize the economy end up causing
more instability.
22. When the economy has an adverse supply shock, policy can offset the output effect of that shock only at the cost of a higher price
level in the long-run.
23. Probably the key insights of macroeconomics are: (1) policies designed to help the economy in the short-run can harm the
economy in the long-run, and (2) policies designed to help the economy in the long-run can have harmful short-run effects.
Examples:
- If taxes are decreased in a recession, AD will shift right and increase Y back to full employment (good short-run effect). The
lower T means lower government saving, which lowers the overall savings rate of the economy and reduces the steady-state
equilibrium levels of output and capital per worker (bad long-run effect).
- If policies reduce the government deficit by lower G or higher T, the steady-state levels of output and capital per worker will
increase (good long-term effect). But AD will decline, which reduces Y in the short-run (bad short-run effect).
- If the ongoing rate of money supply growth is reduced, this causes lower inflation (good long-run effect). In the short-run, the
reduction in M (relative to P) will reduce output (bad short-run effect). this is what happened in the early 1980s in the U.S.
- An increase in money growth increases output in the short-run (good short-run effect) but leads to higher inflation in the longrun (bad long-run effect)
24. Virtually any macroeconomic issue can be placed into one of the following categories: (1) the level of output relative to trend, or
(2) the trend level of output. Those in category (1) are short-term issues, while those in category (2) are long-term issues. In
democracies with frequent elections, there may be too much emphasis on the short-run, with the consequence that the economy
suffers in the long-run.