Short-Run Economic Fluctuations
Recession: a period of declining real incomes and rising unemployment
Depression: a severe recession
1. Aggregate Demand and Aggregate Supply
1.1 Three Key Facts about Economic Fluctuations
- Economic Fluctuations Are Irregular and Unpredictable
- Most Macroeconomic Quantities Fluctuate Together
- As Output Falls, Unemployment Rises
1.2 Explaining Short-Run Economic Fluctuations
Most economists believe that classical theory describes the world in the long run but not in the short run.
1.3 The Aggregate-Demand Curve
1.3.1 Why the Aggregate-Demand Curve Slopes Downward
How the price level affects the quantity of goods and services demanded for consumption, investment, and net exports?
- The Wealth Effect: A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend (consume) more.
- The Interest-Rate Effect: price level ↑ ⇒ people need more money to buy goods ⇒ saving ↓ , IR ↑ ⇒ investment ↓
- The Exchange-Rate Effect: price level ↓ ⇒ IR ↓ ⇒ demand for U.S. government bonds ↓ ⇒ the supply of dollars in the market for foreign-currency exchange ↑ ⇒ the real value of the dollar in foreign exchange markets ↓ ⇒ cheaper for foreigners, U.S. net exports ↑
1.3.2 Why the Aggregate-Demand Curve Might Shift
- Changes in Consumption: stock market boom, preference change of saving or spending, tax cutting (consumption ↑)
- Changes in Investment: tech. advances, optimistic/pessimistic perspective, monetary policy, investment tax credit
- Changes in Government Purchases: building more highways
- Changes in Net Exports: conditions of foreign economies
1.4 The Aggregate-Supply Curve
1.4.1 Aggregate-Supply Curve Is Vertical in the Long Run
In the long run, an economy’s production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.
1.4.2 Why the Long-Run Aggregate-Supply Curve Might Shift
natural level of output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate
- Changes in Labor
- Changes in Capital
- Changes in Natural Resources
- Changes in Technological Knowledge
1.4.3 Why the Aggregate-Supply Curve Slopes Upward in the Short Run
- The Sticky-Wage Theory
- The Sticky-Price Theory: menu cost ⇒ prices don't change; price level ↑ ⇒ people feel cheaper ⇒ demand & output ↑
- The Misperceptions Theory: unexpectedly low price level ⇒ some suppliers think their relative prices have fallen ⇒ production ↓
1.4.4 Why Might the Short-Run Aggregate-Supply Curve Shift?
- Changes in Labor: the quantity of labor available
- Changes in Capital: physical or human capital
- Natural Resources
- Changes in Technology
- Changes in the Expected Price Level
1.4.5 Summary
Short-run aggregate supply:
$$
Y = Y_N + a (P_\text{actual} - P_\text{expected}) ~ , a > 0
$$
How to analyze the effects of a shift in the short-run?
e.g.
Key points in step 3 & 4:
- people's expected price level changes after the short-run fluctuation happens, so the short-run aggregate supply changes
2. The Influence of Monetary and Fiscal Policy on Aggregate Demand
2.1 How Monetary Policy Influences Aggregate Demand
Theory of liquidity preference: Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance
e.g. monetary policy works through interest rates
liquidity trap: If interest rates have already fallen to around zero, monetary policy may no longer be effective.
Solutions:
- forward guidance: promise that interest rates will remain low
- quantitative easing: conduct expansionary open-market operations with a larger variety of financial instruments
2.2 How Fiscal Policy Influences Aggregate Demand
2.2.1 The Multiplier Effect
The Multiplier Effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending
marginal propensity to consume (MPC): the fraction of extra income that a household consumes rather than saves. $$ \text{Multiplier} = {1 \over 1 - \text{MPC}} $$
2.2.2 The Crowding-Out Effect
the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
2.3 Using Policy to Stabilize the Economy
Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action
- recession ⇒ ↓ tax ⇒ AD ↑
Problem: Cannot achieve a balanced budget
3. The Short-Run Trade-off between Inflation and Unemployment
3.1 The Phillips Curve
a curve that shows the short-run trade-off between inflation and unemployment
3.2 Shifts in the Phillips Curve: The Role of Expectations
3.2.1 The Long-Run Phillips Curve
3.2.2 The Short-Run Phillips Curve
natural-rate hypothesis: the claim that unemployment eventually returns to its normal, or natural, rate, regardless of the rate of inflation
3.3 Shifts in the Phillips Curve: The Role of Supply Shocks
3.4 The Cost of Reducing Inflation
sacrifice ratio: the number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point
rational expectations: the theory that people optimally use all the information they have, including information about government policies, when forecasting the future