• Recession - a period of declining real incomes and rising unemployment

  • Depression- a severe recession

20.1: Three Key Facts about Economic Fluctuations

Fact 1: Economic Fluctuation are Irregular and Unpredictable:

• The business cycle- fluctuations in the economy

  • Economic fluctuations correspond to changes in business conditions

  • This turn can be somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern

Fact 2: Most Macroeconomic Quantities Fluctuate Together:

• Real GDP is the variable most commonly used to monitor short-run changes in the economy

  • This is because it measures the value of all goods and services produced within a given period of time

  • When real GDP falls in a recession, personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and etc. all follow

Fact 3: As Output Falls, Unemployment Rises:

• The economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force

  • When real GDP declines, the rate of unemployment rises

20.2: Explaining Short-Run Economic Fluctuations

The Reality of Short-Run Fluctuations:

• Most economists believe that classical theory describes the world in the long run but not in the short run.

The Model of Aggregate Demand and Aggregate Supply:

• model of aggregate demand and aggregate supply- the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

• aggregate-demand curve- a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

• aggregate-supply curve- a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

20.3: The Aggregate-Demand Curve

• How price level affects the quantity of goods and services

  • The price level and consumption: 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 more. The increase in consumer spending means a larger quantity of goods and services demanded.

  • The price level and investment: the interest-rate effect

    • A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded

  • The price level and net exports: the exchange-rate effect

    • When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded

• OVERALL:

1. Consumers are wealthier, which stimulates the demand for consumption goods.

2. Interest rates fall, which stimulates the demand for investment goods.

3. The currency depreciates, which stimulates the demand for net exports.

Why the Aggregate-Demand Curve Might Shift:

• A few example events

  • Shifts arising from changes in consumption

  • Shifts arising from changes in investment

  • Shifts arising from changes in government purchases

  • Shifts arising from changes in net exports

20.4: The Aggregate-Supply Curve

Why the 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.

Why the Long-Run Aggregate-Supply Curve Might Shift:

• Natural rate of output- the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

• A few sources of the change:

  • Shifts arising from changes in labor

  • Shifts arising from changes in capital

  • Shifts arising from changes in natural resources

  • Shifts arising from changes in technological knowledge

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation:

• Short-run fluctuations in output and the price level should be viewed as deviations from the continuing long-run trends of output growth and inflation.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run:

• When the price level rises above the level that people expected, output rises above its natural rate, and when the price level falls below the expected level, output falls below its natural rate.

• A few theories for the upward slope of the short-run aggregate-supply curve

  • The Sticky-Wage theory

    • Nominal wages are slow to adjust to changing economic conditions.

  • The Sticky-Price Theory

    • The prices of some goods and services also adjust sluggishly in response to changing economic conditions.

  • The Misperceptions Theory

    • changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output.

Why the Short-Run Aggregate-Supply Curve Might Shift:

• An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the left.

• A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate supply curve to the right

20.5: Two Causes of Economic Fluctuations

The Effects of a Shift in Aggregate Demand:

• People lose confidence in the future and alter their plans

• Households cut back on their spendings and delay major purchases

• Firms put off buying new equipment

Four Steps to Analyzing Macroeconomic Fluctuations:

1. Decide whether the event shifts the aggregate demand curve or the aggregate supply Table 3 curve (or perhaps both).

2. Decide in which direction the curve shifts.

3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run.

4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.

The Effects of a Shift in Aggregate Supply:

• Stagflation- a period of falling output and rising prices