Recessions and Economic Fluctuations

Recessions

• Recession: A period of declining real incomes and rising unemployment.
  • Rule of thumb: Two consecutive quarters of negative real GDP growth.
• Depression: A severe recession.
  • Rule of thumb:
    • Three consecutive years of negative real GDP growth.
    • A 10% decline in real GDP.

Key Facts About Economic Fluctuations

• Economic fluctuations are irregular and unpredictable.
  • The business cycle.
• As output falls, unemployment rises.
• Most macroeconomic quantities fluctuate together.
  • Recessions are economy-wide phenomena.

Short-Run Economic Fluctuations

• Real GDP and investment spending decline during recessions.
• Unemployment rises during recessions.

Long-Run Equilibrium

• The economy begins in long-run equilibrium.
• This is the intersection of the Aggregate Demand (AD), Long-Run Aggregate Supply (LRAS), and Short-Run Aggregate Supply (SRAS) curves.

Long-Run Equilibrium

• The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve.
• When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level.
• As a result, the short-run aggregate-supply curve crosses this point as well.

Two Ways to a Recession

• 1. Decrease in Aggregate Demand
  • Example: A wave of pessimism shifts the aggregate demand curve to the left.

A Contraction in Aggregate Demand

• Short Run:
  • A fall in aggregate demand is represented by a leftward shift in the aggregate-demand curve (from AD1 to AD2).
  • The economy moves from point A to point B.
  • Output falls from Y1 to Y2.
  • The price level falls from P1 to P2.
• Long Run:
  • As the expected price level adjusts, the short-run aggregate-supply curve shifts to the right (from AS1 to AS2).
  • The economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve.
  • The price level falls to P3.
  • Output returns to its natural rate, Y1.

Causes of Economic Fluctuations: Decrease in Aggregate Demand

• Short-run:
  • Output falls.
  • Price level falls.
• Long-run:
  • The short-run aggregate supply curve shifts right.
  • Wages adjust.
  • Output returns to the natural rate.
  • Price level falls.

Causes of Economic Fluctuations

• 2. Decrease in Aggregate Supply
  • Example: An increase in production costs (e.g., oil prices) shifts the short-run aggregate supply curve to the left.

An Adverse Shift in Aggregate Supply

• When an event increases firms’ costs, the short-run aggregate-supply curve shifts to the left (from AS1 to AS2).
• The economy moves from point A to point B.
• The result is stagflation:
  • Output falls from Y1 to Y2.
  • The price level rises from P1 to P2.

Causes of Economic Fluctuations: Decrease in Aggregate Supply

• Short-run:
  • Stagflation occurs.
  • Output falls.
  • Price level rises.
• Long-run (if AD is held constant):
  • Short-run AS shifts back to the right.
  • Wages adjust.
  • Output returns to the natural rate.
  • Price level returns.