Business Fluctuations: Aggregate Demand and Supply

Chapter 13: Business Fluctuations: Aggregate Demand and Supply

Outline of the Chapter

  • The Aggregate Demand Curve

  • The Long-Run Aggregate Supply Curve

  • Real Shocks

  • Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve

  • Shocks to the Components of Aggregate Demand

  • Understanding the Great Recession and the COVID-19 Recession

  • Takeaway

Definitions

  • Business Fluctuations: Fluctuations in the growth rate of real GDP around its trend growth rate.

  • Recession: A significant, widespread decline in real income and employment.

Introduction to Aggregate Demand and Supply

  • To understand economic cycles such as booms and recessions, a model of aggregate demand (AD) and aggregate supply (AS) needs to be developed.

  • The model incorporates three curves:

    • Aggregate Demand Curve

    • Long-Run Aggregate Supply Curve

    • Short-Run Aggregate Supply Curve

  • The AD-AS model illustrates how unexpected economic disturbances, or "shocks," can temporarily alter growth rates.

The Aggregate Demand Curve

  • Definition: The aggregate demand curve shows all combinations of inflation and real growth that align with a specified rate of spending growth.

Derivation of the AD Curve

  • The AD curve can be derived using the quantity theory of money in dynamic form:
    ext{Growth rate of the money supply} + ext{Growth in velocity} = ext{Growth rate of prices (inflation)} + ext{Growth rate of real GDP}

  • Here are necessary components of the formula:

    • Growth rate of the money supply

    • Growth in velocity

    • Growth rate of prices (inflation)

    • Growth rate of real GDP

Examples of the AD Curve

  • Example 1:

    • Money growth = 5%

    • Velocity = 0%

    • Real growth = 0%

    • Conclusion: Inflation rate = 5%.

  • Example 2:

    • Money growth = 5%

    • Velocity = 0%

    • Real growth = 3%

    • Conclusion: Inflation rate = 2%.

  • An AD curve indicates that combinations of inflation and real growth that sum to the specified spending growth rate (e.g., 5% in the above examples).

Shifts in the Aggregate Demand Curve

  • Increased spending leads to

    • Higher inflation rate or

    • Higher growth rate.

  • Increased Spending Growth: More money supply or increased velocity shifts the AD curve up and right.

  • Decreased Spending Growth: A reduction in money supply or decreased velocity shifts the AD curve inward.

The Long-Run Aggregate Supply Curve

  • The long-run aggregate supply curve (LRAS) is determined by:

    • Increases in labor and capital stocks

    • Increases in productivity

  • Definition: The Solow growth rate is the economy's potential growth rate—independent of inflation—that would occur under flexible prices and existing real factors of production.

  • The LRAS curve is represented as a vertical line at the Solow growth rate.

  • Important Concept: Potential growth does not depend on the inflation rate.

Shifts in the LRAS Curve

  • Business fluctuations can be linked to real shocks that shift the Solow growth rate.

  • Real Shocks: These are rapid changes in economic conditions affecting productivity of capital and labor, influencing GDP and employment. Potential sources of shocks include:

    • Wars

    • Weather events

    • Major regulations

    • Mass strikes

    • Terrorist activities

    • New technological advancements

  • The intersection of the AD and LRAS curves sets the equilibrium inflation rate and growth rate.

Effects of Real Shocks

  • Negative real shocks cause:

    • LRAS curve shifts left, increasing inflation while reducing growth.

  • Positive real shocks cause:

    • LRAS curve shifts right, decreasing inflation while increasing growth.

Real Shocks: Specific Examples

  • Agricultural Sector:

    • As the foundational contributor to India's GDP, weather shocks significantly impact agricultural output and GDP.

    • While increasingly less influential in a growing economy, weather still has a degree of impact.

Historical Data on Rainfall Shocks

  • Analysis demonstrates that deviations in rainfall directly correlate with growth rates of agricultural and overall GDP.

  • Oil Shocks:

    • Reduction of oil supply in a manufacturing sector impacts GDP adversely due to the productivity relationship between oil, labor, and machinery.

    • The first OPEC oil shock saw oil prices more than triple over two years (1973).

Graph of Oil Price and U.S. Recessions

  • Graphical representation lays bare the correlation between real price spikes and recessions, including historical timelines of major events impacting oil prices.

Short-Run Aggregate Supply Curve

  • Definition: The short-run aggregate supply (SRAS) curve illustrates the positive relationship between inflation and real growth during periods of price and wage stickiness.

  • The SRAS curve is upward sloping:

    • An increase in AD results in inflation and growth rise short-term, while a decrease results in both falling.

  • Each SRAS correlates with a particular rate of expected inflation.

Characteristics of the SRAS Curve

  • When AD increases, price stickiness and wage rigidity lead to delayed inflation adjustments.

  • Conversely, during a decrease in AD, the economy can spiral into a lengthy recession as prices fail to adjust downward rapidly.

Aggregate Demand Shocks

  • Definition: Aggregate demand shock signifies a rapid, unexpected shift in the AD curve (spending).

  • Positive shocks increase inflation or growth short-term while settling into long-term influences post-adjustment to the Solow rate only stimulating inflation.

Keynesian Perspective

  • John Maynard Keynes posited that inadequate aggregate demand can trigger recessions in markets where prices aren't perfectly flexible.

Real-World Applications of Demand Shocks

  • The economic responses of firms and workers to demand shocks include confusion over nominal wage versus real wage, price change inertia due to "menu costs," and behavioral impacts of uncertainty regarding temporary or permanent change in conditions.

Notable Demand Shock Outcomes

  • Unexpected increases in demand contribute to initial growth but can result in inflationary cycles.

The Great Recession

  • Triggered by a financial crisis stemming from the shadow banking system's exposure and failures.

  • Leading up to 2007, decreased housing prices worried investors about borrower defaults, which initiated a run on shadow banks and caused a collapse in credit availability, further slicing through aggregate demand.

The Great Recession's Financial Data

  • Visual representation highlights the lending discrepancies between shadow and traditional banking over decades, culminating in 2007-2008.

The COVID-19 Pandemic and Recession

  • The pandemic significantly impeded productivity through increased operational costs, school shutdown effects, and direct job losses (over 17 million in a two-month timeframe).

  • The economic impact saw a leftward shift in the LRAS as productivity declined, influencing aggregate demand downward as spending fell sharply on previously common activities.

Stimulus and Recovery Post-COVID

  • Various relief programs implemented, particularly under the Trump and Biden administrations, heightened aggregate demand through fiscal measures, creating growth above long-term levels followed by increased inflation rates.

Conclusion and Takeaway

  • The aggregate demand and supply model effectively analyzes fluctuations in real GDP growth.

  • Real shocks manifest via shifts in the LRAS, while aggregate demand shocks reflect shifts in the AD curve.

  • Economic behaviors such as nominal wage confusion, sticky wages and prices, and menu costs contribute to observable dynamics within short-run aggregate supply curves.

  • Historical crises, particularly the Great Depression, underscore the interconnected nature of aggregate demand and real shocks in economic downturns.