Fluctuation

Overview

This chapter explains short-run fluctuations in output and employment—why economies experience booms and recessions—using the Aggregate Demand (AD) and Aggregate Supply (AS) model.

1. The Model of Aggregate Demand and Aggregate Supply

Aggregate Demand (AD) Curve

• Shows combinations of price level (P) and output (Y) where goods and money markets are in equilibrium.

• Downward-sloping because:

  1. Wealth effect: Lower prices → higher real wealth → higher consumption (C).

  2. Interest rate effect: Lower prices → lower interest rates → higher investment (I).

  3. Exchange-rate effect: Lower prices → lower interest rates → depreciation → higher net exports (NX).

Formula:

Y=C(Y−T)+I(r)+G+NX

• Y: total output

• C,I,G,NX: components of aggregate expenditure

• r: interest rate (negatively affects I)

Aggregate Supply (AS) Curve

Shows how much firms produce at different price levels.

Long-Run Aggregate Supply (LRAS)

• Vertical at natural level of output (Y*), determined by:

  Y*=F(K,L)

  (capital and labor — not affected by price level).

Short-Run Aggregate Supply (SRAS)

• Upward-sloping because:

  • Sticky wages

  • Sticky prices

  • Misperceptions of relative prices

2. Short-Run vs. Long-Run Equilibrium

• Short-run equilibrium: intersection of AD and SRAS.

• Long-run equilibrium: where AD, SRAS, and LRAS all meet.

Fluctuations: caused by shifts in either AD or AS.

3. Shifts in Aggregate Demand

• Increase in AD → higher output (short run) → higher prices (long run).

• Decrease in AD → lower output (short run) → lower prices (long run).

Causes:

• Changes in monetary policy (M) or fiscal policy (G, T).

• Changes in expectations (e.g., consumer confidence).

4. Shifts in Aggregate Supply

• Short-run AS shifts due to:

  • Supply shocks (oil price increase, natural disasters)

  • Wage changes or expectations of inflation

Formula for short-run production (simple version):

Y=Yˉ+a(P−P^e)

• Yˉ: natural output

• P: actual price level

• P^e: expected price level

• a: responsiveness of output to unexpected price changes

• Interpretation: When actual prices > expected prices → firms produce more.

5. Policy Implications

• Monetary & Fiscal Policy: used to stabilize output when AD shifts.

• In the long run: output returns to natural level Y*; only prices adjust.

🧮 Key Formulas Summary

🔑 Key Takeaways

• In the short run, output fluctuates with aggregate demand.

• In the long run, the economy returns to its natural level of output.

• Policy tools can shift AD to stabilize fluctuations.

• The AS–AD model integrates real and nominal variables, bridging the short-run Keynesian and long-run classical views.

📘 Chapter 10: Aggregate Demand II — Applying the IS–LM Model

1. Overview

This chapter builds on Chapter 9 by showing how to derive the Aggregate Demand (AD) curve using the IS–LM model, which explains short-run fluctuations by combining:

• The goods market (IS curve) and

• The money market (LM curve).

The IS–LM model determines equilibrium output (Y) and interest rate (r) in the short run.

2. The IS Curve (Investment–Saving)

• Shows combinations of interest rates and output where the goods market is in equilibrium.

• Derived from:
  

  (Y = C(Y - T) + I(r) + G)

• Slope: Negative — higher (r) reduces investment → lower output.

• Shifts:

  • ↑ Government spending (G) → IS shifts right.

  • ↑ Taxes (T) → IS shifts left.

  • ↑ Consumer confidence → IS shifts right.

Formula:

3. The LM Curve (Liquidity–Money)

• Represents equilibrium in the money market:

• 
  $\frac{M}{P}$ = L(r, Y)

• where (L(r, Y)) is money demand (↓ with r, ↑ with Y).

• Slope: Upward — higher income increases money demand, raising interest rate for equilibrium.

• Shifts:

  • ↑ Money supply (M) → LM shifts right/down (lower r).

  • ↑ Price level (P) → LM shifts left/up (higher r).

4. Short-Run Equilibrium

• Found where IS and LM intersect:

  • Determines equilibrium output (Y) and interest rate (r).

• Changes in fiscal or monetary policy move these curves and thus change AD.

5. Policy Analysis

Fiscal Policy (through IS)

• Expansionary fiscal policy: ↑G or ↓T → IS shifts right → higher Y and r.

• Contractionary fiscal policy: ↓G or ↑T → IS shifts left → lower Y and r.

Monetary Policy (through LM)

• Expansionary monetary policy: ↑M → LM shifts right → lower r, higher Y.

• Contractionary monetary policy: ↓M → LM shifts left → higher r, lower Y.

6. The Aggregate Demand Curve from IS–LM

• Each point on the AD curve corresponds to an equilibrium in the IS–LM model for a given price level.

• As (P) increases → real money supply ((M/P)) decreases → LM shifts left → output (Y) falls.
  ➡ Thus, the AD curve slopes downward.

7. Fiscal–Monetary Policy Mix

• Policymakers can use monetary and fiscal tools to stabilize the economy.

  • E.g., a fiscal expansion can be offset by tight monetary policy.

  • Coordination between the two is crucial.

🧮 Key Formulas Summary

🔑 Key Takeaways

• The IS–LM model links the real economy (goods market) with the monetary sector (money market).

• Fiscal policy shifts the IS curve; monetary policy shifts the LM curve.

• Together, they determine short-run equilibrium and shape the Aggregate Demand curve.

• The price level affects the real money supply, providing the link between the AD–AS model and IS–LM analysis.