GDP growth averages approximately 3 percent per year over the long run, but experiences considerable fluctuations in the short run.
Consumption and investment both fluctuate alongside GDP. However, consumption tends to be less volatile, while investment is more volatile than GDP.
Unemployment increases during recessions and decreases during expansions.
Okun’s Law: There is a negative relationship between GDP and unemployment.
Index of Leading Economic Indicators (LEI)
Published monthly by the Conference Board.
Aims to predict changes in economic activity six to nine months in the future.
Used for planning by businesses and governments, but it's not a perfect predictor.
Components of the LEI index:
Average workweek in manufacturing
Initial weekly claims for unemployment insurance
New orders for consumer goods and materials
New orders, nondefense capital goods
ISM new orders index
New building permits issued
Index of stock prices
Lending credit index
Yield spread (10 years minus 3 months) on Treasuries
Index of consumer expectations
Time Horizons in Macroeconomics
Long Run: Prices are flexible and respond to supply and demand changes.
Short Run: Many prices are sticky or predetermined. The economy behaves differently due to these sticky prices.
Classical Macro Theory Recap (Chapters 3–10)
Output is supply-side determined based on:
Capital supply
Labor supply
Technology
Changes in demand for goods and services (C, I, G) only affect prices, not quantities.
Assumes complete price flexibility.
Applies to the long run.
Sticky Prices
Output and employment depend on demand.
Demand is affected by:
Fiscal policy (G and T)
Monetary policy (M)
Exogenous factors, such as changes in C or I
The Model of Aggregate Demand and Supply
This model is used by most mainstream economists and policymakers to understand economic fluctuations and stabilization policies.
It illustrates how the price level and aggregate output are determined.
It highlights the differences in the economy’s behavior in the short run versus the long run.
Aggregate Demand
The aggregate demand curve illustrates the relationship between the price level and the quantity of output demanded.
A simple theory of aggregate demand based on the quantity theory of money is used.
The Quantity Equation as Aggregate Demand
Recall the quantity equation from Chapter 4: MV=PY
Given values for M and V, this equation implies an inverse relationship between P and Y.
The Downward-Sloping AD Curve
An increase in the price level (P) causes a decrease in real money balances (PM), leading to a decrease in the demand for goods and services.
Shifting the AD Curve
A reduction in the money supply (M) shifts the aggregate demand curve to the left.
An increase in the money supply (M) shifts the aggregate demand curve to the right.
Aggregate Supply in the Long Run
In the long run, output is determined by factor supplies and technology.
Yˉ is the full-employment or natural level of output where the economy’s resources are fully employed.
Full employment means that unemployment equals its natural rate (not zero).
The Long-Run Aggregate Supply Curve
In the long run, output is determined by the amounts of capital and labor and by the available technology; it does not depend on the price level.
Therefore, the long-run aggregate supply (LRAS) curve is vertical.
Long-Run Effects of a Decrease in M
Starting at initial equilibrium A, a decrease in M shifts AD inward.
The economy reaches a new equilibrium at B with a lower price level but the same level of output.
Aggregate Supply in the Short Run
Many prices are sticky in the short run.
Assume all prices are stuck at a predetermined level in the short run.
Firms are willing to sell as much as customers are willing to buy at that price level.
Therefore, the short-run aggregate supply (SRAS) curve is horizontal.
The Short-Run Aggregate Supply Curve
The SRAS curve is horizontal.
The price level is fixed at a predetermined level (Pˉ), and firms sell as much as buyers demand.
Short-Run Effects of a Decrease in M
Starting in initial equilibrium at A, M decreases.
The decrease in M causes AD to shift inward.
The inward shift causes the economy to move to a new equilibrium at B, where output falls, and the price level remains the same.
From the Short Run to the Long Run
Over time, prices gradually become “unstuck.”
The adjustment of prices is what moves the economy to its long-run equilibrium.
The Short- and Long-Run Effects of a Decrease in M
The inward shift in AD causes the economy to move to a new short-run equilibrium at B, and then prices adjust, and the economy reaches the new long-run equilibrium at C.
Shocks
Shocks are exogenous changes in aggregate supply or demand.
Shocks temporarily push the economy away from full employment.
Example: exogenous decrease in velocity.
If the money supply is held constant, a decrease in V means people will be using their money in fewer transactions, causing a decrease in demand for goods and services.
The Effects of a Positive Demand Shock
A positive demand shock shifts AD outward to AD2, and the economy has a new short-run equilibrium at B.
The economy self-adjusts with increased prices and causes the economy to reach the new long-run equilibrium at C.
Supply Shocks
A supply shock alters production costs and affects the prices that firms charge (also called price shocks).
Examples of adverse supply shocks:
Bad weather reduces crop yields, pushing up food prices.
Oil cartel raise the price of oil.
Favorable supply shocks lower costs and prices.
CASE STUDY: The 1970s Oil Shocks
Early 1970s: OPEC coordinated a reduction in the supply of oil.
Oil prices rose:
11 percent in 1973
68 percent in 1974
16 percent in 1975
Sharp oil price increases are supply shocks because they significantly impact production costs and prices.
Predicted Effects of the Oil Shock
Inflation rate up
Output down
Unemployment up
…and then a gradual recovery
Late 1970s: As the economy was recovering, oil prices shot up again, causing another huge supply shock!
The 1980s Oil Shocks
1980s: A favorable supply shock—a significant fall in oil prices
As the model predicts, inflation and unemployment fell.
Stabilization Policy
Stabilization policy: policy actions aimed at reducing the severity of short-run economic fluctuations.
Example: using monetary policy to combat the effects of adverse supply shocks
Stabilizing Output with Monetary Policy
A negative supply shock shifts SRAS up.
Without intervention from the Central Bank, the economy would reach a new equilibrium at B.
However, the Central Bank responds by increasing the money supply, shifting AD out, resulting in a new equilibrium at C (with higher price level, and no reduction in output).
The Covid-19 Recession
Initially, the shock to the economy was an inward shift in LRAS.
Businesses closed.
Businesses that remained open saw decreased productivity because of social distancing.
However, as businesses closed, consumers lost the ability to spend money, AD shifted inward due to C decreasing.
Unable to dine-in at restaurants
Unable to travel
Unable to attend concerts, movies, sporting events, museums, etc.
Ending the recession is foremost a public health issue, not an economics issue.
Chapter Summary
Long run: Prices are flexible, output and employment are always at their natural rates, and the classical theory applies.
Short run: Prices are sticky, and shocks can push output and employment away from their natural rates.
Aggregate demand and supply: a framework to analyze economic fluctuations
The aggregate demand curve slopes downward.
The long-run aggregate supply curve is vertical because output depends on technology and factor supplies but not prices.
The short-run aggregate supply curve is horizontal because prices are sticky at predetermined levels.
Shocks to aggregate demand and supply cause fluctuations in GDP and employment in the short run.
The Fed can attempt to stabilize the economy with monetary policy.