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Flashcards in Week 8 Deck (46)
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1

Business cycle

Fluctuations in the economy are often called the business cycle

2

Three key facts about economic fluctuations

Economic fluctuations are irregular and unpredictable.

Most macroeconomic variables (that measure some types of income or production) fluctuate together
Do they do so by the same amounts?

As output falls, unemployment rises
Why?

3

Explaining short-run economic fluctuations

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

4

The basic model of economic fluctuations

Two main macroeconomic variables, output and prices, are used to develop a model to analyze the short-run fluctuations.
The economy’s output of goods and services measured by ...?
The overall price level measured by...?

The model looks at the aggregated behaviour of households and firms, how it is affected by Y and P and how these in turn affect the behaviour

5

AD

The aggregate-demand curve (AD) shows the quantity of goods and services that households, firms, and the government want to buy at each price level

6

An important note AD

it is also possible to present the model in terms of inflation rather than the price level, with the intuition slightly changed (inflation rate used in a textbook)

7

Components of AD

The aggregate demand for goods and services has four components:

Aggregate Demand = C + I + G + NX

Aggregate Supply = Y

In equilibrium, supply = demand

Therefore, in equilibrium Y = C + I + G + NX

8

The aggregate-demand curve illustrated

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9

The demand curve for an individual commodity is downward sloping because of two effects:

Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute)

Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice cream

10

The demand curve for an individual commodity is downward sloping because of two effects:


EXTRA NOTES

But the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effect
It is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.

11

Shifts in the Aggregate Demand Curve

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12

Why the Aggregate-Demand Curve Might Shift

Shifts arising from

Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)

Investment: technological progress, business confidence, tax rates, money supply

Government Purchases

Net Exports: foreign GDP, expectations about exchange rates

13

The aggregate-supply curve

The aggregate-supply curve (AS) shows the quantity of goods and services that firms choose to produce and sell at each price level.
In the long run (LR), is Y affected by P?
What is then the slope of LRAS?

14

The long-run aggregate-supply curve

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15

Why the Long-Run Aggregate-Supply Curve Might Shift

Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.

16

Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.

Labor: population growth, immigration, natural rate of unemployment

Capital, physical or human

Natural Resources: price of imported oil

Technology

Laws, government policies

17

The short-run aggregate-supply curve

We empirically observe that in the SR, unlike the LR, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease does the opposite
Put differently, P has temporary but not permanent positive effect on Y

18

The short-run aggregate-supply curve

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19

WHY does a nominal variable like M or P have effect on a real variable like Y???

There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS

20

There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS

(1) the misperceptions theory
(2) the sticky-wage theory
(3) the sticky-price theory

21

How the SRAS curve shifts

SRAS1 shows the aggregate supply curve for 2010
the expected price level and the natural rate of output, must be on the SRAS curve
If either Pe↓ or YN↑, the green dot moves down or to the right
When the green dot shifts, so must the AS curve

Photo 15/8

22

The long-run equilibrium

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23

Two causes of recession

In some LR equilibrium (called the steady state) all the main variables are either constant or change by a certain (unchanging) percentage
For example: inflation is 2% each year, output growth is 3% each year etc.
New economic developments (shocks) however may shift the three curves further and this leads to SR fluctuations
The economy then has a tendency to go back to some LR equilibrium (either the original one or a new one).
This works through the supply side and is called the self-correcting mechanism

24

Case (1): A Contraction in Aggregate Demand

3 photos
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25

Case (1): ECONOMIC FLUCTUATIONS: AD

Contraction (leftward shift) in Aggregate Demand (AD)

26

Case (1): ECONOMIC FLUCTUATIONS: AD

In the short run

output decreases,
the overall price level decreases, and
the unemployment rate increases

27

Case (1): ECONOMIC FLUCTUATIONS: AD

In the long run

the overall price level decreases,
but output and the unemployment rate remain unchanged at their long-run levels

28

Case (2): ECONOMIC FLUCTUATIONS: AS

A leftward shift in Short-Run Aggregate Supply
Output falls below the natural rate of employment
Unemployment rises
The price level rises
If the government does nothing, the SRAS will shift back to where it was.
The price level, total production and unemployment will be unaffected in the long run.

29

Case (2): An Adverse Shift in Aggregate Supply

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30

Stagflation

Adverse shifts in aggregate supply cause stagflation — a period of recession and inflation
Output falls and prices rise.