Lecture 10: Economic Fluctuations

As we know, the long-term growth in the United States and other advanced economies is quite impressive over the past couple of centuries. We also know that this growth gets interrupted from time to time. As Figure 10-1, repeated here from Figure 2-2 reminds us, the growth process has both periods of growth and periods of recession, when the economy moves from a peak to a trough.

Figure 10-1
Peaks and Troughs in the Economy

The economy does not grow at a constant rate. When it is growing, we say it is expanding. When it is declining, we say it is contracting. When the economy switches from expanding to contracting, we say it has a peak. When it switches from contraction to expansion, we say it has a trough. The shaded period here represents a period of recession or business contraction.

Periods of business contraction are not isolated events. Table 10-1 shows the peaks and troughs in American economic activity from 1854. These cycles are both mild and severe. From 1929 to 1933, real GDP in the United States fell by 30 percent, prices fell almost as much, and nominal GDP fell from $103 to $55 billion. The unemployment rate rose to 25 percent. Most economists and historians refer to this period as the Great Depression. In recent years, we have had only relatively mild recessions, one in 1981-82 and a particularly mild one in 1990-91.

For example, consider the contraction of 1981-82. The late 1970’s had been a period of rapid inflation, and the Federal Reserve System decided to bring inflation under control. They did so. In 1979, the inflation rate was 13.3 percent; by 1982, it was only 3.8 percent. While prices did not decline as they did in 1929-33, the 1982 price level was some 20 percent lower than it would have been without the drop in the inflation rate. As in the case of the Great Depression, the economy suffered. Real GDP fell by 3.0 percent from the fall of 1981 to the fall of 1982. That may not seem like much, but it was enough to cause the unemployment rate to rise from 5.8 to 10.0 percent.

In the case of the 1991-92 recession, the changes were much milder. The unemployment rate rose only about 2 percentage points.

Table 10-1 Dates of Peaks and Troughs of Business Cycles in the United States, 1854-1997
Peak	Trough
???	December 1854	These data come from a long-standing research project of the National Bureau of Economic Research (NBER). While an NBER committee dates when recessions begin and end, the following rule will almost always predict what they are going to do: if Real (Inflation Adjusted) GDP declines for two consecutive quarters, a recession has begun; when Real GDP begins to rise, the recession is declared over.
June 1857	December 1858
October 1860	June 1861
April 1865	December 1867
June 1869	December 1870
October 1873	March 1879
March 1882	May 1885
March 1887	April 1888
July 1890	May 1891
January 1893	June 1894
December 1895	June 1897
June 1899	December 1900
September 1902	August 1904
May 1907	June 1908
January 1910	January 1912
January 1913	December 1914
August 1918	March 1919
January 1920	July 1921
May 1923	July 1924
October 1926	November 1927
August 1929	March 1933
May 1937	June 1938
February 1945	October 1945
November 1948	October 1949
July 1953	May 1954
August 1957	April 1958
April 1960	February 1961
December 1969	November 1970
November 1973	March 1975
January 1980	July 1980
July 1981	November 1982
July 1990	March 1991

Aggregate Demand and Aggregate Supply

When talking about business cycles we once again go back to our basic model of the economy. As we can tell from the lower right hand part of Figure 10-2, our basic graph, we require that the demand and supply of loans be equal. Specifically, we require that

S + M-X = I + G-T

Figure 10-2
Our Basic Model

This figure summarizes the basic macroeconomic model. Starting with the upper left-hand panel and moving counterclockwise, the demand and supply of labor determines the number of people working. In turn, the number of people working determines the total level of GDP. The demand and supply of loans determines the real interest rate, and hence the division of output between consumption and saving. Finally, the equation of exchange determines the price level.

That is saving plus the value of the trade deficit must equal domestic investment plus the government budget deficit. There is another way of stating this requirement that is more useful to us here, namely that the supply and demand of aggregate output be equal. In fact, this was our basic starting point when we derived the requirement that the supply and demand of loans be equal. To refresh our memory, our starting equation was

Y = C + I + G + (X-M)

· Aggregate Supply is the entire productive capacity of the economy. The left-hand side represents Aggregate Supply.

· Aggregate Demand is the total demand for goods and services in an economy by all individuals, firms, and governments. The right hand side represents aggregate demand.

A minor change we want to introduce is to work with the requirement that aggregate demand (AD) must equal aggregate supply (AS), which we do by rewriting our equation as.

Y = AS = AD º C + I + G + (X-M)

Note the use of the "º" symbol. This is mathematical shorthand for "is defined as". In short, there is nothing new when we restate our requirement that the demand and supply of loans be equal as

AS = AD

The aggregate demand and aggregate supply curves

Figure 10-3 shows our aggregate demand and supply curves. Obviously whenever an economist draws supply and demand curves, the curves will be function of some price. Here the "price " is the price level. This requires explanation.

Why is the aggregate demand curve a downward sloping
function of the price level?

As you know, aggregate demand comes from summing up the sources of aggregate demand: Thus we know that

Real Aggregate Demand = Y = C + I + G + (X-M)

Figure 10-3
Aggregate Supply and Demand curves as a Function of Price

Instead of working with the requirement that the demand and supply of loans be equal, we will work with the requirement that aggregate demand and supply be equal.

However, there is actually a second equation for describing the relation between aggregate demand and price. Recall from the equation of exchange that

Nominal Aggregate Demand = PY = MV

And, adjusting for the price level,

Real Aggregate Demand = Y = MV/P

These two equations are two ways to describe purchases at a store. The first equation describes the amount an economy spends on each type of good, here consumption, investment, etc., instead of spending on marshmallows, graham crackers, and chocolate chips. The second equation describes the total amount of money that people spend each year, but in terms of the total dollars spent, here MV/P or the money supply times the number of times each dollar is spent, divided by the price level.

Some people might object to this way of stating aggregate demand. But sometimes it is useful to recognize that there may be two ways of explaining something. For example, why am I teaching this class right now? One explanation is that I am paid to teach this class. Another explanation is that I got up this morning, showered, got dressed, came to my office, then walked into this classroom. Both explanations are true, but offer different insights into my behavior. If you want to explain my behavior, some times you will find one explanation more convenient and other times you will find the other explanation more convenient. They will always give the same answer.

If we want to see the slope of the aggregate demand curve, the second equation is more convenient. Holding both the money supply and velocity constant, aggregate demand curve is a downward sloping function of price. Since Aggregate Demand equals MV/P. it is obvious that the higher the level of P, the lower the level of aggregate demand and vice versa.

Warning Required by the Economist-General

· To some, the use of the equation of exchange to show the aggregate demand curve is a downward sloping function of the price level may look like pulling a rabbit out of a hat. Rest assured that this argument could be made in more detail. More advanced versions of the theory of aggregate demand do not hold velocity constant, but instead hold constant various factors that affect velocity, and thus spell out in more detail the process by which lower price levels lead to a downward sloping aggregate demand curve. The crucial point is that the aggregate demand curve does slope downward.

Why the aggregate supply curve is not a function of price

Long proofs that supply curves slopes upward are generally a sure-fire cure for insomnia. The idea that more of a commodity will be supplied as its price rises is simple, obvious, and compelling. But this supply curve is special. It talks about the supply of aggregate output as a function of the overall price level. And, as we would expect, there is no relation between this aggregate supply curve and the price level. As the graphs on the left hand side of Figure 10-2 make clear, a country’s aggregate supply is determined by the total amount of capital, the number of people who want to work, and the hours they work. A rise in the price level simply means that things that used to cost five pictures of George Washington now cost (say) seven, and why that should make people willing to work harder is surprising. To be sure, one of the things that now costs seven pictures of George Washington is (say) an hour’s worth of your time or my time. Normally we would have no trouble explaining why we would be willing to work more for seven pictures of George than for five. But in this case, remember that the things that we used to be able to buy with those five pictures now cost seven. Unless you have a psychological disorder or a case of extreme patriotism, you don’t work for pictures of George; you work for what they can buy. And the plain truth is that an increase in the price level means that what you get paid, in inflation adjusted terms, does not rise. Thus we would expect no increase in the amount of labor you or I would be willing to supply.

The Short Run Aggregate Supply Curve

But there is another part of the puzzle, which we must now introduce: the short run aggregate supply curve. As you will recall, lecture one discussed the difference between short run and long run supply curves. In this case economists distinguish between a

· Long Run Aggregate Supply Curve and a

· Short Run Aggregate Supply Curve

Economists disagree about the shape of the short run aggregate supply curve AS^SR. Figure 10-4 illustrates two possibilities. Some believe it runs roughly horizontally, such as AS^SR_Flat while others believe it is upward sloping such as AS^SR_Slope. Of course, in the last case, there is also the second question of just how sloped the curve is. We will draw it as an upward sloping curve.

You might want to ask just how much slope the short run aggregate supply curve has. We will defer that question and turn to the more basic question: why does the short run aggregate supply curve differ from the long run supply curve at all?

Figure 10-4
Two possible short run aggregate supply curves

This figure illustrates two possible slopes for the short run aggregate supply curve. In one case it is upward sloping, though not vertical, as is the long run aggregate supply curve. In the other case, it is horizontal.

Why can there be a short run aggregate supply curve?

For there to be a short run aggregate supply curve there must be sticky prices, meaning prices are slow to change. Economists have given a number of explanations of why there can be a sticky prices and a short run aggregate supply curve. Rather than give an exhaustive treatment of these explanations, let's concentrate on just one: the imperfect information explanation.

The idea is quite simple. Suppose a worker who normally earns $10 an hour is offered a chance to work for $11 an hour. While some workers may choose not to work harder, others will conclude that this wage premium will not last forever and will jump at the chance to work harder while they can earn a premium. In our terms, there is a movement along the short run labor supply curve. With more people working more hours, it should come as no surprise that there is a boost in total output.

Of course, if it were simply a nominal wage increase, then it would make no sense to respond by working harder. The worker will still be earning the same amount of real goods and services as before.

So too with firms. We know that the higher the real price a firm receives, the more it will supply. Suppose the price of a bicycle rises from $100 to $106. Is this a real increase or simply an increase in the nominal price? In practice, it is hard to tell. If it is a real increase, the firm can increase its profits by increasing output. If it is only a nominal increase, the firm will lose money by expanding output.

How Imperfect Information Affects Behavior

Both firms and workers thus face a problem that economists call the problem of imperfect information. How does the worker determine that the increase from $10 to $11 an hour is a real increase? And how does the firm decide that the increase in the price it can get for a bicycle is a real price increase?

It turns out to be a complicated problem. It would be foolish to act as if it were certain that the real price had risen from $100 to $106, though would be equally foolish to assume that it was certain that the real price had not risen at all. It turns out after a great deal of mathematics that the solution is to assume that part of the price increase is real. For example, the firm might respond as if the real price of a bicycle had risen from $100 to $102.

So too with workers. Workers, just like firms, have trouble distinguishing between real and nominal increases, and thus adopt the same behavior as firms. They may assume that part of an unexpected increase in their money wage is an increase in the real wage.

Thus a correct equation might be something like the following:

AS^SR = AS^LR + a(P-P^e)

In words, we are saying that the short run aggregate supply equals long run aggregate supply plus an adjustment for the difference between actual and expected inflation. The value of a will depend on just how sure workers and firms are of just what the inflation rate will be.

This, of course, brings us back to our earlier point. If workers work harder then output will go up. Moreover, they will work harder if their real wage has gone up -- or at least if they think their real wage has gone up. Unexpected inflation makes people think their real wage has gone up and thus makes them willing to work harder.

We should note some important restrictions.

· First this works only for unanticipated increases in the price level, or, as some people put it, unexpected inflation. If you expect prices to rise by, say, six percent, you would take the increase in the price of bicycles from $100 to $106 as simply confirmation of your expectations.

· Second if only the nominal price that has gone up, people will eventually realize that and eliminate any increase in output.

Other Explanations

There are other explanations given for a upward sloping aggregate supply curve, include:

· An explanation that prices are sticky because it costs too much to change them. For instance, a restaurant must reprint menus each time it raises prices and may be loath to change them that often.

· An explanation that wages are sticky because it costs too much to change them. It is hard for a professor to expect a wage increase in the middle of the year, for instance.

We need not settle which of these or other explanations to believe, but just note that these may be reasons why there could be an upward sloping supply curve. The important point to remember is that for there to be an upward sloping short run aggregate supply curve prices must be sticky.

The Dynamics of Aggregate Demand and Supply Model

Let's see if we really understand the basic aggregate demand and supply model by considering a few applications. Figure 10-5 illustrates the aggregate demand curve along with both a short run and long run aggregate supply curve. Initially, the economy is in equilibrium with the price level equal to P_o, and output equal to Y_o.

Suppose now that for some reason, the aggregate demand curve shifts to the right to AD'. We need not worry for the moment about why this shift takes place.

· The initial impact is to boost the price level to P₁, and GDP to Y₁.

· The boost in GDP is a temporary effect. The short run supply curve will eventually rotate. In time, GDP will go back to Y_o, while the price level rises all the way to P₂.

Figure 10-5
Taking the AS-AD Model through its paces

If we can increase aggregate demand to AD', we can get a temporary boost in the economy as we move along the short run aggregate supply curve. Over time, however, the curve will rotate, so the boost will be temporary.

Putting the graph this way illustrates why we do not worry about the exact slope of the short run aggregate supply curve. The process of adjustment is a continuous one. In fact, a more accurate picture might be to draw as in Figure 10-6 a whole series of short run aggregate supply curves, such as AS^SR1, AS^SR2, and AS^SR3, with the process of adjustment taking us from one short run aggregate supply curve to another.

Figure 10-6
The Dynamics of Adjustment

This graph shows a whole series of short run aggregate supply curves, such as AS^SR1, AS^SR2, and AS^SR3, with the process of adjustment taking us from one short run aggregate supply curve to another. Here, initially equilibrium is at output equal to Y_o, with the price level at P_o. Then following the increase in aggregate demand, the price level first moves to P₁ then to P₂ then to P₃ then to P₄. At the same time, output first moves to Y₁ then back to Y₂ then to Y₃ and finally back to Y_o.

Here, initially equilibrium is at output equal to Y_o, with the price level at P_o. Then following the increase in aggregate demand, the price level first moves to P₁ then to P₂ then to P₃ then to P₄. At the same time, output first moves to Y₁ then back to Y₂ then to Y₃ and finally back to Y_o. If we were to display this process each time, it would make the graph much too messy. Think of the short run aggregate supply curve as merely a "snapshot" of a continual process.

Applications of the Aggregate Supply Aggregate Demand Model

Let us see if we can apply the aggregate supply and aggregate demand model to a couple of cases.

A 10% Increase in the Money Supply

If a ten-percent rise in the money supply were to lead to an immediate ten-percent rise in prices, then the economy would move to the new long-run equilibrium immediately. Real GDP would not change. The price level would rise by 10%.

	Figure 10-7 A 10% Increase in the Money Supply
1.1Po
	Suppose the Federal Reserve System engages in an open market operation that raises the money supply by ten percent. The effect is to shift the aggregate demand curve up (or to the right).

To see why, recall that MV = PY. If M is going up by 10%, and Y and V are not changing, then P must go up by 10%

With a short run aggregate supply curve, the story is different. As Figure 10-7 shows, both the price level and output initially rise. These effects are temporary. As the short run aggregate supply curve rotates, the price level will move up by ten percent.

Economists have another name for these effects: they talk about whether money is neutral. Money is neutral if a change in the money supply does not affect real GDP or any other real variables.

· In the long run, after the short run aggregate supply curve has rotated to the long run aggregate supply curve, money is neutral.

· In the short run, when the short run aggregate supply curve may be different from the long run aggregate supply curve, money may not be neutral.

To see another illustration of our basic model, suppose that, for whatever reason, there is a fall in velocity, as there would be if people decided to hold on longer to their dollars. For example, people might become more uncertain about the banking system. Here, as Figure 10-8 shows, the fall in velocity would shift the aggregate demand curve to the left. The initial effect would be to first depress both prices and output. Over time, as the short run aggregate supply curve rotated back to the long run aggregate supply curve, output would return to its initial level, while prices fell even further.

Figure 10-8
An Exogenous Fall in Velocity