Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik1 Universität Leipzig Introduction to Economics Lecture 9: Business Cycles Alexander

Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 1

Universität Leipzig

Introduction to Economics

Lecture 9:

Business Cycles

Alexander Fink, PhD


Overview

• Characteristics of short-run fluctuations

• Differences between short-run and long-run economic developments

• Model of short-run fluctuations building on aggregate demand and aggregate supply


Short-Run Economic Fluctuations

• A recession is a period of declining real incomes, and rising unemployment.

• A depression is a severe recession.


Short-Run Economic Fluctuations

Output Y

Time t

Output with full employment

Currrentoutput

„Boom“

„Recession“

The Business Cycle


Three Key Facts About Economic Fluctuations

• Economic fluctuations are irregular and unpredictable.– Fluctuations in the economy are often called the

business cycle.

• Most macroeconomic variables fluctuate together.

• As output falls, unemployment rises.


2008 © Schäffer-Poeschel Verlag für Wirtschaft • Steuern • Recht • GmbH www.sp-dozenten.de Institut für Wirtschaftswissenschaft. Universität Erlangen-Nürnberg. 6

Indicators of Short-Run Fluctuations: German GDP

Real GDP

Growth rate of GDP

Growth rate of GDP in %

Growth rate of GDP

Year

Real GDP (bill. Euro)


2008 © Schäffer-Poeschel Verlag für Wirtschaft • Steuern • Recht • GmbH www.sp-dozenten.de Institut für Wirtschaftswissenschaft. Universität Erlangen-Nürnberg. 7

Indicators of Short-Run Fluctuations: Investments

Investments

Growth rate of investments

Growth rate of Investments in %

Year

Real investments (bill. Euro)


Indicators of Short-Run Fluctuations: Unemployment Rate

Year

Unemployment rate in %


Explaining Short-Run Economic Fluctuations

• How the Short Run Differs from the Long Run– Most economists believe that classical theory

describes the world in the long run but not in the short run.

• Changes in the money supply affect nominal variables but not real variables in the long run.

• The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.


The Basic Model of Economic Fluctuations

• Two variables are used to develop a model to analyze the short-run fluctuations.– The economy’s output of goods and services

measured by real GDP.– The overall price level measured by the CPI or

the GDP deflator.



• The basic model of fluctuations is based on changes in supply and demand:– the aggregated supply– The aggregated demand

• Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.



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

• The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.


Quantity ofOutput

PriceLevel

0

Aggregatesupply

Aggregatedemand

Equilibriumoutput

Equilibriumprice level

Aggregate Demand and Aggregate Supply...


The Aggregate Demand Curve

• The four components of GDP (Y) contribute to the aggregate demand for goods and services.

Y = C + I + G + NXwith:C = Household ConsumptionI = Private InvestmentsG = Government consumptionNX = Net exports


Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

The Aggregate-Demand Curve...


Why the Aggregate-Demand Curve Is Downward Sloping

• The Price Level and Consumption: The Wealth Effect

• The Price Level and Investment: The Interest Rate Effect

• The Price Level and Net Exports: The Exchange-Rate Effect



• The Price Level and Consumption: The Wealth Effect– A decrease in the price level makes consumers

feel more wealthy (the real value of, for instance, cash holdings increases), which in turn encourages them to spend more.

– This increase in consumer spending means larger quantities of goods and services demanded.



• The Price Level and Investment: The Interest Rate Effect– A lower price level reduces the interest rate, which

encourages greater spending on investment goods.– This increase in investment spending means a

larger quantity of goods and services demanded.– Why does the interest rate decrease? With a lower

price level, less money is being held for transactions, i.e. the demand for money decreases.



• The Price Level and Net Exports: The Exchange-Rate Effect– A fall in the Euro price level causes Euro interest rates

to fall.– Lower interests rates relative to other currencies lead

to lower capital inflows and larger capital outflows– The Euro depreciates, which stimulates Euro net

exports.– The increase in net export spending means a larger

quantity of goods and services demanded.


Why the Aggregate-Demand Curve Might Shift

• The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded.

• Many other factors, however, affect the quantity of goods and services demanded at any given price level.

• Shifts arising from – Consumption - Investment– Government Purchases - Net Exports


Shifts in the Aggregate Demand Curve

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2


The Aggregate-Supply Curve

• In the long run, the aggregate-supply curve is vertical.

• In the short run, the aggregate-supply curve is upward sloping.



• The Long-Run Aggregate-Supply Curve– In the long run, an economy’s production of

goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

– The price level does not affect these variables in the long run.


Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

2. . . . does not affect the quantity of goods and services supplied in the long run.

P

The Long-Run Aggregate-Supply Curve



• The Long-Run Aggregate-Supply Curve– The long-run aggregate-supply curve is vertical

at the natural rate of output.– This level of production is also referred to as

potential output or full-employment output.


Why the Long-Run Aggregate-Supply Curve Might Shift

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

• The shifts may be categorized according to the various factors in the classical model that affect output– Labor - Capital– Natural Resources - Technological Knowledge


Quantity ofOutput

Y1980

AD1980

AD1990

Aggregate Demand, AD2000

PriceLevel

0

LRAS1980

Y1990

LRAS1990

Y2000

LRAS2000

P1980

1. In the long run,technological progress shifts long-run aggregate supply . . .

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

Long-Run Growth and Inflation


A New Way to Depict Long-Run Growth and Inflation

• Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.

• In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.

• A decrease in the level of prices tends to reduce the quantity of goods and services supplied.


Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and servicessupplied in the short run.

Y

P

Y2

P2

The Short-Run Aggregate-Supply Curve


Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• When relatives prices (including wages) do not change, we move along the long-run aggregate supply curve and the price level has no effect on output and employment.

• This implies that along the short-run aggregate supply curve relatives do change:– The Misperceptions Theory– The Sticky-Wage Theory– The Sticky-Price Theory



• The Sticky-Wage Theory– Nominal wages are slow to adjust, or are “sticky” in the

short run.

– Wages do not adjust immediately to a fall in the price level.

– If the prices of output goods fall and wages remain constant, profits fall.

– A lower price level makes employment and production less profitable.

– This induces firms to reduce the quantity of goods and services supplied.



• Alternative approaches that are not further discussed here give the same result:– The misperceptions theory– The sticky-price theory


Why the Short-Run Aggregate-Supply Curve Might Shift

• The short-run aggregate supply curve reflects the costs of production

• When the costs of production increase (e.g. because wages rise) firms accordingly increase their prices at any level of output

• The short-run aggregate supply curve ‘shifts up’

• When the costs of production decrease, the short-aggregate supply curve ‘shifts down’


Output Y

Price levelP

0

SRAS1

Increasing costs of production shift the SRAS up.

Y1

P1

SRAS2

P2

34

The Short-Run Aggregate Supply Curve (SRAS)


Why the Short-Run Aggregate Supply Curve Might Shift

• The expected price level affects the SRAS. Why?

• When firms expect the price level (including wages) to increase, they adjust prices.

• At a given price level they will produce less goods and services (in other words: at any given level of output the price rises)


Why the Short-Run Aggregate-Supply Curve Might Shift

• The SRAS shifts to the right when– more of the production factors are available

(labor, capital)– technological progress occurs

These shifts of the SRAS curve are ‘real’ and therefore equivalent to shifts in the long-run aggregate supply curve


Y1 Output Y

Price levelP

0

SRAS1

LRAS1

AEquilibriumprice level

SRAS2

LRAS2

Y2

More factors of production allow to produce more at any price level. The economy moves from A to B.

B

Verschiebung der kurzfristigen Angebotskurve



Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumPrice level

The Long-Run Equilibrium


Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

AS2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

Copyright © 2004 South-Western

A Contraction in Aggregate Demand


Two Causes of Economic Fluctuations

• 1. Shifts in Aggregate Demand– In the short run, shifts in aggregate demand

cause fluctuations in the economy’s output of goods and services.

– In the long run, shifts in aggregate demand affect the overall price level but do not affect output.


Two Causes of Economic Fluctuations

• 2. A Shift in Aggregate Supply– A decrease in one of the determinants of

aggregate supply shifts the curve to the left:• Prices of imports rise

• Prices of inputs rise

– Consequences:• Output falls below the natural rate of employment.

• Unemployment rises.

• The price level rises.


Quantity ofOutput

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregate

supply, AS

Long-runaggregate

supply

Y

AP

AS2

B

Y2

P2

A Negative Supply Shock


The Effects of a Negative Supply Shock

• Stagflation– A negative shock in aggregate supply causes

stagflation—a period of recession and inflation.• Output falls and prices rise.

• Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.


The Effects of a Negative Supply Shock

• Policy Responses to Recession– Policymakers may respond to a recession in one

of the following ways:• Do nothing and wait for prices and wages to adjust.

• Take action to increase aggregate demand by using monetary and fiscal policy.


Quantity ofOutput


PriceLevel

0

Short-runaggregate

supply, AS

Long-runaggregate

supply

Aggregate demand, AD

P2

AP

AS2

3. . . . whichcauses theprice level to rise further . . .

4. . . . but keeps outputat its natural rate.

2. . . . policymakers canaccommodate the shiftby expanding aggregatedemand . . .

1. When short-run aggregatesupply falls . . .

AD2

CP3

Accommodating of a Negative Supply Shock

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Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik1 Universität Leipzig Introduction to Economics Lecture 9: Business Cycles Alexander