Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 1
Universität Leipzig
Introduction to Economics
Lecture 9:
Business Cycles
Alexander Fink, PhD
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 2
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 3
Short-Run Economic Fluctuations
• A recession is a period of declining real incomes, and rising unemployment.
• A depression is a severe recession.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 4
Short-Run Economic Fluctuations
Output Y
Time t
Output with full employment
Currrentoutput
„Boom“
„Recession“
The Business Cycle
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 5
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 6
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)
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 7
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)
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 8
Indicators of Short-Run Fluctuations: Unemployment Rate
Year
Unemployment rate in %
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 9
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 10
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 11
The Basic Model of Economic Fluctuations
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 12
The Basic Model of Economic Fluctuations
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 13
Quantity ofOutput
PriceLevel
0
Aggregatesupply
Aggregatedemand
Equilibriumoutput
Equilibriumprice level
Aggregate Demand and Aggregate Supply...
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 14
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 15
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...
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 16
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 17
Why the Aggregate-Demand Curve Is Downward Sloping
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 18
Why the Aggregate-Demand Curve Is Downward Sloping
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 19
Why the Aggregate-Demand Curve Is Downward Sloping
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 20
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 21
Shifts in the Aggregate Demand Curve
Quantity ofOutput
PriceLevel
0
Aggregatedemand, D1
P1
Y1
D2
Y2
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 22
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 23
The Aggregate-Supply Curve
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 24
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 25
The 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 26
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 27
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 28
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 29
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 30
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 31
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• 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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 32
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
• Alternative approaches that are not further discussed here give the same result:– The misperceptions theory– The sticky-price theory
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 33
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’
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 34
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)
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 35
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)
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 36
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 37
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 38
Natural rateof output
Quantity ofOutput
PriceLevel
0
Short-runaggregate
supply
Long-runaggregate
supply
Aggregatedemand
AEquilibriumPrice level
The Long-Run Equilibrium
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 39
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 40
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 41
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 42
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
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 43
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 44
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.
Winter Semester 2011 Alexander Fink, Institut für Wirtschaftspolitik 45
Quantity ofOutput
Natural rateof output
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