Mankiw Ir Taylor 12 Tema + Uždaviniai

PART 14
SHORT-RUN ECONOMIC
FLUCTUATIONS
30 BUSINESS CYCLES
T he majority of you reading this chapter will have lived through a period of economic change. Many of
you will have been born in the mid-1990s. Between this time and the middle part of the first decade
of the 2000s, many countries in Europe experienced a period of prosperity, relatively strong economic
growth, relatively low and stable inflation, unemployment rates which were not too high and interest rates
which were at relatively low levels.
From about 2007 onwards, things changed. The financial crisis led to serious economic problems in
many countries and a global recession. A recession is characterized by a period of falling incomes and
rising unemployment and technically occurs after two successive quarters of negative growth. If such a
contraction in growth continues and is more severe it might be described as a depression.
recession a period of declining real incomes and rising unemployment. The technical definition gives recession occurring
after two successive quarters of negative economic growth
depression a severe recession
Whilst many countries came out of recession around 2009–2010, economic growth in many European
countries has been weak. Interest rates in many developed countries have been at virtually zero rates for
a number of years, unemployment has risen to alarming levels in some countries but inflation has been
stuck at levels above the target rate for many countries. At the time of writing, the economic prospects
do not look good but by the time you read this chapter things may be improving in your country. By 2016 it
could be that many economies in Europe return once again to a period of stronger growth and an increase
in prosperity.
Your instructors will have experienced the ups and downs of economic activity over a longer period but
they too will have experienced periods of considerable economic problems and periods of strong growth.
The latter part of the 1970s and into the early part of the 1980s was characterized by severe economic
problems in the UK but by the mid-1980s, things improved only to slump again in the early 1990s.
It is clear that the level of economic activity, the amount of buying and selling (the number of transac-
tions) changes over time. Economic activity is an important factor in determining economic growth and in
637
638 PART 14 SHORT-RUN ECONOMIC FLUCTUATIONS
turn the level of employment, unemployment, inflation and other macroeconomic variables. Economists
are pretty much agreed on the causes of long-run changes in macroeconomic equilibrium but there is more
disagreement about what causes short-run variations in economic activity. The short-run swings in eco-
nomic activity vary in size and time-span. In the UK, the recession of 1920–1924, for example, saw GDP
fall by about 9 per cent from its peak over the first 18 months and then take a further 27 months to get
back to its pre-recession peak, and in the next 12 months rise to around 4 per cent above its pre-recession
peak. In 1930–1934, the length of time for the economy to recover to its pre-recession peak was around
48 months but the economy ‘only’ fell to around 7 per cent below its pre-recession peak. In the 1990–1993
recession, the economy took around 32 months to recover but thereafter rose by over 8 per cent above its
pre-recession peak and only fell to around 3 per cent of its pre-recession peak. The post-financial crisis of
2008 until the time of writing has seen the economy falling to around 6 per cent below its pre-recession
peak and has been below the peak consistently for over 60 months. You may be reading this now and the
UK economy has still not managed to reach its pre-recession peak. The business cycle refers to the study
of the fluctuations in economic growth around the trend growth.
business cycle the fluctuations in economic growth around trend growth
TREND GROWTH RATES

Most of the data we will be looking at in this chapter is classed as time series data, observations on a
variable over a time-period and which are ordered over time.
time series data observations on a variable over a time-period and which are ordered over time
Central to the analysis of business cycles is GDP over time. Figure 30.1 shows two graphs: panel (a)
shows GDP in the UK from 1960–2011. The value of GDP is given on the vertical axis in current US dollars
and the horizontal axis is the time period in years. Panel (b) shows GDP across the European Union over
the same time period.
Panel (a) shows that the value of the UK economy in 1960 was around $72 billion but by 2011 the
UK economy was worth around $2.4 trillion. Panel (b) shows the economy of the EU was worth around
$365 billion in 1960 but has grown to some $17.5 trillion in 2011. A trend line has been added in both
cases and this shows how over time the GDP of both the UK and the EU has risen. It also shows
how actual GDP fluctuates around the trend and that there are similarities in these fluctuations. For
example, between 1960 and 1976, trend growth and actual GDP were similar but from around 1977 to
the early 1980s growth was above trend but then started to decline and in the mid-1980s was below
trend. This sort of pattern has been repeated with some periods above trend and some below and it
is noticeable that in the period up to 2008, growth was significantly above trend but was followed by
a sharp fall and growth is currently below trend. The pattern is almost the same as that for the EU as
a whole.
The question arises as to what causes these fluctuations and, ever since the Great Depression in the
1930s, economists have sought to offer models to explain these macroeconomic variations. It is safe to
say that there is disagreement among economists about the cause of these fluctuations and what or
indeed whether any policy measures need to be put in place to deal with the welfare issues that arise.
Welfare issues arise if it is assumed that the economy is deviating in some way from its equilibrium. Policy
is put in place to address the welfare issues that arise. Some economists, however, believe that the eco-
nomy may not be deviating from its equilibrium but instead the economy is moving from one equilibrium
point to another, in which case policy is not required because there are no welfare issues arising if the
economy is in equilibrium. We shall explore these differences later in the chapter.
CHAPTER 30 BUSINESS CYCLES 639
FIGURE 30.1
GDP iin th
the UK and
d EEurope, 1960–2011
Panel (a) shows UK GDP, measured in current US dollars on the vertical axis over the period 1960–2011. Panel (b) shows GDP across the
European Union (also in current US dollars) over the same time period. A trend line has been added in both panels.
Panel (a)
3,000,000,000,000
2,500,000,000,000
2,000,000,000,000
1,500,000,000,000
1,000,000,000,000
500,000,000,000
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Panel (b)
20,000,000,000,000
18,000,000,000,000
16,000,000,000,000
14,000,000,000,000
12,000,000,000,000
10,000,000,000,000
8,000,000,000,000
6,000,000,000,000
4,000,000,000,000
2,000,000,000,000
0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Data Concepts
When dealing with macroeconomic variables there are a number of concepts that we will utilize over
the coming chapters which need to be understood. Figure 30.2 shows the rate of growth of UK GDP
between 1960 and 2011. It is clear from this figure that the rate of growth fluctuates over the time period.
From 1962, growth accelerated and reached 5 per cent in 1964 before slowing down to between 2.8 and
2.0 per cent up to 1968. Thereafter growth accelerated again reaching 7.3 per cent in 1973 before the
economy slumped dramatically and economic activity actual shrank in 1974 and 1975. The pattern of rise
and fall is repeated in the time period shown thereafter.
GDP shows a pattern of peaks and troughs and periods where growth is accelerating, decelerating and
in some cases is declining. The peak is where economic activity reaches a high and real output begins to
decline. A trough is where economic activity reaches a low and the decline ends. These are both turning
points in economic activity.
peak where economic activity reaches a high and real output begins to decline
trough where economic activity reaches a low and the decline ends
FIGURE 30.2
UK GDP G
Growth
th R
Rate,
t 1960–2011 (%)
UK GDP fluctuates between various peaks and troughs over the period. In some cases, GDP growth is positive for a number of years
and so the economy is growing during that time, but in other years GDP growth is negative and the economy shrinks.
7.5
5.5
3.5
1.5
–0.5
–2.5
–4.5
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
When economic activity is accelerating and the rate of growth is rising each year this represents a
period of expansion. Depending on the rate at which real output is accelerating, it may be referred to as a
boom. In 2003, UK GDP grew at 3.8 per cent, in 2004 it grew at 2.9 per cent. It is important to note that
economic activity slowed down in 2004 but still continued to grow. Taking a simple example to illustrate
this, if economic activity is measured in terms of the number of tonnes of steel produced, if output was
10 million tonnes in 2002 and 12 million tonnes in 2003, then the growth rate is 2 per cent. If output
is 13.5 million tonnes in 2004, the growth rate is now 1.25 per cent; growth has slowed compared to
2003 but the economy is still producing more steel than the year before. This is why we use the terms
‘accelerating’ and ‘decelerating’ to describe changes in the rate of growth of GDP when it is positive.
However, when real output actually shrinks then there is a contraction in the economy. If output
of steel in 2005 was 13 million tonnes, the economy would have shrunk; less steel is being produced
compared to 2004 and growth will be −3.8 per cent.
contraction when real output is lower than the previous time period
If expansion is considerably above trend then the term ‘boom’ might be appropriate but if growth is
only just above trend then that term may not be applicable. It is important to be aware of the language
used when discussing economic growth; the news media are keen to use emotive words such as ‘boom’,
‘bust’ and ‘slump’ when reporting growth data. Is a growth rate of 0.25 per cent ‘a slump’ for example?
In Figure 30.2 we can find the mean of the data represented by adding the sum of the annual growth
rates (124) and dividing by the number of years (51). The mean growth rate over this period is 2.4 per cent.
In describing periods of accelerating and decelerating growth, therefore, we can compare the growth rate
at a particular time period with the mean growth rate. The period from 1970 to 1973 might reasonably
be called a period of boom given that the rate of growth of GDP averaged almost 5 per cent during that
time reaching a peak of 7.3 per cent in 1973. In 2008 and 2009, GDP growth was −1.0 and −4.0 per cent
respectively, considerably below the mean growth rate for the whole period of 2.4 per cent.
The difference between a peak and a trough in the business cycle and trend output is called the
amplitude. Figure 30.2 shows that this can vary considerably. In 1973 the amplitude was 4.9 but in 1984
was 0.3 and in 1981 was −3.7. The length of the time between peaks and troughs in economic activity
also varies considerably. Between 1993 and 2008, the UK enjoyed a period of persistent growth. The
difference between peak and trough was 16 years. Prior to this, the difference between peak and trough
(1988–1991) was just four years.
amplitude the difference between peak and trough and trend output
SELF TEST What are the main phases of the business cycle?
Trends
An important point of disagreement about economic time series data is the existence of trends. A trend
is the underlying long-term movement in a data series. The trend can be upwards over time, downwards
or constant. Earlier we took the mean (average) of the growth rate in UK GDP between 1960 and 2011 as
being 2.4 per cent. The mean of a set of time series data can be used as the trend.
trend the underlying long term movement in a data series
Figure 30.1 showed UK and EU GDP between 1960 and 2011 and a trend line was added to the data
showing very clearly that the trend was upwards over the time period shown. Trends can demonstrate pat-
terns over a period which can be described as stationary and nonstationary. Stationary data are time series
data that have a constant mean value over time, whereas nonstationary data are time series data where
the mean value can either rise or fall over time. The data in Figure 30.1 would suggest that GDP is non-
stationary data rising over time. Other economic variables might exhibit the characteristic of stationary data;
unemployment, for example, tends to be more characteristic of stationary data. In the period 1993 to 2003,
UK unemployment averaged 1.92 million whereas in the period from 2004–2011, unemployment averaged
1.99 million. As with any statistical analysis, care has to be taken to consider what data have been included,
how the data have been constructed, what time period is involved and what test has been applied, and there
is often disagreement about appropriate statistical tests and measurements used in economic analysis.
stationary data time series data that has a constant mean value over time
nonstationary data time series data where the mean value can either rise or fall over time
CAUSES OF CHANGES IN THE BUSINESS CYCLE

Having looked at some of the ways in which the data in macroeconomic time series are used and some
background to the study of the business cycle, we now turn to asking questions about what causes
changes in economic activity. We know that the economy is made up of households and firms and so it is
reasonable to expect that the behaviour of these two elements of the economy have a role to play in how
economic activity changes. Firms and households make decisions.
Household Spending Decisions

Households make decisions on how much labour to supply. The amount of labour supplied depends in
part on the real wage rate. The rate of growth of wages in relation to prices affects consumers’ purchas-
ing power. How consumers perceive changes in real wages is an important factor in decision-making.
Households also make consumption decisions on everyday goods and services, leisure and entertainment
and also on what are sometimes called ‘big-ticket’ items such as durable household goods (TVs, washing
machines, cars, fridge freezers etc.) not to mention decisions on purchasing houses or flats. Purchasing
decisions on these items may in themselves be cyclical; if a newly-wed couple buys a house, for example,
it may be that in the next year they spend considerable amounts on furniture, decorating and household
goods. It then may be several years before goods begin to wear out and need replacing or the house
needs decorating again.
Households will also make decisions based on changes in interest rates, house prices and taxation.
Increases in interest rates may encourage a rise in saving and a reduction in consumption; changes in
house prices affect people’s wealth and the effect can lead to changes in spending, especially if people are
able to borrow on the strength of the value of their property. Changes in tax rates affect different people
in different ways and can have a considerable impact on behaviour.
Firms’ Decision-Making
Firms make decisions about production levels – how much output to produce – based on what they think
they can sell. If firms face strong demand they are likely to increase output and may have to take on more
workers and buy more raw materials and semi-finished goods in order to satisfy demand. Some firms may
look to expand by investing in new equipment and machinery or by acquiring new premises or even other
firms. Firms also make decisions about how many workers to hire (or release) based on the real wage rate
and productivity levels. If the real wage rate falls then firms can afford to hire more workers; if productivity
levels rise then costs can be lowered and firms can be more competitive. Firms will also monitor stock
levels (stock is often referred to as inventories). If stocks are building up then it may be that sales are
slowing down, whereas if stocks are falling demand may be strong and sales rising. Firms will respond
to changes in inventory levels by expanding or contracting output as necessary or investing in new plant
and equipment or on mergers and acquisitions. The government is also a key economic actor; it makes
decisions on taxes and spending and how much to borrow to finance its activities.
External Forces
Economic activity is also affected by events abroad. In an open economy, movements in exchange rates
affect the competitiveness of domestic and foreign firms through changes in import and export prices.
Economic activity abroad can also have an impact on countries as consumption and investment decisions
by firms and consumers abroad change. The UK Chancellor of the Exchequer in 2012 regularly pointed
to the problems in the euro area as a reason why the UK economy had not recovered from recession as
quickly as had originally been predicted.
We also have to take into account the effect of events which are often totally unpredictable such as
drought, flood, tsunamis, hurricanes, extreme cold or earthquakes, through to events such as political
upheaval, war, terrorism and conflict which can have far-reaching effects on individual countries and the
global economy.
Government Policy
Governments have control over a considerable amount of economic activity. Governments make decisions
about tax rates and have to try and consider the incentive effects of changes in tax rates. Decisions about
major infrastructure investment can be made by governments which can have ripple effects throughout
an economy. Government agents can also have an effect on economic activity. Central banks are inde-
pendent of most governments but have links with government. In the UK, for example, the government
sets the target for inflation which the Bank of England is responsible for. The Bank of England then sets
monetary policy to meet the target the government has set. Changes in interest rates will affect both
households and firms through policy decisions like quantitative easing and measures designed to help
ease credit flows to business and households.
Confidence and Expectations

Households and firms not only make decisions based on current needs but also on the future. It is unlikely
that an individual will make a decision to take out a loan for €15,000 to buy a car if that person believes
the security of their job is in question. The news media provide information on the state of the economy,
governments make pronouncements, senior finance ministers and banking officials are interviewed about
their forecasts for the economy. Employees will get a sense of how the firms they work for are perform-
ing and those in the public sector may take close note of government policy decisions. Workers may look
at current inflation rates and their wage rise and may make judgements about inflation in the future and
therefore what sort of wage rise they need to maintain their standard of living. Firms may also look at
inflation rates and make judgements about price rises to consumers based on what they expect inflation
to be in the future and how inflation in raw materials might affect their costs.
Our expectations of the future shape our decisions, and confidence of firms and households to make
decisions is something that is very difficult to quantify and equally difficult to know when it changes. At
what point does any individual begin to believe that stock or house prices have reached a peak, at what
point does a firm make the decision to make redundancies and why does confidence begin to decline or
to pick up? These are all difficult questions to answer but confidence and expectations play a significant
part in swings in economic activity.
SELF TEST A country’s finance minister presents the government’s annual financial statement and advises
that she expects GDP to contract sharply in the coming year because of adverse international economic
conditions. How might such a speech influence confidence and expectations of households and firms?
BUSINESS CYCLE MODELS

Attempts to try and understand how business cycles occur have led to different models which differ in the
assumptions that are made. On the one hand there are models which assume that markets clear quickly and
as a result the welfare of economic actors (firms and households) is maximized and there are no reasons
why economic actors should change their behaviour. On the other hand there are models which assume
that markets do not always clear quickly and that rigidities are present in the market, particularly with regard
to prices and wages which mean that for a time, economic actors will not be maximizing welfare.
We will provide an overview of the different business cycle models with perspectives that consider
the supply side of the economy and then we will look at models associated with the demand side of the
economy.
Supply Side – The New Classical Model

This model is based around analysis of the supply side of the economy and the operation of the labour
market. It is assumed that the labour market clears but that workers have imperfect information. The model
highlights the importance of anticipated and unanticipated price changes. If workers correctly anticipate
price changes they can change their behaviour such that real wages and the amount of labour they supply
adjust to clear the market. For example, if the price level rises, the real wage will fall and firms will be
encouraged to hire more labour. If the price change is anticipated, workers will recognize that real wages
will fall and will supply less labour. The demand for labour will be greater than the supply of labour so the
nominal wage will rise. However, the real wage at the new equilibrium will be constant.
If workers do not anticipate the change in prices, the real wage will fall, firms will demand more labour
but workers continue to offer the same amount of labour hours so the demand for labour will be in excess
of the supply and the nominal wage will rise but the rise will be less than the price rise. The result is that
output will rise but the real wage will fall. The increase in output will be above trend GDP. In this model
there has been a deviation from equilibrium output because workers have incomplete information and are
not aware of the impact of changes in the price level.
Aggregate Supply Shocks A further aspect of the new classical model looks at how shocks to aggreg-
ate supply can cause deviations from trend output. These shocks can affect the productivity of factors of
production and can be temporary such as the effect of natural disasters, or permanent such as can happen
when new technologies are developed. The developments in computer technology over the last 30 years,
for example, have had a permanent impact on productivity which few would have envisaged.
If supply shocks are temporary, such as the effect of an earthquake, productivity declines and demand
for labour and other factors will fall which will also leads to a fall in output below trend GDP. It is possible
to observe aspects of this argument in events which have occurred in the last ten years. An earthquake in
Northern Japan in 2011 caused extensive damage and disruption to supply chains across the globe. Firms
found that component parts were in short supply and some firms had to lay off workers and suspend pro-
duction until the supply chains were re-established. The global nature of business means that such natural
disasters can have far-reaching effects.
Supply Side – The Keynesian Model

In the next chapter we will look in more detail at the contribution of John Maynard Keynes to macroeco-
nomics. One of the main propositions that Keynes put forward was that markets do not clear as quickly as
classical economists believed. The Keynesian assumption is that the ability of the goods and labour market
to clear are impaired by the existence of sticky prices and sticky wages.
In labour markets, firms enter into contractual agreements with workers and are also constrained by
labour market legislation and regulation which means that it is not always easy to adjust the labour force
to changed economic circumstances. Excess demand or supply in the labour market will not be eliminated
quickly by changes in wages because of these wage rigidities, and in particular wages tend to be sticky
downwards in that it is difficult for firms to adjust wages down when there is an excess supply of labour
as a result of changing economic conditions, such as a change in the price level.
Sticky prices occur where there are costs to firms of changing prices. We introduced the idea of menu
costs in Chapter 27. Changing economic conditions in the goods market may warrant a change in price to
clear the market but because firms face costs in changing prices it may be that prices are changed infre-
quently. In addition to the internal costs to firms of diverting labour resources to changing prices, firms will
have agreements with suppliers and retailers about prices built into contracts which may not be capable
of being re-negotiated for some time. The existence of menu costs mean that prices will be sticky and
prevent markets from clearing in the short run.
Demand Side – The New Classical Model

We have noted in earlier chapters that aggregate demand is composed of consumption spending, invest-
ment spending, government spending and net exports. Changes to any or all of the components of aggreg-
ate demand could cause a deviation of output from trend. Later in the book we will look at causes of shifts
in aggregate demand but in this section we are going to trace through the effect of an assumed change
in aggregate demand. A rise in aggregate demand, for example, will, ceteris paribus, lead to a rise in the
price level. A rise in the price level reduces real wages and firms look to hire more workers with the result
that the nominal wage will rise. The rise in aggregate demand will lead to an increase in output and the
price level increases. The increase in the number of workers hired causes a fall in unemployment. The New
Classical interpretation rests on workers misinterpreting a rise in nominal wages as a rise in real wages, in
other words, they do not fully take into account the effect on wages of the price rise. We referred to this
in Chapter 27 as the inflation fallacy.
The result of this is that the economy moves to a temporary equilibrium where the expectations of
some economic actors are not fully incorporated because they are incorrect. However, over time, work-
ers will begin to realize that real wages have changed and as a result begin to change their behaviour. As
workers negotiate for wage rises that maintain their standard of living, firms’ costs rise and some firms
will cut back supply with the result that the economy returns to trend output but with a higher price level
once expectations have fully adjusted.
If aggregate demand falls then the economy will enter a period of contraction with output and prices
falling in the short run. The reverse process to the one outlined above will take place. Real wages rise and
firms begin to cut back on output which increases unemployment. The demand for labour will be in excess
of the supply of labour and nominal wage rates will fall. Workers see the fall in nominal wages as a fall in
the standard of living but over time their expectations will adjust to take into account the fall in the price
level and output will return to trend.
Cyclical Implications The analysis provided above has implications for the nature of the cyclicality of
key macroeconomic variables. In the new classical model, when output is above trend, unemployment is
countercyclical and employment will be above trend and so be procyclical. Inflation will be procyclical but
real wages will be countercyclical because as output rises real wages fall.
Demand Side – The Keynesian Model

Remember that the Keynesian model assumes sticky prices and wages. If there is an increase in aggregate
demand then wages and prices will take time to adjust. The increase in demand will mean firms’ stocks begin
to decline and so they will take steps to increase output and in so doing increase employment. In the short
run, therefore, output increases above trend but the price level does not change because of sticky prices.
Over time, however, the economy will return to trend because firms will eventually be able to raise
prices and nominal wages will also increase. The rise in nominal wages affects firms’ costs and some will
begin to cut back output which returns to trend but with a higher price level (which is the same outcome
as that given in the new classical model above), but the way in which the economy has adjusted to the
deviation from trend has differed. If aggregate demand is reduced, the reverse situation will apply and
explains why recessions occur.
The speed with which the economy returns to trend after an aggregate demand shock will depend
on the time it takes for prices and wages to adjust to the changed economic conditions. In this model,
employment, real wages and inflation are procyclical and unemployment is countercyclical.
Real Business Cycles

At the heart of the model of real business cycles is the belief that changes in technology, both positive and
negative technology shocks, affect productivity regardless of the real wage rate. The model assumes that
there are no market imperfections, that firms and households are profit and utility maximizing and that
markets clear. Against the background of these assumptions, if there is a negative technology shock then
labour productivity falls and the demand for labour falls. Output will fall as a result and unemployment will
increase. Output falls because aggregate supply falls, which creates excess demand in the economy. An
excess of aggregate demand will lead to a rise in the price level. If the price level increases this affects the
real interest rate. Recall that the real interest rate is the nominal interest rate minus inflation. If inflation
rises and the nominal interest rate is constant then the real interest rate will rise. A rise in the real interest
rate would lead to a fall in investment by firms.
The causes of business cycles, therefore, are technology shocks that cause permanent shifts in aggregate
supply, but when aggregate supply shifts the expectations of economic actors are still correct and so there
is no reason for governments or central banks to intervene and apply policy prescriptions. The real business
cycle model, therefore, does not see growth over time as being a deterministic trend but a stochastic one.
In real business cycle models, employment, labour productivity and real wages are procyclical.
CASE STUDY Kydland and Prescott and Real Business Cycles

Fi EE. K
Finn Kydland and Edward C. Prescott won the Nobel Prize for Economics in 2004 and their award was
based on the work they had done on business cycles. Their work became associated with real business
cycles because of the focus on real shocks to the economy as opposed to nominal shocks as the key
driver of deviations in output. The question Kydland and Prescott were interested in was not measuring
business cycles but focusing on the pattern of output and employment around the trend and asking why
this seemed to happen in a repeated fashion over time.
Many textbooks explain the business cycle in terms of four phases – boom, slowdown, recession,
upturn. The term ‘cycle’ implies a ‘what goes around comes around’ type of approach to an economy.
Such a view of cycles implies an almost inevitable trend where growth turns into boom, which in turn
leads to the start of decline that leads to recession before the process begins again. However, Kydland
and Prescott used a generally agreed scientific definition of ‘cycles’ that makes reference to a point of
departure – in this case the trend of economic growth. Kydland and Prescott refer to these recurrent
departures as ‘deviations’.
They argue that business cycles must be seen as periodic deviations from trend growth and that busi-
ness cycles are neither inevitable nor evolutionary. As such the explanation for a downturn in economic
activity cannot, in itself, be found in the reasons why growth occurred in the first place. Equally, the seeds
of an expansion in growth are not to be found in a recession.
In analysing the behaviour of these deviations from trend they sought to challenge some conventional
wisdom that had grown up around business cycles. For example, in times of economic downturn the
expectation would be that the price level would fall and in times of strong economic growth it would be
anticipated that prices would rise – in other words, inflation is procyclical. This implies that in a downturn
firms seek to reduce prices to encourage sales and are prevented from increasing prices to improve
margins because of the lack of demand. Similarly, in times of economic growth, firms experience rising
demand and possibly wage and other costs. They are able to increase prices to improve margins without
too much damage to business because of the strong growth in demand.
Kydland and Prescott argued that, in fact, price showed a countercyclical behaviour – when economic
growth slowed down, prices rose and when economic growth was strong, prices fell. They further argued
that real wages fall as growth increases and vice versa (or are not related to the business cycle) and that
the money supply was an important factor in leading economic growth.
Price procyclicality is important because if we are looking for the causes of changes in economic
activity as a whole, we would presume to be looking for something fairly major as being the cause – large
price rises, for example, or shocks caused by changes in things like the money supply. If price procyclical-
ity is a myth then research into the causes of changes in cycles might be misguided. Think of it in terms of
a thermometer in a room. The thermometer tells us what the temperature of the room is but is not a cause
of the temperature. Looking at the properties of the thermometer to explain the temperature of the room
would lead us down the wrong path.
Kydland and Prescott argue that an important factor in explaining business cycles is the decisions
people make about how they devote their time between leisure (non-market activities) and income-
earning activities. After analysing the factors that may influence business cycles they come to the
following conclusions:
t Aggregate hours worked (a measure of labour input) is strongly correlated with changes in GDP. The
problem with this is that the contributions to GDP for all workers are considered the same. Kydland and
Prescott point out that the contribution by the hours worked by a brain surgeon is not the same as that of
a porter in a hospital. With some consideration of this, Kydland and Prescott conclude that real wages
are more procyclical and something which traditional literature on business cycles would not suggest.
t The capital stock is largely unrelated to real GDP but is closely correlated if a time lag of about one
year is included.
t With regard to the factors affecting aggregate demand – consumption, investment and government
spending – Kydland and Prescott report that consumption and investment are highly procyclical
whereas government spending does not seem to be correlated with growth.
(Continued)
t They also comment that imports are procyclical as are exports but with a six-month to a year time lag.
t Labour and capital income is strongly procyclical.
t They find no evidence that narrow money (M1) leads the business cycle. In other words, they do not
find evidence that a rise in M1 will lead to a spurt in growth.
t Credit arrangements are likely to play a significant role in future analysis of business cycle theory.
t The price level is countercyclical.
Kydland and Prescott’s work has prompted considerable research not least the necessity to look at
what might be happening in the macroeconomy. It might be necessary to look at factors other than those
that simply describe the data. This emphasis on the quantitative features rather than qualitative features
(what it tells us rather than what we think it might signify) has been a feature of a re-assessment of stat-
istical analysis in economics, particularly the analysis of time series data. What do long-term time series
tell us in relation to short-term series?
Real business cycle theory does not view a recession as a ‘failure’ in the economy nor might a boom
also be seen as a failure. (A boom might be interpreted as a failure in economic management because it
is unsustainable which is why politicians often refer to the ‘bad old days of boom and bust’.) Kydland and
Prescott see business cycles as explanations of shock to the economy that are understandable reactions
rather than failures. Their work tends to dismiss the ‘sticky prices’ explanation for a slowdown in growth
and also the mismatch between investment and consumption and the monetarist argument of market
failure in price signals. Instead they look at real shocks to the economy and the adjustment process to
those shocks, which could last for some time after. Essentially, Kydland and Prescott argued that business
cycles could occur perfectly naturally within a competitive environment despite the implication in
traditional theory that, for example, perfect competition would not result in long periods of unemployment.
Real business cycle theory is not without its critics. In particular, the implication that shocks to supply
tend to be permanent rather than transitory has been questioned as an explanation of recessions, and
empirical studies have also questioned the extent to which the assumptions of the model and the predic-
tions about the cyclicality of economic variables match the evidence.
Finn E. Kydland (left) and

Edward C. Prescott (right);
winners of the Nobel Prize
for Economics in 2004.
CONCLUSION
In this chapter we have provided some background to the more extensive analysis of short-term economic
fluctuations in the coming chapters. We have introduced a number of key concepts which need to be
borne in mind as we tackle the next chapters, not least building a familiarity with the behaviour of key
macroeconomic variables over time.
We have also learned that economists have different interpretations of business cycles based on dif-
ferent assumptions about how the economy works and the extent to which markets clear and how eco-
nomic actors behave. Models of business cycles focus on both the supply side and demand side of the
economy and it is likely that the answers to the questions surrounding policy decisions to help smooth
out deviations in trend growth are to be found in a combination of these different models. The model of
the real business cycle raises questions about whether the trends that we ‘see’ in time series data, which
form the basis of analysis, are actually present and if trends do not exist then policy measures designed
to reduce deviations from trend are misguided.
IN THE NEWS
Employment and Unemployment in an Economic Downturn

We have seen that key macroeconomic variables such as employment and unemployment
behave in particular ways during periods of deviation of output from trend. However, the
experience of the UK economy in recent years has caused economists to re-assess their
assumptions about cyclicality and seek explanations for observed events.
Weak Growth and Rising some interesting questions which what is happening. The answers
Employment have led economists to look closer might lie in a number of areas.
at the data to find answers. Gross Employers know that making staff
In the time period between the domestic product (GDP) during this redundant would help to cut costs
three months to December 2011 period has been sluggish at best. in the short run but they might also
and the same period in 2012 the During 2011, growth was reported be looking at the type of employ-
number of people working full-time at under 1.0 per cent for three of the ees they have. If these employees
in the UK rose by 394,000 and the four quarters, at just 0.4 per cent in have important skills it might not be
number of people working part-time the first quarter of 2012, −0.8 per cent cost-effective to lose them only to
rose by 190,000. This represented in the second quarter, a bounce back have to suffer the cost of having to
the largest increase since 2005 and due to the Olympic Games effect in recruit staff when the upturn comes
meant that the number of people the third quarter of 1.6 per cent and a and possibly train up staff to the
employed in the UK was recorded 0.1 per cent rise in the fourth quarter. levels of those they have already.
as 29.73 million or an employment The Office for National Statistics As a result, some firms may be play-
rate of 71.5 per cent of the popu- reported that GDP in volume terms ing a waiting game and making a
lation aged 16–64. The number of shrank by 0.3 per cent in the fourth judgement that short-term benefits
people unemployed in the three quarter of 2012 and Her Majesty’s in terms of cost saving might be out-
months to December 2011 stood at Treasury (HMT) reported real GDP weighed by the medium-term disad-
2.66 million and in the same period in 2010 as £1,427 billion in 2010 and vantages of not having the right staff
in 2012 the figure was 2.51 million. £1,440 billion in 2011. at the right time and so are holding
The claimant count in January In a time, therefore, when the onto employees.
2012 stood at 1.60 million and in economy of the UK is performing It might also be the case that
December 2012 at 1.55 million. poorly, it might be expected that if employees are taking into account
In themselves, these figures employment is procyclical and unem- the prospects facing them in a tough
might not seem particularly remark- ployment countercyclical, why are economic environment and agree-
able but when set against the per- both behaving contrary to expecta- ing far more flexible working con-
formance of the economy during tions? For some time, economists and ditions with employers in an effort
a similar time period they do raise analysts have been asked to explain to hold onto their jobs. This might
(Continued)
include accepting reduced working available. There has also been an 2008. What this means is that the UK
hours or agreeing cuts in pay to help increase in the number of people is producing 12.8 per cent less than
employers to continue to afford to becoming self-employed with some it would have been if pre-recession
keep workers on. Average earnings 367,000 registering as self-employed levels of productivity growth had
growth was under 2 per cent in 2011 between 2008 and 2012 according to been maintained. The reasons why
and slowed from 1.7 per cent to the ONS. If people are working part- employment has been rising and
1.4 per cent in 2012. With inflation time or are self-employed then they unemployment rising by less than
running above 2.5 per cent over these are not unemployed even though expected is that real wages are
two years, real wages fell which may they might not be in a ‘first choice’ low, business investment has been
also help to explain why employment employment position. weak (16 per cent lower than its
rose or why unemployment did not The Institute for Fiscal Studies pre-recession peak) and capital is
rise as much as might be expected (IFS) in the UK published a report misallocated. Capital is misallocated
in an economic downturn. in February 2013 which suggested because banks are being more sym-
The number of people accepting that there was little evidence for pathetic to firms who might be in fin-
part-time work or being employed the idea that firms were ‘hoarding’ ancial trouble or who are suffering
in jobs for which they are over- staff in the expectation of an upturn from lower productivity and are also
skilled (a situation termed under- in the economy. Whilst employment more risk averse in their investment
employment) has also risen. Those levels have remained ‘robust’ and strategies which together reduce
getting part-time jobs might prefer the unemployment ‘mercifully low’, the entry and exit of firms from
full time work but are willing to take contrary to other periods of reces- industry.
part-time jobs rather than have sion experienced in the UK, it is pro-
to claim benefits and might also ductivity which has suffered. The IFS Questions
believe that having some job puts suggests that productivity per hour 1 What is meant by the terms ‘pro-
them in a better position to apply per worker declined by 2.6 per cent cyclical’ and ‘countercyclical’.
for full time work when it becomes in 2013 compared to the beginning of 2 Why would you expect employ-
ment to fall and unemployment
Productivity is a measure of output per worker per period of time. Unemployment to rise during an economic
may not be rising as fast in the UK as expected in a recession but how productive downturn?
are those that are employed? 3 What economic arguments are
there for firms to ‘hoard’ workers
in anticipation of better economic
times to come? How persuasive
do you find these arguments?
4 What effect do falling real
wages have on firms’ decisions
on the demand for labour?
5 The IFS report noted that whilst
both employment and unemploy-
ment had not been affected in
the same way as in previous UK
recessions, the cost has been a
sharp fall in productivity. What
might be the consequences of
the fall in productivity for the UK
economy?
SUMMARY
● Economies experience periods of changing levels of ● Macroeconomic data can be viewed in pairs with one of
economic activity. the pairs generally GDP. The variable compared may be
● Key macroeconomic data are often time series data either procyclical or countercyclical.
which raises questions about the validity and reliability ● Collecting macroeconomic data can allow economists
of statistical tests applied to data sets. to view certain indicators as leading, coincident or
● Economic growth appears to follow a trend which rises lagging.
over a period of time. ● Changes in the business cycle can be caused by
● Deviations from this trend are known as the business changes in decision-making by households and firms,
cycle. by external shocks, government policy and changes in
confidence or expectations of the future.
● The business cycle has characteristic features which
include peaks in economic activity, slowdown, troughs ● Business cycle models differ in the assumptions they
and upturns with key turning points. make about the extent to which markets clear and the
relationship between the supply side and demand side
● Trends can be stationary and nonstationary. Non-
of the economy.
stationary data can exhibit deterministic trends which
change by a constant amount independent of time or ● Real business cycles emphasize the effects of changes
be stochastic where the trend variable changes by a in technology as causes of changes in economic
random amount. activity.
QUESTIONS FOR REVIEW

1 What is time series data? Give three examples of key 5 Unemployment is classified as a lagging indicator.
macroeconomic variables that are examples of time Explain what this means and why unemployment is
series data. classed as such.
2 What are the main stages of a typical business cycle 6 Why might changes in household decision-making
and how long do these stages last? cause a deviation in GDP from trend?
3 What is the difference between a deterministic trend 7 What role does household and firms’ confidence play in
and a stochastic trend? business cycles?
4 Would you expect the following variables to be 8 What is the role of unanticipated price changes in the
procyclical or countercyclical if GDP was above trend? new classical model of business cycles?
Explain. 9 Why do Keynesian models of the business cycle
a. inflation emphasize that markets do not always clear
b. unemployment immediately?
c. employment 10 What is the key difference between real business cycle
d. real wages models and other business cycle models?
e. nominal interest rates.
PROBLEMS AND APPLICATIONS

1 Look at Figure 30.1. For either the UK or the EU: the growth rate of GDP is recorded as 2.8 per cent and
a. estimate the amplitude of the deviations from trend 2.0 per cent respectively. Is the country experiencing a
over the period shown recession? Explain.
b. estimate the length of time between the beginning
3 Go to the national statistics office website for your
of the deviation from trend and the return to trend in
country (this could be the Office for National Statistics in
each case.
the UK or Eurostat for the EU) and look up unemployment
2 In one time period the growth rate of GDP of a country and inflation figures over the last 30 years. Plot the data
is recorded as 3.4 per cent against a trend growth rate on a spreadsheet, graph it and identify the trend. Is the
of output of 2.8 per cent. In the next two time periods, trend stationary, nonstationary or indeterminate? Explain.
4 Is it always possible to discern a trend in any time 7 Why might household and firms’ confidence and
series data? What problems might arise if trends are expectations change leading to deviations in output
apportioned to time series data that are not really from trend? Is there any way in which changes in
present? confidence can be measured to provide an indicator of
changes in economic activity?
5 Look up the following comovements for the country
in which you are studying on an appropriate website. 8 There is a fall in the price level which workers do not
Explain whether the comovements are procyclical or anticipate. Explain what effect such a scenario will
countercyclical: have on output.
a. GDP and inflation 9 To what extent do you think that workers are always
b. GDP and employment fooled by the inflation fallacy?
c. GDP and unemployment
d. GDP and the money supply (M1). 10 Which business cycle model do you find the most
compelling and why?
6 Firms experience a rise in stocks. Explain why this might
have occurred and what you expect firms’ response to
this event might be and how this might affect output.
32 AGGREGATE DEMAND
AND AGGREGATE SUPPLY
W e have seen how economic activity can fluctuate over different time periods. What causes short-run
fluctuations in economic activity? What, if anything, can public policy do to prevent periods of fall-
ing incomes and rising unemployment? When recessions and depressions occur, how can policymakers
reduce their length and severity? These are the questions that we take up now.
The variables that we study are largely those we have already seen in previous chapters. They include
GDP, unemployment and the price level. Also familiar are the policy instruments of government spend-
ing, taxes, the money supply, and interest rates. The focus of our analysis is on the economy’s short-run
fluctuations around its long-run trend.
Although there remains some debate among economists about how to analyse short-run fluctuations,
and in the preceding chapter we introduced the IS-LM model, in this chapter we will look at the model of
AD and AS, which is widely used among economists. Learning how to use this model for analysing the
short-run effects of various events and policies is the primary task ahead.
THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

Short-run fluctuations in economic activity occur in all countries and in all times throughout history. As a
starting point for understanding these year-to-year fluctuations, let’s remind ourselves of some of their
most important properties.
Fact 1: Economic Fluctuations are Irregular and Unpredictable

Economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, busi-
ness is good. During such periods of economic expansion, firms find that customers are plentiful and that
profits are growing. On the other hand, when real GDP falls during recessions, businesses have trouble.
During such periods of economic contraction, many firms experience declining sales and dwindling profits.
We saw in Chapter 30 that economic fluctuations are not at all regular, and they are almost impossible to
predict with much accuracy.
Fact 2: Most Macroeconomic Quantities Fluctuate Together

Real GDP is the variable that is most commonly used to monitor short-run changes in the economy
because it is the most comprehensive measure of economic activity. Real GDP measures the value of all
final goods and services produced within a given period of time. It also measures the total income (adjus-
ted for inflation) of everyone in the economy.
It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure
of economic activity one looks at. Most macroeconomic variables that measure some type of income,
spending or production, fluctuate closely together. When real GDP falls in a recession, so do personal
income, corporate profits, consumer spending, investment spending, industrial production, retail sales,
679
home sales, auto sales and so on. Because recessions are economy-wide phenomena, they show up in
many sources of macroeconomic data.
Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. In
particular, investment spending varies greatly over the business cycle. When economic conditions deteri-
orate, much of the decline is attributable to reductions in spending on new factories, housing and invent-
ories. Investment in the UK, for example, fell by 5.1 per cent in 2008, by −11.4 per cent in 2009, and was
just positive at 0.1 per cent in 2010 before another fall of 2.9 per cent in 2011.
Fact 3: As Output Falls, Unemployment Rises

Changes in the economy’s output of goods and services are strongly correlated with changes in the
economy’s utilization of its labour force. In other words, when real GDP declines the rate of unemploy-
ment rises. The negative relationship between unemployment and real GDP is referred to as Okun’s law
after the Yale economist who published his observations in the 1960s. Okun noted that in order to keep
the unemployment rate steady, real GDP needs to grow at or close to its potential. If the unemployment
rate is to be reduced then real GDP must grow above potential. Being more specific, to reduce the unem-
ployment rate by 1 per cent in a year, real GDP must rise by around 2 per cent more than potential GDP
over the year.
Okun’s law a ‘law’ which is based on observations that in order to keep the unemployment rate steady, real GDP needs to
grow at or close to its potential
Okun’s findings are hardly surprising: when firms choose to produce a smaller quantity of goods and
services, they lay off workers, expanding the pool of unemployed. However, there is generally a time-lag
between any downturn in economic activity and a rise in unemployment and vice versa. Even when posi-
tive growth resumes, therefore, unemployment is likely to continue to rise for some time afterwards. As
we noted in Chapter 30, unemployment is referred to as a ‘lagged indicator’.
EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

Describing the patterns that economies experience as they fluctuate over time is easy. Explaining what
causes these fluctuations is more difficult. Indeed, compared to the topics we have studied in previous
chapters, the theory of economic fluctuations remains controversial. In this chapter and the next two
chapters, we develop the model that most economists use to explain short-run fluctuations in economic
activity.
How the Short Run Differs from the Long Run

In previous chapters we developed theories to explain what determines most important macroeco-
nomic variables in the long run. We have looked at the level and growth of productivity and real GDP;
explained how the financial system works and how the real interest rate adjusts to balance saving and
investment; why there is always some unemployment in the economy; explained the monetary system
and how changes in the money supply affect the price level, the inflation rate and the nominal interest
rate; and then extended this analysis to open economies in order to explain the trade balance and the
exchange rate.
All of this previous analysis was based on two related ideas – the classical dichotomy and monetary
neutrality. Recall that the classical dichotomy is the separation of variables into real variables (those that
measure quantities or relative prices) and nominal variables (those measured in terms of money). Accord-
ing to classical macroeconomic theory, changes in the money supply affect nominal variables but not
real variables. As a result of this monetary neutrality, we were able to examine the determinants of real
CHAPTER 32 AGGREGATE DEMAND AND AGGREGATE SUPPLY 681
variables (real GDP, the real interest rate and unemployment) without introducing nominal variables (the
money supply and the price level).
Do these assumptions of classical macroeconomic theory apply to the world in which we live? The
answer to this question is of central importance to understanding how the economy works: most eco-
nomists believe that classical theory describes the world in the long run but not in the short run. Beyond
a period of several years, changes in the money supply affect prices and other nominal variables but do
not affect real GDP, unemployment or other real variables. When studying year-to-year changes in the eco-
nomy, however, the assumption of monetary neutrality is no longer appropriate. Most economists believe
that, in the short run, real and nominal variables are highly intertwined. In particular, changes in the money
supply can temporarily push output away from its long-run trend.
To understand the economy in the short run, therefore, we need a new model. To build this new model,
we rely on many of the tools we have developed in previous chapters, but we have to abandon the clas-
sical dichotomy and the neutrality of money.
The Basic Model of Economic Fluctuations

Our model of short-run economic fluctuations focuses on the behaviour of two variables. The first variable
is the economy’s output of goods and services, as measured by real GDP. The second variable is the overall
price level, an average of prices of all goods and services in an economy as measured by the CPI or the
GDP deflator. Notice that output is a real variable, whereas the price level is a nominal variable. Hence,
by focusing on the relationship between these two variables, we are highlighting the breakdown of the
classical dichotomy.
price level an average of prices of all goods and services in an economy as measured by the CPI or the GDP deflator
We analyse fluctuations in the economy as a whole with the model of aggregate demand (AD) and
aggregate supply (AS), which is illustrated in Figure 32.1. On the vertical axis is the overall price level in the
economy. On the horizontal axis is the overall quantity of goods and services. The aggregate demand curve
FIGURE 32.1
Price level
A
Aggregate
t DDemand
d and Aggregate
Supply
Economists use the model of AD and AS
Aggregate
to analyse economic fluctuations. On the supply
vertical axis is the overall level of prices.
On the horizontal axis is the economy’s
total output of goods and services. Output
and the price level adjust to the point at Equilibrium
which the AS and AD curves intersect. price level
Aggregate
demand
0 Equilibrium Quantity of output

output
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 produce and
sell at each price level. According to this model, the price level and the quantity of output adjust to bring AD
and AS into balance.
model of aggregate demand and aggregate supply the model that most economists use to explain short-run
fluctuations in economic activity around its long-run trend
aggregate demand curve a curve that shows the quantity of goods and services that households, firms and the
government want to buy at each price level
aggregate supply curve a curve that shows the quantity of goods and services that firms choose to produce and sell at
each price level
It may be tempting to view the model of AD and AS as nothing more than a large version of the model
of market demand and market supply, which we introduced in Chapter 3. Yet in fact this model is quite
different. When we consider demand and supply in a particular market for a good such as tablet com-
puters, the behaviour of buyers and sellers depends on the ability of resources to move from one market
to another. When the price of tablet computers rises, the quantity demanded falls because buyers will
use their incomes to buy products other than tablets. Similarly, a higher price of tablets raises the quantity
supplied because firms that produce these gadgets can increase production by hiring workers away from
other parts of the economy. This microeconomic substitution from one market to another is impossible
when we are analysing the economy as a whole. After all, the quantity that our model is trying to explain –
real GDP – measures the total quantity produced in all of the economy’s markets. To understand why the
AD curve is downwards sloping and why the AS curve is upwards sloping, we need a macroeconomic
theory. Developing such a theory is our next task.
SELF TEST How does the economy’s behaviour in the short run differ from its behaviour in the long
run? ● Draw the model of AD and AS. What variables are on the two axes?
THE AGGREGATE DEMAND CURVE

The AD curve tells us the quantity of all goods and services demanded in the economy at any given price
level. As Figure 32.2 illustrates, the AD curve is downwards sloping reflecting the inverse relationship
between the price level and national income we outlined in Chapter 31. This means that, other things
equal, a fall in the economy’s overall level of prices (from, say, P1 to P2) tends to raise the quantity of goods
and services demanded (from Y1 to Y2).
Why the Aggregate Demand Curve Slopes Downwards

Why does a fall in the price level raise the quantity of goods and services demanded? To answer this ques-
tion it is useful to recall that GDP (which we denote as Y ) is the sum of consumption (C), investment (I ),
government purchases (G) and net exports (NX ):
Y = C + I + G + NX
Each of these four components contributes to the AD for goods and services. For now, we assume that
government spending is fixed by policy. The other three components of spending – consumption, invest-
ment and net exports – depend on economic conditions and, in particular, on the price level. To understand
the downwards slope of the AD curve, therefore, we must examine how the price level affects the quantity
of goods and services demanded for consumption, investment and net exports.
FIGURE 32.2
Price level
The A
Th Aggregate
t DDemand Curve
A fall in the price level from P1 to P2
increases the quantity of goods and
services demanded from Y1 to Y2 . There
are three reasons for this negative P1
relationship. As the price level falls,
real wealth rises, interest rates fall
and the exchange rate depreciates.
These effects stimulate spending P2
on consumption, investment and 1. A decrease
net exports. Increased spending on Aggregate
in the price
demand
these components of output means a level ...
larger quantity of goods and services
demanded. 0 Y1 Y2 Quantity of output
2. ... increases the quantity of

goods and services demanded.
The Price Level and Consumption: The Wealth Effect Consider the money that you hold in your pocket
and your bank account. The nominal value of this money is fixed, but its real value is not. When prices
fall, this money is more valuable because then it can be used to buy more goods and services. Thus, a
decrease in the price level makes consumers wealthier, which in turn encourages them to spend more.
The increase in consumer spending means a larger quantity of goods and services demanded.
The Price Level and Investment: The Interest Rate Effect As we discussed in Chapter 27, the price
level is one determinant of the quantity of money demanded. The lower the price level, the less money
households need to hold to buy the goods and services they want. When the price level falls, therefore,
households try to reduce their holdings of money by lending some of it out which in turn increases the
supply of real money balances. For instance, a household might use its excess money to buy interest-
bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the
bank would use these funds to make more loans. In either case, as households try to convert some
of their money into interest-bearing assets, they drive down interest rates. Lower interest rates, in
turn, encourage borrowing by firms that want to invest in new factories and equipment and by house-
holds who want to invest in new housing. Thus, a lower price level reduces the interest rate, encour-
ages greater spending on investment goods, and thereby increases the quantity of goods and services
demanded.
The Price Level and Net Exports: The Exchange Rate Effect As we have just discussed, a lower price
level lowers the interest rate. In response, some investors will seek higher returns by investing abroad.
For instance, as the interest rate on European government bonds falls, an investment fund might sell
European government bonds in order to buy US government bonds. As the investment fund tries to con-
vert its euros into dollars in order to buy the US bonds, it increases the supply of euros in the market for
foreign currency exchange. The increased supply of euros causes the euro to depreciate relative to other
currencies. Because each euro buys fewer units of foreign currencies, non-European goods (i.e. imports)
become more expensive to European residents but exporters find that foreign buyers get more euros for
each unit of their currency. This change in the real exchange rate (the relative price of domestic and foreign
goods) increases European exports of goods and services and decreases European imports of goods and
services. Net exports, which equal exports minus imports, also increase. Thus, when a fall in the European
price level causes European interest rates to fall, the real value of the euro falls, and this depreciation
stimulates European net exports and thereby increases the quantity of goods and services demanded in
the European economy.
Summary There are, therefore, three distinct but related reasons why a fall in the price level increases the
quantity of goods and services demanded: (1) consumers are wealthier, which stimulates the demand for
consumption goods; (2) interest rates fall, which stimulates the demand for investment goods; and (3) the
exchange rate depreciates, which stimulates the demand for net exports. For all three reasons, the AD
curve slopes downwards.
It is important to keep in mind that the AD curve (like all demand curves) is drawn holding ‘other things
equal’. In particular, our three explanations of the downwards sloping AD curve assume that the money
supply is fixed. That is, we have been considering how a change in the price level affects the demand for
goods and services, holding the amount of money in the economy constant. As we will see, a change in
the quantity of money shifts the AD curve. At this point, just keep in mind that the AD curve is drawn for
a given quantity of money.
Why the Aggregate Demand Curve Might Shift

In Chapter 31, we noted how changes in monetary and fiscal policy can cause a shift in the LM and IS
curves and, at a given price level, a shift in AD. We are going to explore shifts in the AD curve in more
detail here. The downwards slope of the AD 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 a given price level. When one of these other factors changes, the AD curve
shifts.
Let’s consider some examples of events that shift AD. We can categorize them according to which
component of spending is most directly affected.
Shifts Arising from Consumption Suppose people suddenly become more concerned about saving for
retirement and, as a result, reduce their current consumption. Because the quantity of goods and ser-
vices demanded at any price level is lower, the AD curve shifts to the left. Conversely, imagine that a
stock market boom makes people wealthier and less concerned about saving. The resulting increase in
consumer spending means a greater quantity of goods and services demanded at any given price level,
so the AD curve shifts to the right.
Thus, any event that changes how much people want to consume at a given price level shifts the AD
curve. One policy variable that has this effect is the level of taxation. When the government cuts taxes, it
encourages people to spend more, so the AD curve shifts to the right. When the government raises taxes,
people cut back on their spending and the AD curve shifts to the left.
Shifts Arising from Investment Any event that changes how much firms want to invest at a given price
level also shifts the AD curve. For instance, imagine that the computer industry introduces a faster line of
computers, and many firms decide to invest in new computer systems. Because the quantity of goods
and services demanded at any price level is higher, the AD curve shifts to the right. Conversely, if firms
become pessimistic about future business conditions, they may cut back on investment spending, shifting
the AD curve to the left.
Tax policy can also influence AD through investment. An investment tax credit (a tax rebate tied to a
firm’s investment spending) increases the quantity of investment goods that firms demand at any given
interest rate. It therefore shifts the AD curve to the right. The repeal of an investment tax credit reduces
investment and shifts the AD curve to the left.
Another policy variable that can influence investment and AD is the money supply. As we discuss more
fully in the next chapter, an increase in the money supply lowers the interest rate in the short run (the
LM curve shifts to the right). This makes borrowing less costly, which stimulates investment spending
and thereby shifts the AD curve to the right at a given price level. Conversely, a decrease in the money
supply shifts the LM curve to the left and raises the interest rate, discourages investment spending, and
thereby shifts the AD curve to the left at the given price level. Many economists believe that changes in
monetary policy have been an important source of shifts in AD in most developed economies at some
points in their history.
Shifts Arising from Government Purchases The most direct way that policymakers shift the AD curve
is through government purchases. For example, suppose the government decides to reduce purchases
of new weapons systems. Because the quantity of goods and services demanded at any price level is
lower, the AD curve shifts to the left. Conversely, if the government starts building more motorways, the
result is a greater quantity of goods and services demanded at any price level, so the AD curve shifts to
the right.
Shifts Arising from Net Exports Any event that changes net exports for a given price level also shifts
AD. For instance, when the US experiences a recession, it buys fewer goods from Europe. This reduces
European net exports and shifts the AD curve for the European economy to the left. When the US recovers
from its recession, it starts buying European goods again, shifting the AD curve to the right.
Net exports sometimes change because of movements in the exchange rate. Suppose, for instance,
that international speculators bid up the value of the euro in the market for foreign currency exchange. This
appreciation of the euro would make goods produced in the euro area more expensive compared to for-
eign goods, which would depress net exports and shift the AD curve to the left. Conversely, a depreciation
of the euro stimulates net exports and shifts the euro area AD curve to the right.
Summary In the next chapter we analyse the AD curve in more detail in relation to the tools of monetary
and fiscal policy which can shift AD and whether policymakers should use these tools for that purpose.
At this point, however, you should have some idea about why the AD curve slopes downwards and what
kinds of events and policies can shift this curve. Table 32.1 summarizes what we have learned so far.
The AD Curve: Summary

TABLE 32.1
Why does the AD curve slope downward?
1 The wealth effect: A lower price level increases real wealth, which encourages spending on
consumption.
2 The interest-rate effect: A lower price level reduces the interest rate, which encourages
spending on investment.
3 The exchange-rate effect: A lower price level causes the real exchange rate to depreciate,
which encourages spending on net exports.
Why might the AD curve shift?

1 Shifts arising from consumption: An event that makes consumers spend more at a given
price level (a tax cut, a stock market boom) shifts the AD curve to the right. An event that
makes consumers spend less at a given price level (a tax hike, a stock market decline) shifts
the AD curve to the left.
2 Shifts arising from investment: An event that makes firms invest more at a given price level
(optimism about the future, a fall in interest rates due to an increase in the money supply)
shifts the AD curve to the right. An event that makes firms invest less at a given price level
(pessimism about the future, a rise in interest rates due to a decrease in the money supply)
shifts the AD curve to the left.
3 Shifts arising from government purchases: An increase in government purchases of goods
and services (greater spending on defence or motorway construction) shifts the AD curve to
the right. A decrease in government purchases on goods and services (a cutback in defence
or motorway spending) shifts the AD curve to the left.
4 Shifts arising from net exports: An event that raises spending on net exports at a given price
level (a boom overseas, an exchange rate depreciation) shifts the AD curve to the right.
An event that reduces spending on net exports at a given price level (a recession overseas,
an exchange rate appreciation) shifts the AD curve to the left.
SELF TEST Explain the three reasons why the AD curve slopes downwards. ● Give an example of an event
that would shift the AD curve. Which way would this event shift the curve?
THE AGGREGATE SUPPLY CURVE

The AS curve tells us the total quantity of goods and services that firms produce and sell at any given price
level. Unlike the AD curve, which is always downwards sloping, the AS curve shows a relationship that
depends crucially on the time horizon being examined. In the long run, the AS curve is vertical, whereas
in the short run the AS curve is upwards sloping. To understand short-run economic fluctuations, and
how the short-run behaviour of the economy deviates from its long-run behaviour, we need to examine
both the long-run AS curve and the short-run AS curve.
Why the Aggregate Supply Curve is Vertical in the Long Run

What determines the quantity of goods and services supplied in the long run? We implicitly answered
this question earlier in the book when we analysed the process of economic growth. In the long run, an
economy’s production of goods and services (its real GDP) depends on its supplies of labour, capital and
natural resources, and on the available technology used to turn these factors of production into goods and
services. Because the price level does not affect these long-run determinants of real GDP, the long-run AS
curve is vertical, as in Figure 32.3. In other words, in the long run, the economy’s labour, capital, natural
resources and technology determine the total quantity of goods and services supplied, and this quantity
supplied is the same regardless of what the price level happens to be.
The vertical long-run AS curve is, in essence, just an application of the classical dichotomy and monet-
ary neutrality. As we have already discussed, classical macroeconomic theory is based on the assump-
tion that real variables do not depend on nominal variables. The long-run AS curve is consistent with this
idea because it implies that the quantity of output (a real variable) does not depend on the level of prices
(a nominal variable). As noted earlier, most economists believe that this principle works well when study-
ing the economy over a period of many years, but not when studying year-to-year changes. Thus, the AS
curve is vertical only in the long run.
One might wonder why supply curves for specific goods and services can be upwards sloping if the
long-run AS curve is vertical. The reason is that the supply of specific goods and services depends on
relative prices – the prices of those goods and services compared to other prices in the economy. For
example, when the price of tablet computers rises, holding other prices in the economy constant, there is
an incentive for suppliers of tablets to increase their production by taking labour, silicon, plastic and other
inputs away from the production of other goods, such as mobile phones or laptop computers. By contrast,
the economy’s overall production of goods and services is limited by its labour, capital, natural resources
and technology. Thus, when all prices in the economy rise together, there is no change in the overall quan-
tity of goods and services supplied because relative prices and thus incentives have not changed.
Why the Long-Run AS Curve Might Shift

The position of the long-run AS curve shows the quantity of goods and services predicted by classical
macroeconomic theory. This level of production is sometimes called potential output or full-employment
output. To be more accurate, we call it the natural rate of output because it shows what the economy
produces when unemployment is at its natural, or normal, rate. The natural rate of output is the level of
production towards which the economy gravitates in the long run.
natural rate of output the output level in an economy when all existing factors of production (land, labour, capital and
technology resources) are fully utilized and where unemployment is at its natural rate
FIGURE 32.3
Price level
The LLong-Run
Th R A Aggregate Supply Curve
In the long run, the quantity of output Long-run
supplied depends on the economy’s aggregate
quantities of labour, capital and natural supply
resources and on the technology for turning
these inputs into output. The quantity P1
supplied does not depend on the overall
price level. As a result, the long-run AS curve
is vertical at the natural rate of output. P2
2. ... does not affect
1. A change the quantity of goods
in the price and services supplied
level ... in the long run.
0 Natural rate Quantity of output

of output
Any change in the economy that alters the natural rate of output shifts the long-run AS curve. Because
output in the classical model depends on labour, capital, natural resources and technological knowledge,
we can categorize shifts in the long-run AS curve as arising from these sources.
Shifts Arising from Labour Imagine that an economy experiences an increase in immigration from
abroad. Because there would be a greater number of workers, the quantity of goods and services supplied
would increase. As a result, the long-run AS curve would shift to the right. Conversely, if many workers left
the economy to go abroad, the long-run AS curve would shift to the left.
The position of the long-run AS curve also depends on the natural rate of unemployment, so any change
in the natural rate of unemployment shifts the long-run AS curve. For example, if the government were
to raise the minimum wage substantially, the natural rate of unemployment would rise, and the economy
would produce a smaller quantity of goods and services. As a result, the long-run AS curve would shift to
the left. Conversely, if a reform of the unemployment insurance system were to encourage unemployed
workers to search harder for new jobs, the natural rate of unemployment would fall and the long-run AS
curve would shift to the right.
Shifts Arising from Capital An increase in the economy’s capital stock increases productivity and,
thereby, the quantity of goods and services supplied. As a result, the long-run AS curve shifts to the right.
Conversely, a decrease in the economy’s capital stock decreases productivity and the quantity of goods
and services supplied, shifting the long-run AS curve to the left.
Notice that the same logic applies regardless of whether we are discussing physical capital or human
capital. An increase either in the number of machines or in the number of university degrees will raise the
economy’s ability to produce goods and services. Thus, either would shift the long-run AS curve to the right.
Shifts Arising from Natural Resources An economy’s production depends on its natural resources, includ-
ing its land, minerals and weather. A discovery of a new mineral deposit shifts the long-run AS curve to the
right. A change in weather patterns that makes farming more difficult shifts the long-run AS curve to the left.
In many countries, important natural resources are imported from abroad. A change in the availability
of these resources can also shift the AS curve. Events occurring in the world oil market, in particular, have
historically been an important source of shifts in AS.
Shifts Arising from Technological Knowledge Perhaps the most important reason that the economy
today produces more than it did a generation ago is that our technological knowledge has advanced. The
invention of the computer, for instance, has allowed us to produce more goods and services from any given
amounts of labour, capital and natural resources. As a result, it has shifted the long-run AS curve to the right.
Although not literally technological, there are many other events that act like changes in technology.
The opening up of international trade has effects similar to inventing new production processes, so it also
shifts the long-run AS curve to the right. Conversely, if the government passed new regulations preventing
firms from using some production methods, perhaps because they were too dangerous for workers, the
result would be a leftwards shift in the long-run AS curve.
Summary The long-run AS curve reflects the classical model of the economy we developed in previous
chapters. Any policy or event that raised real GDP in previous chapters can now be viewed as increasing
the quantity of goods and services supplied and shifting the long-run AS curve to the right. Any policy or
event that lowered real GDP in previous chapters can now be viewed as decreasing the quantity of goods
and services supplied and shifting the long-run AS curve to the left.
A New Way to Depict Long-Run Growth and Inflation

Having introduced the economy’s AD curve and the long-run AS curve, we now have a new way to
describe the economy’s long-run trends. Figure 32.4 illustrates the changes that occur in the economy
from decade to decade. Notice that both curves are shifting. Although there are many forces that govern
the economy in the long run and can in principle cause such shifts, the two most important in practice are
technology and monetary policy. Technological progress enhances the economy’s ability to produce goods
and services, and this continually shifts the long-run AS curve to the right. At the same time, because the
central bank increases the money supply over time, the AD curve also shifts to the right. As the figure illus-
trates, the result is trend growth in output (as shown by increasing Y ) and continuing inflation (as shown
by increasing P ). This is just another way of representing the classical analysis of growth and inflation we
conducted earlier in the book.
FIGURE 32.4
2. ... and growth in the Long-run
Long-Run Growth and money supply shifts aggregate
Inflation in the Model of aggregate demand ... supply
Aggregate Demand and LRAS1995 LRAS2005 LRAS2015
Aggregate Supply Price
As the economy becomes level
better able to produce
goods and services over
time, primarily because of 1. In the long run,
technological progress, the technological
long-run AS curve shifts to progress shifts
the right. At the same time, long-run aggregate
P2015
supply ...
as the central bank increases 4. ... and
the money supply, the AD ongoing inﬂation.
curve also shifts to the right. P2005
In this figure, output grows
Aggregate
from Y1995 to Y2005 and then demand, AD2015
to Y2015 , and the price level
P1995
rises from P1995 to P2005 and
AD2005
then to P2015 . Thus, the model
of AD and AS offers a new
way to describe the classical AD1995
analysis of growth and
inflation. 0 Y1995 Y2005 Y2015 Quantity of output
3. ... leading to growth

in output ...
The purpose of developing the model of AD and AS, however, is not to dress our long-run conclusions
in new clothing. Instead, it is to provide a framework for short-run analysis, as we will see in a moment. As
we develop the short-run model, we keep the analysis simple by not showing the continuing growth and
inflation depicted in Figure 32.4. But always remember that long-run trends provide the background for
short-run fluctuations. Short-run fluctuations in output and the price level should be viewed as deviations
from the continuing long-run trends.
Why the AS Curve Slopes Upward in the Short Run

We now come to the key difference between the economy in the short run and in the long run: the beha-
viour of AS. As we have already discussed, the long-run AS curve is vertical. By contrast, in the short
run, the AS curve is upwards sloping, as shown in Figure 32.5. That is, over a period of a year or two, an
increase in the overall level of prices in the economy tends to raise the quantity of goods and services
supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.
FIGURE 32.5
Price level
The Sh
Th Short-Run
t R AS C
Curve
In the short run, a fall in the price Short-run
level from P1 to P2 reduces the aggregate
supply
quantity of output supplied from
Y1 to Y2 . This positive relationship P1
could be due to sticky wages, sticky
prices or misperceptions. Over time,
wages, prices and perceptions
adjust, so this positive relationship
is only temporary. P2
1. A decrease 2. ... reduces the quantity
in the price of goods and services
level ... supplied in the short run.
0 Y2 Y1 Quantity of output
What causes this positive relationship between the price level and output? Macroeconomists have
proposed three theories for the upward slope of the short-run AS curve. In each theory, a specific market
imperfection causes the supply side of the economy to behave differently in the short run than it does in
the long run. Although each of the following theories will differ in detail, they share a common theme: the
quantity of output supplied deviates from its long-run or ‘natural’ level when the price level deviates from
the price level that people expected to prevail. When the price level rises above the expected level, output
rises above its natural rate, and when the price level falls below the expected level, output falls below its
natural rate.
The Sticky Wage Theory The first and simplest explanation of the upwards slope of the short-run AS
curve is the sticky wage theory which we initially encountered in Chapter 30. According to this theory,
the short-run AS curve slopes upwards because nominal wages are slow to adjust, or are ‘sticky’, in the
short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts
between workers and firms that fix nominal wages, sometimes for as long as three years. In addition, this
slow adjustment may be attributable to social norms and notions of fairness that influence wage setting
and that change only slowly over time.
To see what sticky nominal wages mean for AS, imagine that a firm has agreed in advance to pay its
workers a certain nominal wage based on what it expected the price level to be. If the price level P falls
W
below the level that was expected and the nominal wage remains stuck at W, then the real wage rises
P
above the level the firm planned to pay. Because wages are a large part of a firm’s production costs,
a higher real wage means that the firm’s real costs have risen. The firm responds to these higher costs by
hiring less labour and producing a smaller quantity of goods and services. In other words, because wages
do not adjust immediately to the price level, a lower price level makes employment and production less
profitable, so firms reduce the quantity of goods and services they supply.
The Sticky Price Theory As we just discussed, the sticky wage theory emphasizes that nominal wages
adjust slowly over time. The sticky price theory emphasizes that the prices of some goods and services
also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs
in part because of the menu costs to adjusting prices. These menu costs include the cost of printing and
distributing price lists or mail-order catalogues and the time required to change price tags. As a result of
these costs, prices as well as wages may be sticky in the short run.
To see the implications of sticky prices for AS, suppose that each firm in the economy announces its
prices in advance based on the economic conditions it expects to prevail. Then, after prices are announced,
the economy experiences an unexpected contraction in the money supply, which (as we have learned)
will reduce the overall price level in the long run. Although some firms reduce their prices immediately in
response to changing economic conditions, other firms may not want to incur additional menu costs and,
therefore, may temporarily lag behind. Because these lagging firms have prices that are too high, their
sales decline. Declining sales, in turn, cause these firms to cut back on production and employment. In
other words, because not all prices adjust instantly to changing conditions, an unexpected fall in the price
level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress
sales and induce firms to reduce the quantity of goods and services they produce.
The Misperceptions Theory A third approach to the short-run AS curve is the misperceptions theory.
According to this theory, changes in the overall price level can temporarily mislead suppliers about what
is happening in the individual markets in which they sell their output. As a result of these short-run mis-
perceptions, suppliers respond to changes in the level of prices, and this response leads to an upwards
sloping AS curve.
To see how this might work, suppose the overall price level falls below the level that people expected.
When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices
have fallen. For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in
the prices of the many items they buy as consumers. They may infer from this observation that the reward
to producing wheat is temporarily low, and they may respond by reducing the quantity of wheat they
supply. Similarly, workers may notice a fall in their nominal wages before they notice a fall in the prices of
the goods they buy. They may infer that the reward to working is temporarily low and respond by reducing
the quantity of labour they supply. In both cases, a lower price level causes misperceptions about relative
prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the
quantity of goods and services supplied.
Summary There are three alternative explanations for the upwards slope of the short-run AS curve:
(1) sticky wages; (2) sticky prices; and (3) misperceptions. Economists debate which of these theories
is correct, and it is very possible each contains an element of truth. For our purposes in this book, the
similarities of the theories are more important than the differences. All three theories suggest that output
deviates from its natural rate when the price level deviates from the price level that people expected. We
can express this mathematically as follows:
Quantity Natural Actual Expected

of output = rate of + a 5 price − price =
supplied output level level
where a is a number that determines how much output responds to unexpected changes in the price level.
Notice that each of the three theories of short-run AS emphasizes a problem that is likely to be only
temporary. Whether the upwards slope of the AS curve is attributable to sticky wages, sticky prices or mis-
perceptions, these conditions will not persist forever. Eventually, as people adjust their expectations, nom-
inal wages adjust, prices become unstuck and misperceptions are corrected. In other words, the expected
and actual price levels are equal in the long run, and the AS curve is vertical rather than upwards sloping.
Why the Short-Run AS Curve Might Shift

The short-run AS curve tells us the quantity of goods and services supplied in the short run for any given
level of prices. We can think of this curve as similar to the long-run AS curve but made upwards sloping
by the presence of sticky wages, sticky prices and misperceptions. Thus, when thinking about what shifts
the short-run AS curve, we have to consider all those variables that shift the long-run AS curve plus a new
variable – the expected price level – that influences sticky wages, sticky prices and misperceptions.
Let’s start with what we know about the long-run AS curve. As we discussed earlier, shifts in the long-
run AS curve normally arise from changes in labour, capital, natural resources or technological knowledge.
These same variables shift the short-run AS curve. For example, when an increase in the economy’s
capital stock increases productivity, both the long-run and short-run AS curves shift to the right. When an
increase in the minimum wage raises the natural rate of unemployment, both the long-run and short-run
AS curves shift to the left.
The important new variable that affects the position of the short-run AS curve is people’s expectation of
the price level. As we have discussed, the quantity of goods and services supplied depends, in the short
run, on sticky wages, sticky prices and misperceptions. Yet wages, prices and perceptions are set on the
basis of expectations of the price level. So when expectations change, the short-run AS curve shifts.
To make this idea more concrete, let’s consider a specific theory of AS – the sticky wage theory.
According to this theory, when workers and firms expect the price level to be high, they are more likely to
negotiate high nominal wages. High wages raise firms’ costs and, for any given actual price level, reduce
the quantity of goods and services that firms supply. Thus, when the expected price level rises, wages
are higher, costs increase, and firms supply a smaller quantity of goods and services at any given actual
price level. Thus, the short-run AS curve shifts to the left. Conversely, when the expected price level falls,
wages are lower, costs decline, firms increase production at any given price level, and the short-run AS
curve shifts to the right.
A similar logic applies in each theory of AS. The general lesson is the following:
● An increase in the expected price level reduces the quantity of goods and services supplied and shifts
the short-run AS curve to the left.
● A decrease in the expected price level raises the quantity of goods and services supplied and shifts the
short-run AS curve to the right.
As we will see in the next section, this influence of expectations on the position of the short-run AS curve
plays a key role in reconciling the economy’s behaviour in the short run with its behaviour in the long run.
In the short run, expectations are fixed, and the economy finds itself at the intersection of the AD curve
and the short-run AS curve. In the long run, expectations adjust, and the short-run AS curve shifts. This
shift ensures that the economy eventually finds itself at the intersection of the AD curve and the long-run
AS curve.
You should now have some understanding about why the short-run AS curve slopes upward and what
events and policies can cause this curve to shift. Table 32.2 summarizes our discussion.
SELF TEST Explain why the long-run AS curve is vertical. ● Explain three theories for why the short-run AS
curve is upwards sloping.
TWO CAUSES OF ECONOMIC FLUCTUATIONS

Now that we have introduced the model of AD and AS, we have the basic tools we need to analyse fluctu-
ations in economic activity. In particular, we can use what we have learned about AD and AS to examine the
two basic causes of short-run fluctuations.
To keep things simple, we assume the economy begins in long-run equilibrium, as shown in Figure 32.6.
Equilibrium output and the price level are determined by the intersection of the AD curve and the long-run
AS curve, shown as point A in the figure. At this point, output is at its natural rate. The short-run AS curve
passes through this point as well, indicating that wages, prices and perceptions have fully adjusted to this
long-run equilibrium. That is, when an economy is in its long-run equilibrium, wages, prices and percep-
tions must have adjusted so that the intersection of AD with short-run AS is the same as the intersection
of AD with long-run AS.
The Short-Run Aggregate Supply Curve: Summary

TABLE 32.2
Why does the short-run aggregate supply curve slope upward?
1 The sticky wage theory : An unexpectedly low price level raises the real wage, which
causes firms to hire fewer workers and produce a smaller quantity of goods and services.
2 The sticky price theory : An unexpectedly low price level leaves some firms with higher-
than-desired prices, which depresses their sales and leads them to cut back production.
3 The misperceptions theory : An unexpectedly low price level leads some suppliers to
think their relative prices have fallen, which induces a fall in production.
Why might the short-run aggregate supply curve shift?

1 Shifts arising from labour : An increase in the quantity of labour available (perhaps due
to a fall in the natural rate of unemployment) shifts the AS curve to the right. A decrease
in the quantity of labour available (perhaps due to a rise in the natural rate of unem-
ployment) shifts the AS curve to the left.
2. Shifts arising from capital : An increase in physical or human capital shifts the AS curve
to the right. A decrease in physical or human capital shifts the AS curve to the left.
3 Shifts arising from natural resources : An increase in the availability of natural resources
shifts the AS curve to the right. A decrease in the availability of natural resources shifts
the AS curve to the left.
4 Shifts arising from technology : An advance in technological knowledge shifts the AS
curve to the right. A decrease in the available technology (perhaps due to government
regulation) shifts the AS curve to the left.
5 Shifts arising from the expected price level : A decrease in the expected price level shifts
the short-run AS curve to the right. An increase in the expected price level shifts the
short-run AS curve to the left.
FIGURE 32.6
Price level
The LLong-Run
Th R EEquilibrium
ili Long-run
The long-run equilibrium of the economy is aggregate
found where the AD curve crosses the long- supply Short-run
aggregate
run AS curve (point A). When the economy
supply
reaches this long-run equilibrium, wages,
prices and perceptions will have adjusted so
that the short-run AS curve crosses this point Equilibrium A
as well. price
Aggregate
demand
of output
The Effects of a Shift in Aggregate Demand

Suppose that for some reason a wave of pessimism suddenly overtakes the economy. The cause might be
a government scandal, a crash on the stock market or the outbreak of war overseas. Because of this event,
many people lose confidence in the future and alter their plans. Households cut back on their spending
and delay major purchases, and firms put off buying new equipment.
What is the impact of such a wave of pessimism on the economy? Such an event reduces the AD for
goods and services. That is, for any given price level, households and firms now want to buy a smaller
quantity of goods and services. As Figure 32.7 shows, the AD curve shifts to the left from AD1 to AD2.
In this figure we can examine the effects of the fall in AD. In the short run, the economy moves along
the initial short-run AS curve AS1, going from point A to point B. As the economy moves from point A to
point B, output falls from Y1 to Y2, and the price level falls from P1 to P2. The falling level of output indicates
that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and
production by reducing employment. Thus, the pessimism that caused the shift in AD is, to some extent,
self-fulfilling: pessimism about the future leads to falling incomes and rising unemployment.
FIGURE 32.7
AC
Contraction
t ti iin A
Aggregate Demand
A fall in AD, which might be due to a wave of pessimism in the economy, is represented with a leftward shift in the AD curve from
AD1 to AD2 . The economy moves from point A to point B. Output falls from Y1 to Y2 , and the price level falls from P1 to P2 . Over time,
as wages, prices and perceptions adjust, the short-run AS curve shifts to the right from AS1 to AS2 , and the economy reaches point C,
where the new AD curve crosses the long-run AS curve. The price level falls to P3 , and output returns to its natural rate, Y1.
2. ... causes output to fall in the short run ...
Price level
Long-run Short-run aggregate

aggregate supply, AS1
supply
AS2
3. ... but over

time, the short-run
P1 A aggregate-supply
curve shifts ...
P2 B
1. A decrease in
aggregate demand ...
P3 C
Aggregate
demand, AD1
AD2
4. ... and output returns
to its natural rate.
What should policymakers do when faced with such a recession? One possibility is to take action to
increase AD. As we noted earlier, an increase in government spending or an increase in the money supply
would increase the quantity of goods and services demanded at any price and, therefore, would shift the
AD curve to the right. If policymakers can act with sufficient speed and precision, they can offset the initial
shift in AD, return the AD curve back to AD1 and bring the economy back to point A. (The next chapter
discusses in more detail the ways in which monetary and fiscal policy influence AD, as well as some of
the practical difficulties in using these policy instruments.)
Even without action by policymakers, the recession will remedy itself over a period of time. Because
of the reduction in AD, the price level falls. Eventually, expectations catch up with this new reality, and
the expected price level falls as well. Because the fall in the expected price level alters wages, prices and
perceptions, it shifts the short-run AS curve to the right from AS1 to AS2 in Figure 32.7. This adjustment of
expectations allows the economy over time to approach point C, where the new AD curve (AD2) crosses
the long-run AS curve.
In the new long-run equilibrium, point C, output is back to its natural rate. Even though the wave of
pessimism has reduced AD, the price level has fallen sufficiently (to P3) to offset the shift in the AD curve.
Thus, in the long run, the shift in AD is reflected fully in the price level and not at all in the level of output.
In other words, the long-run effect of a shift in AD is a nominal change (the price level is lower) but not a
real change (output is the same).
To sum up, this story about shifts in AD has two important lessons:
● In the short run, shifts in AD cause fluctuations in the economy’s output of goods and services.
● In the long run, shifts in AD affect the overall price level but do not affect output.
The Effects of a Shift in Aggregate Supply

Imagine once again an economy in its long-run equilibrium. Now suppose that suddenly some firms exper-
ience an increase in their costs of production. For example, bad weather might destroy some agricultural
crops, driving up the cost of producing food products. Or political or military conflict might interrupt the
shipping of crude oil, driving up the cost of producing oil products.
What is the macroeconomic impact of such an increase in production costs? For any given price level,
firms now want to supply a smaller quantity of goods and services. Thus, as Figure 32.8 shows, the short-
run AS curve shifts to the left from AS1 to AS2. (Depending on the event, the long-run AS curve might also
shift. To keep things simple, however, we will assume that it does not.)
FIGURE 32.8
1. An adverse shift in the short-run
A Ad
An Adverse Shift iin aggregate-supply curve ...
Aggregate Supply
Price level
When some event increases firms’
costs, the short-run AS curve shifts Long-run Short-run
to the left from AS1 to AS2 . The aggregate AS2 aggregate
economy moves from point A to supply supply, AS1
point B. The result is stagflation:
output falls from Y1 to Y2 , and the
price level rises from P1 to P2 .
B
P2
A
P1
3. ... and
the price
level to rise.
Aggregate demand
2. ... causes output to fall ...
In this figure we can trace the effects of the leftward shift in AS. In the short run, the economy moves
along the existing AD curve, going from point A to point B. The output of the economy falls from Y1 to
Y2 and the price level rises from P1 to P2. Because the economy is experiencing both stagnation (falling
output) and inflation (rising prices), such an event is sometimes called stagflation.
stagflation a period of falling output and rising prices
What should policymakers do when faced with stagflation? There are no easy choices. One possibil-
ity is to do nothing. In this case, the output of goods and services remains depressed at Y2 for a while.
Eventually, however, the recession will remedy itself as wages, prices and perceptions adjust to raise
production costs. A period of low output and high unemployment, for instance, puts downwards pressure
on workers’ wages. Lower wages, in turn, increase the quantity of output supplied. Over time, as the
short-run AS curve shifts back towards AS1, the price level falls, and the quantity of output approaches its
natural rate. In the long run, the economy returns to point A, where the AD curve crosses the long-run AS
curve. This is the view that believers of free markets might adopt.
Alternatively, policymakers who control monetary and fiscal policy might attempt to offset some of
the effects of the shift in the short-run AS curve by shifting the AD curve. This possibility is shown in
Figure 32.9. In this case, changes in policy shift the AD curve to the right from AD1 to AD2 – exactly enough
to prevent the shift in AS from affecting output. The economy moves directly from point A to point C.
Output remains at its natural rate, and the price level rises from P1 to P3. In this case, policymakers are said
to accommodate the shift in AS because they allow the increase in costs to permanently affect the level
of prices. This intervention by policymakers would be seen as being desirable by supporters of Keynes.
FIGURE 32.9
Accommodating
A d ti an A
Adverse Shift in Aggregate Supply
Faced with an adverse shift in AS from AS1 to AS2 , policymakers who can influence AD might try to shift the AD curve to the right
from AD1 to AD2 . The economy would move from point A to point C. This policy would prevent the supply shift from reducing output
in the short run, but the price level would permanently rise from P1 to P3 .
1. When short-run aggregate

Price level supply falls ...
Long-run Short-run
aggregate AS2 aggregate
supply supply, AS1
P3 C 2. ... policy makers can

P2 accommodate the shift
A by expanding aggregate
3. ... which P1 demand ...
causes the
price level
to rise 4. ... but keeps output AD2
further ... as its natural rate.
Aggregate demand, AD1

of output
These different views on policy action form a key aspect of the debate between economists about
action in the face of short-run fluctuations in economic activity.
To sum up, this story about shifts in AS has two important lessons:
● Shifts in AS can cause stagflation – a combination of recession (falling output) and inflation (rising
prices).
● Policymakers who can influence AD cannot offset both of these adverse effects simultaneously.
CASE STUDY Stagflation in Iceland?

Th economy off IIceland was badly affected by the financial crisis with three of its main banks, Kaupthing, Landsbanki
The
and Glitnir, all failing. The collapse of these banks led to the Icelandic economy slumping. Figure 32.10 shows how
significant and rapid the decline in the economy was between mid-2007 and mid-2009. The annual change in GDP
was reported as −18.2 per cent in 2008 and −9.1 per cent in 2009. The economy began to improve slowly and returned
to growth in early 2010 and growing at a rate of 3 – 4 per cent between the middle of 2011 to November 2012 when
the economy contracted once again.
FIGURE 32.10
IInflation
fl ti andd EEconomic Growth in Iceland
The figure charts inflation and economic growth measured as a change from the previous quarter between 2005 and 2012.
CPI inﬂation 2 period Moving Average (GDP growth (quarterly))
20
15
10
–5
–10
Average
Average
Average
September
Average
November
December
September
January
February
October
November
December
September
January
February
October
November
December
March
September
August
January
February
October
November
December
April
June
March
August
January
February
October
January
May
July
April
June
March
August
May
July
April
June
March
August
May
July
April
June
May
July
2005 2006 2007 2008 2009 2010 2011 2012 2013
Inflation, meanwhile, has been a problem. Between

2005 and March 2006, inflation was under 2.0 per cent
but began to accelerate after that time before easing in
the latter part of 2007. Once the full effects of the financial
crisis took hold, inflation accelerated, quickly reaching a
high of 21.9 per cent in January 2009. Inflation has eased
since then but the trend since November 2010 is upwards.
The aftermath of the financial crisis left Iceland facing The collapse of the banking system in Iceland not only affected
the twin problems of accelerating inflation and shrinking the people of Iceland but across many other parts of Europe too.
economic activity. It can be argued that the particular
circumstances of the banking collapse in Iceland led to the stagflation but what of the future for Iceland? There are fears that
Iceland could again be heading for a period of stagflation. The rate of growth of inflation seems to be accelerating and some
analysts expect inflation to be over 5 per cent in the coming years but at the same time growth seems to be slowing. Statistics
Iceland reported that preliminary GDP figures for 2012 would show growth of 1.6 per cent – not a contraction in the economy
but a growth rate below that forecast. There was a 50 per cent chance that these figures could be revised downwards.
SELF TEST Suppose that the election of a popular prime minister suddenly increases people’s confidence in
the future. Use the model of AD and AS to analyse the effect on the economy.
NEW KEYNESIAN ECONOMICS

We introduced Keynesian economics and the IS-LM model in Chapter 31. Recall that Keynesian economics
developed in response to the depression of the 1930s, when it appeared that the assumptions of classical
economics that markets would clear, were failing. Keynesian ideas were the mainstay for economic policy
across the developed world in the post-war era and there was something of a consensus amongst econ-
omists that our understanding of the macroeconomy was considerable. The latter part of the 1960s began
to reveal some flaws in that assumption as global conditions changed. The breakdown of fixed exchange
rates in the late 1960s and the oil crisis in the early 1970s presented macroeconomists with significant
challenges in explaining the economic conditions that existed in some countries – stagflation in particular.
Economics came to be classified as a debate between Keynesians on the one hand, who pointed
to markets not clearing quickly, and the neo or new classicists on the other hand, who re-emphasized
the efficiency of markets and argued that microeconomics provided a foundation for understanding
macroeconomics.
Out of this debate emerged a group who were referred to as the New Keynesians. New Keynesian
economics placed an emphasis on providing sound microeconomic principles to underpin Keynesian
macroeconomics. Specifically, the New Keynesians sought to explain how price and wage stickiness had
its foundation in the microeconomic analysis of labour markets and price setting by firms.
Features of New Keynesian Economics

New Keynesians would argue that short-run fluctuations in economic output violate the classical dichot-
omy, as outlined earlier in this chapter. Changes in nominal variables like the money supply do have an
influence on output and employment – real variables. In addition, they would argue that to develop an
understanding of changes in economic activity, an understanding of the imperfections in the economy
is necessary – that firms operate under imperfect competition, that consumers and firms are subject to
imperfect information and that there are built-in rigidities in the economy which hinder the movement of
prices and wages as we have noted.
So, can we conclude from this that the economists classed as New Keynesians are supporters of
demand management but with some reservations? The answer to this is ‘no’. The splitting of economics
into different schools of thought has been convenient for the mass media to present disagreements
between economists in relatively simple terms. The reality is that there is probably more agreement in
economics that most members of the public would imagine. A difference in some base assumptions and
a difference in the relative size of parameters in models is largely the reason why economists disagree.
Many economists would subscribe to the view that changes in the money supply affect aggregate demand
(a so-called ‘monetarist’ view) but also agree that price rigidities in the macroeconomy exist because of
imperfections in the microeconomy. Some New Keynesian economists would, equally, not be in support
of policy intervention to correct short-term fluctuations in the economy by attempting to manipulate
aggregate demand. The main reason being that they would argue that the effects of such policy interven-
tions take time to work through the economy by which time economic conditions have changed and so
the policy will not be as effective as anticipated. Changes in interest rates, for example, are estimated to
take around 18 months to work through the economy; tax changes might be received in different ways by
different people and it is never certain enough to predict how people will react to a tax cut or a tax increase
in any precise quantifiable way to make such a policy option a clear-cut choice. Equally, policies to increase
government spending, on infrastructure projects for example, often take many years to have any effect
even if such projects are ‘shovel ready’ – able to be put in operation quickly.
The response to the financial crisis has reinvigorated the debate between whether active intervention
by central banks and governments to boost the economy in the face of persistent sluggish growth and
rising unemployment is the best policy response, or whether a ‘do nothing’ option is preferable to allow
markets to adjust to changed conditions. It is always easy to seize on one headline statement by any
economist and immediately seek to pigeon-hole that view. New Keynesian economics reminds us that
the complexities of the economy perhaps deserve a more discerning look at the detail behind what econ-
omists are actually saying and how much they agree and why they agree, as much as why they might
disagree and the extent of such disagreements.
CONCLUSION
This chapter has achieved two goals. First, we have discussed some of the important facts about short-run
fluctuations in economic activity. Second, we have introduced a basic model to explain those fluctuations,
called the model of AD and AS. We continue our study of this model in the next chapter in order to under-
stand more fully what causes fluctuations in the economy and how policymakers might respond to these
fluctuations.
IN THE NEWS
Expectations
One of the key tasks of policymakers is to set the tone for expectations in the economy – such
expectations have to be realistic and also believed by the population if the policy is to have
any credence.
Moderating Inflationary would be tightened with a target of 13 monetary policy being adopted else-
Expectations in China per cent growth in M2 for 2013. Zhou where in the world. Quantitative eas-
noted that this target was lower than ing in the US and UK should lead to a
The Governor of the central bank the actual growth in M2 in 2012, which higher money supply and was likely to
of China, the People’s Bank of was over 14 per cent and reflected lead to a weakening of the pound and
China (PBoC), Zhou Xiaochuan, the desire by the PBoC to help boost dollar against the yuan. A stronger
re-emphasized the commitment of the economic growth in China. Part of the yuan would affect China’s exporters
PBoC to keeping inflation under con- pro-growth policy that was a focus of and also raise the cost of imports
trol in a speech made in March 2013. 2012 included government spending which would put pressure on inflation.
The comments followed the release on infrastructure and the looser mon-
of inflation data which showed the etary policy also allowed more people Questions
CPI accelerating to 3.2 per cent in to be able to borrow money to buy 1 Using your understanding of the
February 2013, a ten-month high. property. However, the PBoC noted model of AD and AS, what factors
Zhou noted that this was higher than that house prices increased over 12 might be causing an increase in
forecast and that this emphasized the per cent in Beijing and had risen in 53 inflation in China?
need to ensure the PBoC acted to of 70 major cities across the country 2 Why might the increase in the
moderate inflationary expectations in and house price inflation was some- rate of inflation in March 2013 to
the economy. thing that it wanted to control. a ten-month high, trigger expect-
To reinforce the message that Whilst China intends to tighten ations of higher inflation in the
inflation would be kept under control, monetary policy, the PBoC also noted future and what effect might this
Zhou announced that the growth in that it was monitoring the potential have on the Chinese economy in
the money supply, as measured by M2, effect on China’s economy of looser the absence of policy changes
by the Chinese authorities?
New housing development in China is partly in response to rising wage levels 3 Why would the PBoC’s announce-
fuelling increased demand which in turn is leading to rising house prices. ment that monetary policy be
tightened influence expectations
and what would you think the res-
ults of such a policy announce-
ment, assuming it was enforced,
would be?
4 Assuming the growth of M2 is
tightened, use the AD and AS
model to analyse the likely effect
on inflation and national income
in China.
5 Why would a loose monetary
policy in countries like the US
and UK lead to a strengthening of
the Chinese currency and what
would you expect the effect on
AD in China to be as a result?
SUMMARY
● All societies experience short-run economic fluctu- to reduce employment and production. According to the
ations around long-run trends. These fluctuations are sticky price theory, an unexpected fall in the price level
irregular and largely unpredictable. When recessions leaves some firms with prices that are temporarily too
do occur, real GDP and other measures of income, high, which reduces their sales and causes them to cut
spending and production fall, and unemployment rises. back production. According to the misperceptions the-
● Economists analyse short-run economic fluctuations ory, an unexpected fall in the price level leads suppliers
using the model of AD and AS. According to this model, to mistakenly believe that their relative prices have fallen,
the output of goods and services and the overall level of which induces them to reduce production. All three the-
prices adjust to balance AD and AS. ories imply that output deviates from its natural rate when
the price level deviates from the price level that people
● The AD curve slopes downwards for three reasons.
expected.
First, a lower price level raises the real value of house-
holds’ money holdings, which stimulates consumer ● Events that alter the economy’s ability to produce output,
spending. Second, a lower price level reduces the such as changes in labour, capital, natural resources or
quantity of money households’ demand; as house- technology, shift the short-run AS curve (and may shift the
holds try to convert money into interest-bearing long-run AS curve as well). In addition, the position of the
assets, interest rates fall, which stimulates investment short-run AS curve depends on the expected price level.
spending. Third, as a lower price level reduces interest ● One possible cause of economic fluctuations is a shift
rates, the local currency depreciates in the market in AD. When the AD curve shifts to the left, for instance,
for foreign currency exchange, which stimulates net output and prices fall in the short run. Over time, as a
exports. change in the expected price level causes wages,
● Any event or policy that raises consumption, investment, prices and perceptions to adjust, the short-run AS curve
government purchases or net exports at a given price shifts to the right, and the economy returns to its natural
level increases AD. Any event or policy that reduces rate of output at a new, lower price level.
consumption, investment, government purchases or net ● A second possible cause of economic fluctuations is
exports at a given price level decreases AD. a shift in AS. When the AS curve shifts to the left, the
● The long-run AS curve is vertical. In the long run, the short-run effect is falling output and rising prices – a
quantity of goods and services supplied depends on the combination called stagflation. Over time, as wages,
economy’s labour, capital, natural resources and tech- prices and perceptions adjust, the price level falls back
nology, but not on the overall level of prices. to its original level, and output recovers.
● Three theories have been proposed to explain the ● New Keynesian economics represents a research tra-
upwards slope of the short-run AS curve. According to dition that questions the classical dichotomy and recog-
the sticky wage theory, an unexpected fall in the price nizes imperfections in the economy as key elements in
level temporarily raises real wages, which induces firms explaining short run deviations from trend.
QUESTIONS FOR REVIEW

1 What do you understand by the term ‘economic activity’? 7 List and explain the three theories for why the short-run
2 What is the official definition of a recession? aggregate supply curve is upwards sloping.
3 Name two macroeconomic variables that decline 8 What might shift the aggregate demand curve to the
when the economy goes into a recession. Name one left? Use the model of aggregate demand and aggregate
macroeconomic variable that rises during a recession. supply to trace through the effects of such a shift.
4 Draw a diagram with aggregate demand, short-run 9 What might shift the aggregate supply curve to the left?
aggregate supply and long-run aggregate supply. Be Use the model of aggregate demand and aggregate
careful to label the axes correctly. supply to trace through the effects of such a shift.
5 List and explain the three reasons why the aggregate 10 What outcomes are possible if both aggregate demand
demand curve is downwards sloping. and aggregate supply are both shifting? Use the model
6 Explain why the long-run aggregate supply curve is of aggregate demand and aggregate supply to outline
vertical. some of these possible outcomes.
PROBLEMS AND APPLICATIONS

1 Why do you think that investment is more variable over a. How the economy recovers from a recession and
the business cycle than consumer spending? Which returns to its long-run equilibrium without any policy
category of consumer spending do you think would intervention.
be most volatile: durable goods (such as furniture and b. What determines the speed of that recovery?
car purchases), non-durable goods (such as food and
7 Suppose the central bank expands the money
clothing) or services (such as haircuts and medical
supply, but because the public expects this action, it
care)? Why?
simultaneously raises its expectation of the price level.
2 Suppose that the economy is in a long-run equilibrium. What will happen to output and the price level in the
a. Use a diagram to illustrate the state of the short run? Compare this result to the outcome if the
economy. Be sure to show AD, short-run AS and central bank expanded the money supply but the public
long-run AS. didn’t change its expectation of the price level.
b. Now suppose that a financial crisis causes AD to fall.
8 Suppose workers and firms suddenly believe that
Use your diagram to show what happens to output
inflation will be quite high over the coming year. Suppose
and the price level in the short run. What happens to
also that the economy begins in long-run equilibrium,
the unemployment rate?
and the AD curve does not shift.
c. Use the sticky wage theory of AS to explain what
will happen to output and the price level in the a. What happens to nominal wages? What happens to
long run (assuming there is no change in policy). real wages?
What role does the expected price level play in this b. Using an AD/AS diagram, show the effect of the
adjustment? Be sure to illustrate your analysis with change in expectations on both the short-run and
a graph. long-run levels of prices and output.
c. Were the expectations of high inflation accurate?
3 Explain whether each of the following events will Explain.
increase, decrease or have no effect on long-run AS.
9 Explain whether each of the following events shifts the
a. The country experiences a wave of immigration. short-run AS curve, the AD curve, both, or neither. For
b. The government raises the minimum wage above the each event that does shift a curve, use a diagram to
national average wage level. illustrate the effect on the economy.
c. A war leads to the destruction of a large number of
a. Households decide to save a larger share of their
factories.
income.
4 In Figure 32.7, how does the unemployment rate at b. Cattle farmers suffer a prolonged period of foot-and-
points B and C compare to the unemployment rate at mouth disease which cuts average cattle herd sizes
point A? Under the sticky wage explanation of the short- by 80 per cent.
run AS curve, how does the real wage at points B and C c. Increased job opportunities overseas cause many
compare to the real wage at point A? people to leave the country.
5 Explain why the following statements are false. 10 Suppose that firms become very optimistic about future
business conditions and invest heavily in new capital
a. ‘The AD curve slopes downwards because it is the
equipment.
horizontal sum of the demand curves for individual
goods.’ a. Use an AD/AS diagram to show the short-run effect
b. ‘The long-run AS curve is vertical because economic of this optimism on the economy. Label the new levels
forces do not affect long-run AS.’ of prices and real output. Explain, in words, why the
c. ‘If firms adjusted their prices every day, then the aggregate quantity of output supplied changes.
short run AS curve would be horizontal.’ b. Now use the diagram from part (a) to show the new
d. ‘Whenever the economy enters a recession, its long- long-run equilibrium of the economy. (For now, assume
run AS curve shifts to the left.’ there is no change in the long-run AS curve.) Explain, in
words, why the aggregate quantity of output demanded
6 For each of the three theories for the upwards slope changes between the short run and the long run.
of the short-run AS curve, carefully explain the c. How might the investment boom affect the long-run
following. AS curve? Explain.

Mankiw Ir Taylor 12 Tema + Uždaviniai

Uploaded by

Copyright:

Available Formats

Mankiw Ir Taylor 12 Tema + Uždaviniai

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Mankiw Ir Taylor 12 Tema + Uždaviniai

Uploaded by

Copyright:

Available Formats

PART 14

business cycle the fluctuations in economic growth around trend growth

TREND GROWTH RATES

trend the underlying long term movement in a data series

CAUSES OF CHANGES IN THE BUSINESS CYCLE

Household Spending Decisions

Confidence and Expectations

BUSINESS CYCLE MODELS

Supply Side – The New Classical Model

Supply Side – The Keynesian Model

Demand Side – The New Classical Model

Demand Side – The Keynesian Model

Real Business Cycles

CASE STUDY Kydland and Prescott and Real Business Cycles

Finn E. Kydland (left) and

Employment and Unemployment in an Economic Downturn

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

Fact 1: Economic Fluctuations are Irregular and Unpredictable

Fact 2: Most Macroeconomic Quantities Fluctuate Together

Fact 3: As Output Falls, Unemployment Rises

EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

How the Short Run Differs from the Long Run

The Basic Model of Economic Fluctuations

0 Equilibrium Quantity of output

THE AGGREGATE DEMAND CURVE

Why the Aggregate Demand Curve Slopes Downwards

2. ... increases the quantity of

Why the Aggregate Demand Curve Might Shift

The AD Curve: Summary

Why might the AD curve shift?

THE AGGREGATE SUPPLY CURVE

Why the Aggregate Supply Curve is Vertical in the Long Run

Why the Long-Run AS Curve Might Shift

0 Natural rate Quantity of output

A New Way to Depict Long-Run Growth and Inflation

3. ... leading to growth

Why the AS Curve Slopes Upward in the Short Run

Quantity Natural Actual Expected

Why the Short-Run AS Curve Might Shift

TWO CAUSES OF ECONOMIC FLUCTUATIONS

The Short-Run Aggregate Supply Curve: Summary

Why might the short-run aggregate supply curve shift?

The Effects of a Shift in Aggregate Demand

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

Long-run Short-run aggregate

3. ... but over

The Effects of a Shift in Aggregate Supply

stagflation a period of falling output and rising prices

1. When short-run aggregate

P3 C 2. ... policy makers can

0 Natural rate Quantity of output

CASE STUDY Stagflation in Iceland?

2005 2006 2007 2008 2009 2010 2011 2012 2013

Inflation, meanwhile, has been a problem. Between

NEW KEYNESIAN ECONOMICS

Features of New Keynesian Economics

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS