EC102 WEEK 4

(Pages 66-73 not in exam)

Economic fluctuations
Graph on slide75
 variable growth from quarter to quarter
 on average there is positive growth, but variability in growth process

Fluctuations are not that desirable; would be better to have a more stable economy.
Why?
 Unemployment is very strongly related to fluctuations; a measure of the distress
people in the labour market experience
 High unemployment- high crime rate
 Unemployment does really go up when the economy is slowing (graph slide 77)
 Creates volatility in people’s lives; uncertainty

Fluctuations= significant deviations from the long-run growth rate

Shocks:
 Expansionary (positive shocks): shocks that tend to make the economy grow faster
than normal
 Contractionary (negative shocks): make the economy grow slower or even shrink
 Demand vs supply shocks
 Economists believe that when most of the time the economy fluctuates, it’s because
of demand shocks
 Shocks need to be aggregate shocks, to have an impact on the economy (a macro-
shock as opposed to a micro-shock)

GDP composition=
- Goods and services bought by households (C)
- Goods and services bought or produced by the government (G)
- Investment goods bought by firms, (and new houses) (I)
- Goods, serviced and investment goods sold abroad, minus goods, services and
investment goods bought abroad (NX)

An aggregate demand shock happens when there is significant change in the plans of one of
the above agents e.g. families increasing consumption by 10% (anything that causes
changes in planned spending on any of the GDP components)
Examples:
 For G: Government increases spending on weapons, or changes ideology e.g. labour
party likes public spending, conservatives don’t (when conservatives are elected,
public spending is cut)
 For I and C: taxes (increase in income tax, consumers’ disposable income is lower so
they consume less), or psychology (once people feel more optimistic, they are more
inclined to spend- confidence shocks)- Keynes believed that these changes in
 confidence by consumers and investors are important for demand shocks; animal
spirits
 For NX: foreign demand shocks (e.g. if Europe is booming, they will demand more
British goods and services and vice versa)

How do demand shocks lead to economic fluctuations?

 GDP= C + I + G + NX is not a causal relationship; the equation does not allow us to
have a theory of how demand shocks translate to fluctuations; when one goes up on
the right-hand side, it doesn’t necessarily mean that the left-hand side will also go
up; when consumers desire to spend more, producers need to be convinced to
produce this much more (from change in production plan to realised production
change)
1. Consumer spending increases
2. Firms experience increases in sales and orders (expansion in production)
3. We assume the marginal cost of production is increasing (marginal cost= cost of
producing one extra unit of output); e.g. car producer: has a standard
production, but if you want to increase production (e.g. in the night-time), costs
will increase (electricity, night time wages etc): mark-up will become sub-
optimally smaller for them, so how do they restore the original mark-up?
4. Pricing decisions: firms (price-setting firms) will have a certain amount of market
power and will seek for an optimal ratio between marginal cost and market price;
marginal cost will be coming closer and closer to the price in the market when
production increase; mark up of price over average cost will be lower;
5. Marginal cost increases & mark-up falls: increase prices to restore the original
mark-up
6. Quantities demanded begin to shrink; prices are increasing, so the higher
spending by consumers is buying a smaller amount of quantities; the quantities
adjust to the original level with the higher price

Why does the price increase match the increase in demand?

 Consumers are doing what they were planning to do; the agents who wanted to
spend more, have actually spent more (original spending plans satisfied): equilibrium
 Firms know that they want to have a certain mark-up of price over marginal cost; if
the price goes up then the MC should go up by the same amount; cost=price of
inputs, quantities that determine my cost are the same, and all the prices in the
economy go up, then the MC of inputs goes up by the same amount
After an aggregate demand shock
 Quantities change in the same direction
 Prices gradually adjust in the same direction
 Quantities gradually return to initial values
 After prices have adjusted, no long-term effect on quantities
The natural rate of economic activity
= the level of output which the economy gravitates back to after price adjustment
 Conceptual idea: not something we can measure, because the economy is constantly
moving in response to shocks; not necessarily constant over time (maybe lower or
higher in certain periods)- poses problem for policy making
  In general: above the natural level: the economy is stretched (mark-ups for
producers higher)- inflationary pressures
 Below the natural rate level: the economy has slack- deflationary pressures

Role of price stickiness

How quickly do producers start noticing that mark-ups are down?
=size and duration of effect on quantities depend on speed of price adjustment
 Fast price adjustment: small temporary impact on quantities
 Slow price adjustment: large temporary impact on quantities
 Tolerating contraction in mark-up is crucial for some period
 Change in prices are rare

Countercyclical policy
Governments try to reduce the volatility of GDP growth
 Counter negative aggregate demand shocks to stop the economy from falling below
the natural rate
 Counter positive aggregate demand shocks to stop the economy from rising above
the natural rate, i.e. to counter inflation
1. Fiscal policy: changes in government spending and taxes to counter demand shocks;
run by the Treasury (the executive branch of government usually)
2. Monetary policy: purchases and sales of financial assets, setting of statutory interest
rates

Fiscal policy and the government budget:

Deficit= spending- tax revenues
- If the deficit goes up, government is stimulating demand
- If the deficit falls, government does something that takes away from aggregate
demand
i.e. changes in the deficit summarise the impact of FP on demand
the government interacts with the cycle in two ways:
1. A source of demand shocks (e.g. austerity)
2. A tool to counter other demand shocks (e.g. fiscal stimulus policies 2007-2009)