Lecture 8

Economic Fluctuations

References:
N.G. Mankiw, “Principles of Economics”, 8th edition, chapters 33+34
NEU, “Economics”, chapters 15, 18

September 2019
 (a) Real GDP

Billions of Recessions
1992 Dollars
$7,000
6,500 Real GDP
6,000
5,500
5,000
4,500
4,000
3,500
3,000
2,500
1965 1970 1975 1980 1985 1990 1995
 Real GDP per Real GDP per
Person at Person at End Growth Rate
Country Period Beginning of Period of Period (per year)
Japan 1890-1997 $1,196 $23,400 2.82%
Brazil 1900-1990 619 6,240 2.41
Mexico 1900-1997 922 8,120 2.27
Germany 1870-1997 1,738 21,300 1.99
Canada 1870-1997 1,890 21,860 1,95
China 1900-1997 570 3,570 1.91
Argentina 1900-1997 1,824 9,950 1.76
United States 1870-1997 3,188 28,740 1.75
Indonesia 1900-1997 708 3,450 1.65
United Kingdom 1870-1997 3,826 20,520 1.33
India 1900-1997 537 1,950 1.34
Pakistan 1900-1997 587 1,590 1.03
Bangladesh 1900-1997 495 1,050 0.78
Content
1. Aggregate Demand AD
2. Aggregate Supply AS
3. Equilibrium state of AD-AS
 Explain economic fluctuations
Price
 Base on microeconomics Supply

 Demand-Supply
 Output, Price
Equip.
Price
 Derive macroeconomics
model Demand
 Aggregate Supply
 Aggregate Demand Equip. Output
Output
 Total Output
 Price level
 1. Aggregate Demand
1. Aggregate Demand
 Definition: is the Total Output demanded by all
economic agents
 Determinants of AD
 Consumption C
 Investment I
 Government Spending G
 Net Export (NX=X - IM).
AD = C + I + G + NX. = C + I + G + X - IM
WHY DOES THE AGGREGATE-DEMAND CURVE
SLOPE DOWNWARD?

The Wealth Effect

 The Interest-Rate Effect

 The International Trade Effect

7
 WHY DOES THE AGGREGATE-DEMAND CURVE SLOPE DOWNWARD?

The Wealth Effect

Pricelevel
Price levelfalls
falls

Price level

Consumersfeel
feel

Ag
Consumers
morewealthy
wealthy

g
more

re
P1

ga
te
de
P2

m
Theyspend
They spendmore
more

an
d
Quantityofofgoods
Quantity goods Y1 Y2 Quantity of
andservices
and services output
demandedrises
demanded rises

8
 WHY DOES THE AGGREGATE-DEMAND CURVE SLOPE DOWNWARD?

The Interest-Rate Effect

Price level falls Price

level

Households hold less money

P1
and lend some out

Ag
g
re
g at
e
de
P2

m
an
They convert their money into

d
interest-bearing assets

0
Y1 Y2
Interest-rate falls Quantity of
output

Quantity of goods
Firms want to borrow more and and services
spend more in investment goods demanded rises 9
 WHY DOES THE AGGREGATE-DEMAND CURVE SLOPE DOWNWARD?

The International Trade Effect

U.S Price
U.S goods Both
level falls
relatively less Americans
relative to
expensive and foreigners
foreign price
than foreign buy more
evel (exchange-
goods U.S goods
rate doesn’t
change)

Quantity
U.S net NX
of goods
exports
and services rises
rise
demanded
rises

10
 Causes to the shift of AD
P

C
I
C
P1 G
I
NX
AD1
G AD
NX  AD1

0 Y1 Y* Y1 Y
 Aggregate Supply AS
 Definition AS
is total output of final goods and services that all
firms ready to produce and sell at a given price level
 Potential capacity
 Readiness to supply
 2. Aggregate Supply AS
 Definition AS
is total output of final goods and services that all
firms ready to produce and sell at a given price level
 question: what determines the readiness to
produce/supply
 Production factors
 Maximization of profit
  The Sticky-Wage Theory:
Nominal wages are slow to adjust, or are “sticky”, in the
short run.

Wages do not adjust immediately to the price level,

a lower price level makes employment and production less
profitable, which induces firms to reduce the quantity of
goods and services supplied.

14
Short-run Aggregate Supply: ASSR
 Maximization of Profit
Profit = Total Revenue – Total Cost
= P x Y – Labor cost – other costs
= P x Y – L x W – other costs
MPL = ΔY = W
ΔL P
 Sticky-Wage theory (in short-run)
 W=W P rises  W/P falls  L rises  Y rises
P falls  W/P rises  L falls  Y falls

W P
P
Supply
of
Goods
and
Demand Services
for Labor

L Y
 Short-run Aggregate Supply: ASSR
P

Prod
ASSR cost
K

P1 L
R
1. Price falls T
P2
2. Causes a fall in output
from Y1 to Y2

0 Y2 Y1 Total Output
 Exercise 11
 Explain the following situations will affect AD or AS
 Explain the changes in price level and GDP?
 Explain the new state will be recession/booming if the
initial state is long-run equilibrium?
a) The stock market declines…
b) The Federal Gov. increases spending…
c) The technological improvement…
d) A recession overseas…
3. Equilibrium state AD-AS

 What determines equilibrium state

 Demand Shock

 Supply Shock

 Demand shock and supply shock together

What determines equilibrium of
AD-AS
P
K, L, R, T, Cost
AS

Po
E0 Equilibrium

AD
C, I, G, X, IM
0 Yo Total Output
What determines equilibrium of
AD-AS
P
AS

Po
E0 Long-run Equilibrium

AD

0 Potential Total Output

Output
Y*
What determines equilibrium of AD-
AS:
When actual output is less than Potential output
P
AS

E1
P1 Recession/Depression

AD

0 Total Output
Y1 < Y*
What determines equilibrium
of AD-AS:
When actual output is higher than Potential output
P
AS

E2
P2
Booming/Bubble

AD

Total Output
0
Y* < Y2
 A demand shock causes…
2. In short-run P
P and Y fall…

AS1

P1 A

P2 B
1. Demand falls and
shifts to the left…

AD2 AD1
0 Y2 Y1 Total Output
 A supply shock causes
P 1. AS shifts to the left…

AS2
AS1

B
P2
A
P1
3. …and price
to rise

AD
0
Y2 Y1 Total Output
2. …cause total output to fall…
4. Long-run equilibrium

 After a shock from AD or AS

 There is equilibrium in goods market

but unequilibrium in labor market

 Changes in wages in long run lead to

AS adjustment
 Case 1 AD shock to reduce

P
P reduces, Y reduces,
AS U increases

Long-run: W reduces
P0

P1
Production costs reduces
P2
AD

Y1 Y0 Y AS shifts right:
Y* Y increases = Y*
 Case 2 AS shock to reduce

P
P increases, Y reduces,
AS U increases

P2
Long-run: W reduces
P0

Production costs reduces

AD

Y0 Y AS shifts right:
Y* Y increases = Y*
 Case 3 AD shock to increase

P
P increases, Y increases,
AS U reduces
P2

P1
Long-run: W increases
P0

Production costs increases

AD

Y0 Y1 Y AS shifts left:
Y* Y reduces= Y*
 Case 4 AS shock to increase

P
P reduces, Y increases,
AS U reduces

Long-run: W increases
P0

P2
Production costs increases

AD

Y0 Y2 Y AS shifts left:
Y* Y reduces= Y*
 Summary for AD and AS
ASLR (given K, L, R, T)
P Production Cost
ASSR Capital K
Labour L
Natural Resources R
Technology T
E0
P0

Consumption C
Investment I
Gov. Spending G
AD Export X
Import IM

0 Y0 = Y* Y
 Assume that the economy is initially at the
potential output. With each of the events in
ex.10, explain the new state for the economy
ASLR (K, L, R, T)
P Production Cost
Capital K
Labour L
AS Natural Resources R
Technology T

P0 E0
Consumption C
Investment I
Gov. Spending G
Export X
Import IM
AD

0 Y0 = Y* Y
 Price
1. Firms are
Level
pessimistic about the
future of the It takes a
economy and reduce quite long
Aggregate time for wage
investment supply and price
adjustment

Equilibrium 2. Wages and

price level other materials’
prices reduce

Aggregate
demand

0 Equilibrium Quantity of
output Output
33