Managerial Economics

Economic Fluctuations

Dr Davide Contu
Davide.contu@cud.ac.ae
 Economic fluctuations

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 Economic fluctuations

• As output falls, unemployment rises.

-Changes in real GDP are inversely related to changes

in the unemployment rate.

-During times of recession, unemployment rises su

bstantially.

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 How can we explain economic fluctuations?

• The Short Run differs from the Long Run

-Most economists believe that classical theory describes th

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

8 Changes in the money supply affect nominal variables

but not real variables in the long run.
8 The assumption of monetary neutrality is not
appropriate when studying year-to-year changes in
the economy.

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 How can we explain economic fluctuations?

• Two variables are used to develop a model to analyze

the short-run fluctuations.

-The economy’s output of goods and services measur

ed by real GDP.

-The overall price level measured by the CPI or the G

DP deflator.

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 How can we explain economic fluctuations?

-Economist use the model of aggregate demand a

nd aggregate supply to explain short-run fluctuatio
ns in economic activity around its long-run trend.

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 How can we explain economic fluctuations?

-Economist use the model of aggregate demand a

nd aggregate supply to explain short-run fluctuatio
ns in economic activity around its long-run trend.

-The aggregate-demand curve shows the quantity

of goods and services that households, firms, and th
e government want to buy at each price level.

This information is confidential and was prepared by Bain & Company solely for training purposes; it is not to be relied on by any 3rd party without Bain's prior written consent. 7
 How can we explain economic fluctuations?

-Economist use the model of aggregate demand a

nd aggregate supply to explain short-run fluctuatio
ns in economic activity around its long-run trend.

-The aggregate-demand curve shows the quantity

of goods and services that households, firms, and th
e government want to buy at each price level.

-The aggregate-supply curve shows the quantity of

goods and services that firms choose to produce and
sell at each price level.

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The Aggregate-Demand Curve

Price
Level

P2

1. A decrease
Aggregate
in the price
demand
level . . .

0 Y Y2 Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.

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The Short-Run Aggregate-Supply Curve

Price
Level

Short-run
aggregate
supply

P2
1. A decrease 2. . . . reduces the quantity
in the price of goods and services
level . . . supplied in the short run.

0 Y2 Y Quantity of
Output

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Aggregate Demand and Aggregate Supply

Price
Level

Aggregate
supply

Equilibrium
price level

Aggregate
demand

0 Equilibrium Quantity of
output Output
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 The supply curve in the long run

-In the long run, an economy’s production of goods a

nd services depends on its supplies of labor, capital
, and natural resources and on the available techn
ology used to turn these factors of production into g
oods and services.

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 The supply curve in the long run

-In the long run, an economy’s production of goods a

nd services depends on its supplies of labor, capital
, and natural resources and on the available techn
ology used to turn these factors of production into g
oods and services.

-The price level does not affect these variables in the

long run.

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 The supply curve in the long run

-In the long run, an economy’s production of goods a

nd services depends on its supplies of labor, capital
, and natural resources and on the available techn
ology used to turn these factors of production into g
oods and services.
How would we represent graphically
the
-The pricelong runnot
level does supply curve
affect these then?
variables in the
long run.

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The Long-Run Aggregate-Supply Curve

Price
Level

Long-run
aggregate
supply

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

of output Output

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 Short-Run Economic Fluctuations

• Economic activity fluctuates from year to year.

-In most years production of goods and services rises.

-In some years normal growth does not occur, causing a r

ecession.

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 Short-Run Economic Fluctuations

GDP Growth

https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
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 Short-Run Economic Fluctuations

GDP Growth

https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
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 Short-Run Economic Fluctuations

GDP Growth

https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
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 Short-Run Economic Fluctuations

GDP Growth

https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG
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 There are more and less severe fluctuations

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

rising unemployment (definition changes across
countries, but usually it is good practice to call a
recession a phase of robust production decline and/or
consumption decline).

• A depression is a much more severe recession.

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 There are more and less severe fluctuations

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

rising unemployment (definition changes across
countries, but usually it is good practice to call a
recession a phase of robust production decline and/or
consumption decline).

• A depression is a much more severe recession.

https://www.frbsf.org/education/publications/doctor-econ/2007/february/recession-depression-difference/
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 Three key facts around economic fluctuations

• Economic fluctuations tend to be irregular and difficult to predict.

• Most macroeconomic variables might fluctuate together.

• As output falls, unemployment is expected to rises.

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 Three key facts around economic fluctuations

• Economic fluctuations tend to be irregular and difficult to predict.

This information is confidential and was prepared by Bain & Company solely for training purposes; it is not to be relied on by any 3rd party without Bain's prior written consent. 24
 Three key facts around economic fluctuations

• Economic fluctuations tend to be irregular and difficult to predict.

This information is confidential and was prepared by Bain & Company solely for training purposes; it is not to be relied on by any 3rd party without Bain's prior written consent. 25
 Three key facts around economic fluctuations

• Economic fluctuations tend to be irregular and difficult to predict.

This information is confidential and was prepared by Bain & Company solely for training purposes; it is not to be relied on by any 3rd party without Bain's prior written consent. 26
 Three key facts around economic fluctuations

• Most macroeconomic variables might fluctuate together.

• As output falls, unemployment is expected to rises.

This information is confidential and was prepared by Bain & Company solely for training purposes; it is not to be relied on by any 3rd party without Bain's prior written consent. 27
 The Basic Model of Economic Fluctuations

• Two variables are used to develop a model to analyze the short-

run fluctuations.
-The economy’s output of goods and services measured by real GDP.
-The overall price level measured by the CPI or the GDP deflator.

• The Basic Model of Aggregate Demand and Aggregate Supply

-Economist use the model of aggregate demand and aggregate supply t
o explain short-run fluctuations in economic activity around its long-ru
n trend.
-The aggregate-demand curve shows the quantity of goods and service
s that households, firms, and the government want to buy at each pric
e level.
-The aggregate-supply curve shows the quantity of goods and services
that firms choose to produce and sell at each price level.

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 The aggregate demand curve depend on…?

• The four components of GDP (Y) contribute to the aggregate

demand for goods and services.
Y = C + I + G + NX

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 Why the Aggregate-Demand curve is downward sloping?

• The Price Level and Consumption: The Wealth Effect

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

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 Why the Aggregate-Demand curve is downward sloping

• The Price Level and Consumption: The Wealth Effect

-A decrease in the price level makes consumers feel more wealthy, whi
ch in turn encourages them to spend more.

-This increase in consumer spending means larger quantities of goods a

nd services demanded.

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 Why the Aggregate-Demand curve is downward sloping

• The Price Level and Investment: The Interest Rate Effect

-A lower price level reduces the interest rate, which encourages greater
spending on investment goods.

-This increase in investment spending means a larger quantity of goods

and services demanded.

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 Why the Aggregate-Demand curve is downward sloping

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

-For instance, when a fall in the U.S. price level causes U.S. interest rat
es to fall, the real exchange rate depreciates, which stimulates U.S. ne
t exports (because it is now cheaper to buy US goods from abroad).

-The increase in net export spending means a larger quantity of goods

and services demanded.

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 Why the Aggregate-Demand Curve might shift?

• The downward slope of the aggregate demand curve shows that a

fall in the price level raises the overall quantity of goods and
services demanded.

• Many other factors, however, affect the quantity of goods and

services demanded at any given price level.

• When one of these other factors changes, the aggregate demand

curve shifts. Shifts can be caused by changes in:

-Consumption
-Investment
-Government Purchases
-Net Exports

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 The short run supply curve is instead positively sloped.
Why?

• The Misperceptions Theory

-Changes in the overall price level temporarily mislead suppliers about what is hap
pening in the markets in which they sell their output:
-A lower price level causes misperceptions about relative prices. These mispercepti
ons induce suppliers to decrease the quantity of goods and services supplied.

• The Sticky-Wage Theory

-Nominal wages are slow to adjust, or are “sticky” in the short run:
-Wages do not adjust immediately to a fall in the price level.
-A lower price level makes employment and production less profitable. This induces
firms to reduce the quantity of goods and services supplied.

• The Sticky-Prices Theory

-Prices of some goods and services adjust sluggishly in response to changing econo
mic conditions:
-An unexpected fall in the price level leaves some firms with higher-than-desired pr
ices.
-This depresses sales, which induces firms to reduce the quantity of goods and serv
ices they produce.

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 Why the short run Aggregate-Supply Curve might shift?

• The upward slope of the aggregate supply curve shows that a fall
in the price level leads to a decrease in the overall quantity of
goods and services supplied.

• Many other factors, however, affect the quantity of goods and

services supplied at any given price level.

• When one of these other factors changes, the aggregate supply

curve shifts. Shifts can be caused by changes in:
-Labor
-Capital
-Natural Resources
-Technology
-Expected Price Level

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 We discussed earlier that the supply curve in the
long run is vertical…

• The Long-Run Aggregate-Supply Curve

-In the long run, an economy’s production of goods and services depen
ds on its supplies of labor, capital, and natural resources and on the av
ailable technology used to turn these factors of production into goods
and services.

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

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 The Long-Run Aggregate-Supply Curve

Price
Level

Long-run
aggregate
supply

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

of output Output

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Copyright © 2004 South-Western
 Why the Long-Run Aggregate-Supply Curve Might shift?

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

• The shifts may be categorized according to the various factors in

the classical model that affect output. Shifts might arise from
changes in:
-Labor
-Capital
-Natural Resources
-Technological Knowledge

• No impact of expected prices in the long run.

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 Let us explore impacts of shifts over time

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Long-Run Growth and Inflation Example of
monetary
Short-run 2. . . . and growth in the Long-run policy
money supply shifts
fluctuations in aggregate demand . . .
aggregate
supply,
output and price LRAS1980 LRAS1990 LRAS2000
level should be Price
viewed as Level

deviations from
the continuing 1. In the long run,
long-run trends. technological
progress shifts
P2000 long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990

AD1980

0 Y1980 Y1990 Y2000 Quantity of

Output
3. . . . leading to growth
in output . . .
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The Long-Run Equilibrium

Price
Level
Long-run
aggregate
Short-run
supply
aggregate
supply

Equilibrium A
price

Aggregate
demand

0 Natural rate Quantity of

of output Output

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A Contraction in Aggregate Demand

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

Price
Level
Long-run Short-run aggregate
aggregate supply, AS
supply
AS2

3. . . . but over
time, the short-run
P A aggregate-supply
curve shifts . . .
P2 B
1. A decrease in
aggregate demand . . .
P3 C
Aggregate
demand, AD
AD2
0 Y2 Y Quantity of
4. . . . and output returns Output
to its natural rate.
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 Major determinants of economic fluctuations:

• Shifts in Aggregate Demand

-In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
-In the long run, shifts in aggregate demand affect the overall price lev
el but do not affect output.

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 Major determinants of economic fluctuations:

• An Adverse Shift in Aggregate Supply

-A decrease in one of the determinants of aggregate supply shifts the c
urve to the left:
8 Output falls below the natural rate of employment.
8 Unemployment rises.
8 The price level rises.

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An Adverse Shift in Aggregate Supply

1. An adverse shift in the short-

run aggregate-supply curve . . .
Price
Level

Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand

0 Y2 Y Quantity of
2. . . . causes output to fall . . . Output
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 The Effects of a Shift in Aggregate Supply

• Stagflation
-Adverse shifts in aggregate supply cause stagflation—a period of reces
sion and inflation.
8 Output falls and prices rise.
8 Policymakers who can influence aggregate demand cannot offset
both of these adverse effects simultaneously.

• Policy Responses to Recession

-Policymakers may respond to a recession in one of the following ways:
8 Do nothing and wait for prices and wages to adjust.
8 Take action to increase aggregate demand by using monetary and
fiscal policy.

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Accommodating an adverse Shift in Aggregate
Supply

1. When short-run aggregate

supply falls . . .
Price
Level
Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

P3 C 2. . . . policymakers can
P2 accommodate the shift
A by expanding aggregate
3. . . . which P demand . . .
causes the
price level
to rise 4. . . . but keeps output AD2
further . . . at its natural rate.
Aggregate demand, AD

0 Natural rate Quantity of

of output Output
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 Summary

• All societies experience short-run economic fluctuations around long-run trends.

• These fluctuations are irregular and largely unpredictable.
• When recessions occur, real GDP and other measures of income, spending, and production fall, and
unemployment rises.
• Economists analyze short-run economic fluctuations using the aggregate demand and aggregate supply
model.
• According to the model of aggregate demand and aggregate supply, the output of goods and services and the
overall level of prices adjust to balance aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and
an exchange rate effect.
• Any event or policy that changes consumption, investment, government purchases, or net exports at a given
price level will shift the aggregate-demand curve.
• In the long run, the aggregate supply curve is vertical.
• The short-run, the aggregate supply curve is upward sloping.
• The are three theories explaining the upward slope of short-run aggregate supply: the misperceptions theory,
the sticky-wage theory, and the sticky-price theory.
• Events that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve.
• Also, the position of the short-run aggregate-supply curve depends on the expected price level.
• One possible cause of economic fluctuations is a shift in aggregate demand.
• A second possible cause of economic fluctuations is a shift in aggregate supply.
• Stagflation is a period of falling output and rising prices.

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