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Short-run fluctuations in output and employment are called the business cycle. In previous chapters, we developed theories to explain how the economy behaves in the long run; now we’ll seek to understand how the economy behaves in the short run.

Short-run fluctuations in output and employment are called the business cycle. In previous chapters, we developed theories to explain how the economy behaves in the long run; now we’ll seek to understand how the economy behaves in the short run.

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Business Cycle

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GDP is the first place to start when analyzing the business cycle,since it is the largest gauge of economic conditions.

The National Bureau of Economic Research (NBER) is the officialdeterminer of whether the economy is suffering from a recession.A recession is usually defined by a period in which there are twoconsecutive declines in real GDP.

In recessions, both consumption and investment decline; however,investment (business equipment, structures, new housing and inventories) is even more susceptible to decline.

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In recessions, unemployment rises. This negative (when one rises, the other falls) relationship between unemployment and GDP is called Okun’s Law, after Arthur Okun, the economist who first studied it. In short, it is defined as: Percentage Change in Real GDP = 3.5% - 2 the Change in the Unemployment RateIf the unemployment rate remains the same, real GDP grows byabout 3.5 percent. For every percentage point the unemployment raterises, real GDP growth typically falls by 2 percent. Hence, if theunemployment rate rises from 5 to 8 percent, then real GDP growthwould be:Percentage Change in Real GDP = 3.5% - 2 (8% - 5%) = - 2.5%In this case, GDP would fall by 2.5%, indicating that the economyis in a recession.

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Many economists in business and government have the roleof forecasting short-run fluctuations in the economy. One waythat economists arrive at forecasts is through looking at leadingindicators.

Each month, the Conference Board, a private economics Research announces the index of leading economic indicators,which consists of 10 data series.

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1) Average workweek of production workers in manufacturing2) Average initial weekly claims for unemployment insurance3) New orders for consumer goods and materials adjusted for inflation4) New orders, nondefense capital goods5) Vendor performance6) New building permits issued7) Index of stock prices8) Money-supply (M2) adjusted for inflation9) Interest rate spread: the yield spread between 10-year Treasurynotes and 3-month treasury bills10) Index of consumer expectations

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Classical macroeconomic theory applies to the long run but not to the short run–WHY?

The short run and long run differ in terms of the treatment of prices.In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are “sticky” at some predetermined level.

Because prices behave differently in the short run than in the long run, economic policies havedifferent effects over different time horizons.

Let’s see this in action.

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Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. It tells us the quantity of goods and services people want to buy at any given level of prices. Recall the Quantity Theory of Money (MV=PY), where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output. It makes the not quite realistic, but very convenient assumption that velocity is constant over time. Also, when interpreting this equation, recall that the quantity equation can be rewritten in terms of the supply and demand for real money balances: M/P = (M/P)d = kY, where k = 1/V is a parameter determining how much money people want to hold for every dollar of income. This equation states that supply of money balances M/P is equal to the demand and that demand is proportional to output.The assumption of constant velocity is equivalent to the assumption ofa constant demand for real money balances per unit of output.

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The Aggregate Demand (AD) curve shows the negative relationship between the price level P and quantity of goods and services demanded Y. It is drawn for a given value of the money supply M. The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real balances M/P, and therefore the lower the quantity of

goods and services demanded Y.

Pri

ce le

vel

Output (Y)

AD

As the price level decreases, we’dmove down along the AD curve.Any changes in M or V would shiftthe AD curve.Remember that the demand for realoutput varies inversely with the pricelevel.

Y = MV/P

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Think about the supply and demand for real money balances. If output is higher, people engage in more transactions and need higher real balances M/P. For a fixed money supply M, higher real balances imply a lower price level. Conversely, if the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded.

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Pri

ce le

vel

Output (Y)

AD'AD

A decrease in the money supply Mreduces the nominal value of outputPY. For any given price level P,output Y is lower. Thus, a decrease in the money supply shifts the ADcurve inward from AD to AD'.

A decrease in the money supply Mreduces the nominal value of outputPY. For any given price level P,output Y is lower. Thus, a decrease in the money supply shifts the ADcurve inward from AD to AD'.

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Pri

ce le

vel

Output (Y)

AD'AD

An increase in the money supply Mraises the nominal value of outputPY. For any given price level P,output Y is higher. Thus, an increase in the money supply shifts the ADcurve outward from AD to AD'.

An increase in the money supply Mraises the nominal value of outputPY. For any given price level P,output Y is higher. Thus, an increase in the money supply shifts the ADcurve outward from AD to AD'.

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Aggregate supply (AS) is the relationship between the quantity of goods and services supplied and the price level. Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon.

There are two different aggregate supply curves: the long-run aggregatesupply curve (LRAS) and the short-run aggregate supply curve (SRAS).We also must discuss how the economy makes the transition from theshort run to the long run.

But, first, let’s build the long-run aggregate supply curve (LRAS).

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Because the classical model describes how the economy behaves in the long run, we can derive the long-run aggregate supply curve from theclassical model.

Recall the amount of output produced depends on the fixed amounts ofcapital and labor and on the available technology.

To show this, we write Y = F(K, L) = Y

According the classical model, output does not depend on the price level. Let’s think about this considering the market clearing process inthe labor market, the “L” component of the production function.

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Real wage,

W/PW/P

nndd

Hours worked

Let’s begin at full employment, n*, with a wage of W/P0.

nn *

W/PW/P00

W/W/22PP00

Now let’s see how workers will respond when there is a sudden increase in the price level.

nnss

(Employees)

(Employers)

nn

At this new lower real wage, workers will cut back on hours worked.

But, at the sametime, employers increase their demandfor workers.

nn What will happen next?What will happen next?

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W/PW/P

nndd

Hours worked nn *

WW//22PP00

(Employees)

(Employers)

nn nn

So, right now the labor market is in “disequilibrium” where the quantity demanded exceeds the quantity supplied.

nnss

We’re now going to see how “flexible wages” will allow the labor market to come back to equilibrium, at full employment, n*.

To hire more workers, the employer must raise the real wage to 2W.

22WW//22PP00

As a result of 2W, more workers are hired, and the labor marketcan move...

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The vertical line suggests that changes in the price level

will have no lasting impact onfull employment.

The vertical line suggests that changes in the price level

will have no lasting impact onfull employment.

The mechanism we just went through will enable usto build our long run aggregate supply curve.

PP

YYYY

Y=F (K, L)

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A reduction in the money supply shifts the aggregate demand curve downward

from AD to AD'. Since the AS curve is vertical in the long

run, the reduction in AD affects the price level, but not

the level of output.

A reduction in the money supply shifts the aggregate demand curve downward

from AD to AD'. Since the AS curve is vertical in the long

run, the reduction in AD affects the price level, but not

the level of output.

The vertical-aggregate supply curve satisfies the classical dichotomy,because it implies that the level of output is independent of the money

supply. This long-run level of output, Y, is called the full-employment ornatural level of output. It is the level of output at which the economy’s

resources are fully employed, or more realistically, at whichunemployment is at its natural rate.

PP

YYYY

B

A

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Remember that the the vertical LRAS curve assumed that changes in the price level left no lasting impact on Y (because of the market-clearing process)--that will be the model for examining the long term. But we need a theory for the short run, defined as the interval of time during which markets are not fully cleared.

P

Y

LRAS

YY = F (K,L)

P0

ADADA

B

C

A simple, but useful first approach is to assume short-run price rigidity meaning that the aggregate supply

curve is flat. As AD shifts to AD we slide in an east-west direction to point B on the short run aggregate supply

curve (SRAS).Then, in the long run, we move from

B to C (move up and along AD).

SRAS

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PP

YY

LRASLRAS

YY

Y = F (K,L)Y = F (K,L)

ADAD

SRASSRAS

In the long run, the economy finds itself at the intersection of thelong-run aggregate supply curve and aggregate demand curve. Becauseprices have adjusted to this level, the SRAS crosses this point as well.

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The economy begins in long-run equilibrium at point A. Then, a reduction in aggregate demand, perhaps caused by a decrease in the money supply M, moves the economy from point A to point B, whereoutput is below its natural level. As prices fall, the economy recovers from the recession, moving from point B to point C.

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Exogenous changes in aggregate supply or aggregate demand are called shocks. A shock that affects aggregate supply is called asupply shock. A shock that affects aggregate demand is calleda demand shock. These shocks that disrupt the economy push outputand unemployment away from their natural levels.

A goal of the aggregate demand/aggregate supply model is to helpexplain how shocks cause economic fluctuations. Economists usethe term stabilization policy to refer to the policy actions taken to reduce the severity of short-run economic fluctuations. Stabilizationpolicy seeks to dampen the business cycle by keeping output andemployment as close to their natural rate as possible. The model in this chapter is a simpler version of the one we’ll see in coming chapters.

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The economy begins in long-run equilibrium at point A. An increasein aggregate demand, due to an increase in the velocity of money,moves the economy from point A to point B, where output is aboveits natural level. As prices rise, output gradually returns to its naturalrate, and the economy moves from point B to point C.

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An adverse supply shock pushes up costs and prices. If AD is held constant, the economy moves from point A to point B, leading tostagflation—a combination of increasing prices and declining levelof output. Eventually, as prices fall, the economy returns to the natural rate at point A.

SRASSRAS''

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In response to an adverse supply shock, the Fed can increase aggregatedemand to prevent a reduction in output. The economy moves frompoint A to point B. The cost of this policy is a permanently higherlevel of prices.

SRASSRAS''

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Aggregate demandAggregate supplyShocksDemand shocksSupply shocksStabilization policy

Aggregate demandAggregate supplyShocksDemand shocksSupply shocksStabilization policy