Short-run

Short-runfluctuations
fluctuationsin
inoutput
outputand
andemployment
employmentare
are
called
calledthe
thebusiness
businesscycle.
cycle.In
Inprevious
previouschapters,
chapters,we
we
developed
developedtheories
theoriesto
toexplain
explainhow
howthe
theeconomy
economy
behaves
behavesin
inthe
thelong
longrun;
run;now
nowwell
wellseek
seekto
tounderstand
understand
how
howthe
theeconomy
economybehaves
behavesin
inthe
theshort
shortrun.
run.

Chapter
Nine

Business Cycle

Chapter
Nine

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 official
determiner of whether the economy is suffering from a recession.
A recession is usually defined by a period in which there are two
consecutive 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.
Chapter
Nine

In recessions, unemployment rises. This negative (when one rises,

the other falls) relationship between unemployment and GDP is
called Okuns 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 Rate
If the unemployment rate remains the same, real GDP grows by
about 3.5 percent. For every percentage point the unemployment
rate
rises, real GDP growth typically falls by 2 percent. Hence, if the
unemployment rate rises from 5 to 8 percent, then real GDP growth
would 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 economy
Chapter
4
is in
a recession.
Nine

Many economists in business and government have the role

of forecasting short-run fluctuations in the economy. One way
that economists arrive at forecasts is through looking at leading
indicators.
Each month, the Conference Board, a private economics
Research announces the index of leading economic indicators,
which consists of 10 data series.

Chapter
Nine

1) Average workweek of production workers in manufacturing

2) Average initial weekly claims for unemployment insurance
3) New orders for consumer goods and materials adjusted for inflation
4) New orders, nondefense capital goods
5) Vendor performance
6) New building permits issued
7) Index of stock prices
8) Money-supply (M2) adjusted for inflation
9) Interest rate spread: the yield spread between 10-year Treasury
notes and 3-month treasury bills
10) Index of consumer expectations

Chapter
Nine

Classical macroeconomic theory applies to the long run but not to

the short runWHY?
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 have
different effects over different time horizons.
Lets see this in action.
Chapter
Nine

LRAS

Chapter
Nine

LRAS

SRAS

SRAS

SRAS

AD

AD

AD

LRAS

LRAS

LRAS

LRAS

SRAS

SRAS

SRAS

AD

AD

AD

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 of
a constant demand for real money balances per unit of output.
Chapter
Nine

Price level

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.

AD
Output (Y)
Chapter
Nine

As the price level decreases, wed

move down along the AD curve.
Any changes in M or V would shift
the AD curve.
Remember that the demand for real
output varies inversely with the price
level.
Y = MV/P
10

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.

Chapter
Nine

11

Price level

AAdecrease
decreasein
inthe
themoney
moneysupply
supplyM
M
reduces
reducesthe
thenominal
nominalvalue
valueof
ofoutput
output
PY.
PY. For
Forany
anygiven
givenprice
pricelevel
levelP,
P,
output
outputYYisislower.
lower.Thus,
Thus,aadecrease
decrease
in
inthe
themoney
moneysupply
supplyshifts
shiftsthe
theAD
AD
curve
curveinward
inwardfrom
fromAD
ADto
toAD'.
AD'.
AD
AD'
Output (Y)

Chapter
Nine

12

Price level

An
Anincrease
increasein
inthe
themoney
moneysupply
supplyM
M
raises
raisesthe
thenominal
nominalvalue
valueof
ofoutput
output
PY.
PY. For
Forany
anygiven
givenprice
pricelevel
levelP,
P,
output
outputYYisishigher.
higher.Thus,
Thus,an
anincrease
increase
in
inthe
themoney
moneysupply
supplyshifts
shiftsthe
theAD
AD
curve
curveoutward
outwardfrom
fromAD
ADto
toAD'.
AD'.
AD
AD'
Output (Y)

Chapter
Nine

13

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 aggregate
supply curve (LRAS) and the short-run aggregate supply curve (SRAS).
We also must discuss how the economy makes the transition from the
short run to the long run.
But, first, lets build the long-run aggregate supply curve (LRAS).
Chapter
Nine

14

Because the classical model describes how the economy behaves in the
long run, we can derive the long-run aggregate supply curve from the
classical model.
Recall the amount of output produced depends on the fixed amounts of
capital 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. Lets think about this considering the market clearing process in
the labor market, the L component of the production function.
Chapter
Nine

15

Lets begin at full employment, n*, with a wage of W/P0.

Now lets see how workers will respond when there
is a sudden increase in the price level.
At this new lower real wage,
workers will cut back on hours worked.

Real wage,

ns

W/P

(Employees)

But, at the same

time, employers
increase their demand
for workers.

W/P0
W/2P0
Chapter
Nine

(Employers)

n n * n

Hours worked

nd

What will happen next?

16

So, right now the labor market is in disequilibrium where the quantity
demanded exceeds the quantity supplied.
Were 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.
As a result of 2W,
n
more workers are
(Employees)
hired, and the labor market
can move...

W/P

2W/2P0
W/2P0

(Employers)

nd
n n* n

Chapter
Nine

Hours worked

17

The mechanism we just went through will enable us

to build our long run aggregate supply curve.

P
Thevertical
verticalline
linesuggests
suggeststhat
that
The
changesin
inthe
theprice
pricelevel
level
changes
willhave
haveno
nolasting
lastingimpact
impacton
on
will
fullemployment.
employment.
full

Y
Chapter
Nine

Y=F (K, L)

Y
18

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 or
natural level of output. It is the level of output at which the economys
resources are fully employed, or more realistically, at which
unemployment is at its natural rate.

reductionin
inthe
themoney
money
AAreduction
supplyshifts
shiftsthe
theaggregate
aggregate
supply
demandcurve
curvedownward
downward
demand
fromAD
ADto
toAD'.
AD'. Since
Sincethe
theAS
AS
from
curveisisvertical
verticalin
inthe
thelong
long
curve
run,the
thereduction
reductionin
inAD
AD
run,
affectsthe
theprice
pricelevel,
level,but
butnot
not
affects
thelevel
levelof
ofoutput.
output.
the

A
B
Chapter
Nine

19

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.
LRAS
A simple, but useful first approach is
P
to assume short-run price rigidity
C
meaning that the aggregate supply
B
curve is flat. As AD shifts to AD we
P0
SRAS
A
AD slide in an east-west direction to point
B on the short run aggregate supply
AD
curve (SRAS).
Then, in the long run, we move from
Y
Y
Y = F (K,L)
B to C (move up and along AD).
Chapter
Nine

20

LRAS

SRAS
AD
Y

Y = F (K,L)
In the long run, the economy finds itself at the intersection of the
long-run aggregate supply curve and aggregate demand curve. Because
prices have adjusted to this level, the SRAS crosses this point as well.
Chapter
Nine

21

LRAS

A
C

SRAS
AD
AD'

Y
Y
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, where
output is below its natural level. As prices fall, the economy recovers
from the recession, moving from point B to point C.
Chapter
Nine

22

Exogenous changes in aggregate supply or aggregate demand are

called shocks. A shock that affects aggregate supply is called a
supply shock. A shock that affects aggregate demand is called
a demand shock. These shocks that disrupt the economy push output
and unemployment away from their natural levels.
A goal of the aggregate demand/aggregate supply model is to help
explain how shocks cause economic fluctuations. Economists use
the term stabilization policy to refer to the policy actions taken to
reduce the severity of short-run economic fluctuations. Stabilization
policy seeks to dampen the business cycle by keeping output and
employment as close to their natural rate as possible. The model in
this chapter is a simpler version of the one well see in coming
chapters.
Chapter
Nine

23

LRAS
C
A

SRAS
AD'
AD

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

24

LRAS
B
A

SRAS'
SRAS
AD

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

25

LRAS
B
A
Y

SRAS'
SRAS
AD'
AD
Y

In response to an adverse supply shock, the Fed can increase aggregate

demand to prevent a reduction in output. The economy moves from
point A to point B. The cost of this policy is a permanently higher
level of prices.
Chapter
Nine

26

Aggregate
Aggregatedemand
demand
Aggregate
Aggregatesupply
supply
Shocks
Shocks
Demand
Demandshocks
shocks
Supply
Supplyshocks
shocks
Stabilization
Stabilizationpolicy
policy

Chapter
Nine

27