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Three key facts about economic fluctuationsExplaining short-run economic fluctuationsThe aggregate-demand curveThe aggregate-supply curveTwo causes of recession

Introduction

Over the last 50 years, Australian real GDP has grown about 2% per year. However, in some years GDP has not grown at this normal rate. A period when output and incomes fall, and unemployment rises, is known as a recession when it is mild and a depression when it is severe. This chapter focuses on the economy"s short-run fluctuations around its long-term trend. To do this, we employ the model of aggregate demand and aggregate supply.

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Three key facts about economic fluctuations

Economic fluctuations are irregular and unpredictable: Although economic fluctuations are often termed the business cycle, the term "business cycle" is misleading because it suggests that economic fluctuations follow a regular, predictable pattern. In reality, economic fluctuations are irregular and unpredictable.Most macroeconomic quantities fluctuate together: Although real GDP is usually used to monitor short-run changes in the economy, it really doesn"t matter which measure of economic activity is used because most macroeconomic variables that measure income, spending or production move in the same direction, though by different amounts. Investment is one type of expenditure that is particularly volatile across the business cycle.As output falls, unemployment rises: When real GDP declines, the rate of unemployment rises because when firms produce fewer goods and services, they lay off workers.

Explaining short-run economic fluctuations

Classical theory is based on the classical dichotomy and monetary neutrality. Recall, the classical dichotomy is the separation of economic variables into real and nominal variables, while monetary neutrality is the property that changes in the money supply only affect nominal variables, not real variables. Most economists believe these classical assumptions are an accurate description of the economy in the long run, but not in the short run. That is, over a period of a number of years, changes in the money supply should affect prices but should have no impact on real variables such as real GDP, unemployment, real wages and so on. However, in the short run, from year to year, changes in nominal variables such as money and prices are likely to have an impact on real variables. That is, in the short run, nominal and real variables are not independent.

We use the model of aggregate supply and aggregate demand to explain economic fluctuations. This model can be graphed with the price level, measured by the CPI or the GDP deflator on the vertical axis and real GDP on the horizontal axis. The aggregate-demand curve shows the quantity of goods and services households, firms and government wish to buy at each price level. It slopes negatively. The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level. It slopes positively (in the short run). The price level and output adjust to balance aggregate supply and demand. This model looks like an ordinary microeconomic supply and demand model. However, the reasons for the slopes and the sources of shifts in the aggregate supply and demand curves differ from those for the microeconomic model.

The aggregate-demand curve

Exhibit 1 illustrates the model of aggregate supply and aggregate demand.

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The aggregate-demand curve shows the quantity of goods and services demanded at each price level. Recall, GDP = C + I + G + NX = AD. To address why aggregate demand slopes downward, we address the impact of the price level on consumption (C), investment (I), and net exports (NX). (We ignore government spending (G) because it is a fixed policy variable.) A decrease in the price level increases consumption, investment and net exports for the following reasons:

The price level and consumption: Pigou"s wealth effect. At a lower price level, the fixed amount of nominal money in consumers" pockets increases in value. Consumers feel wealthier and spend more, increasing the consumption component of aggregate demand.The price level and investment: Keynes"s interest-rate effect. At a lower price level, households need to hold less money to buy the same products. They may lend some money by buying bonds or depositing in banks, both of which lower interest rates and stimulate the investment component of aggregate demand.The price level and net exports: Mundell-Fleming"s exchange-rate effect. Since, as described above, a lower price level causes lower interest rates, some Australian investors will invest abroad, increasing the supply of dollars in the foreign currency-exchange market. This act causes the real exchange rate of the dollar to depreciate, reduces the relative price of domestic goods compared to foreign goods, and increases the net-exports component of aggregate demand.

Note that all three explanations begin with a change in price. As price is a variable on the vertical axis, a change in price can only cause a movement along the AD curve, not a shift. All three explanations of the downward slope of the aggregate-demand curve also assume that the money supply is fixed.

When something causes a change in the quantity of output demanded at each price level, it causes a shift in the aggregate-demand curve. The following events and policies cause shifts in aggregate demand:

Shifts arising from changes in consumption: If consumers save more, if stock prices fall so that consumers feel poorer or if taxes are increased, consumers spend less and aggregate demand shifts left.Shifts arising from changes in investment: If firms become optimistic about the future and decide to buy new equipment, if an investment tax credit increases investment, if the RBA increases the money supply which reduces interest rates and increases investment, aggregate demand shifts right.Shifts arising from changes in government purchases: If federal, state or local governments increase purchases, aggregate demand shifts right.Shifts arising from changes in net exports: If foreign countries have a recession and buy fewer goods from Australia or if the value of the dollar rises on foreign exchange markets, net exports are reduced and aggregate demand shifts left.

The aggregate-supply curve

The aggregate-supply curve shows the quantity of goods and services firms produce and sell at each price level. In the long run the aggregate-supply curve is vertical, while in the short run it is upward (positively) sloping. Both can be seen in Exhibit 1.

The long-run aggregate-supply curve is vertical because, in the long run, the supply of goods and services depends on the supply of capital, labour and natural resources, and on production technology. In the long run, the supply of goods and services is independent of the level of prices. It is the embodiment of the classical dichotomy and monetary neutrality. That is, if the price level rises and all prices rise together, there should be no impact on output or any other real variable.

The long-run aggregate-supply curve shows the level of production that is sometimes called potential output or full-employment output. Since in the short run output can be temporarily above or below this level, a better name is the natural rate of output because it is the amount of output produced when unemployment is at its natural, or normal, rate. Anything that alters the natural rate of output shifts the long-run aggregate-supply curve to the right or left. Since in the long run output depends on labour, capital, natural resources and technological knowledge, we group the sources of the shifts in long-run aggregate supply into these categories:

Shifts arising from labour: If there is immigration from abroad or a reduction in the natural rate of unemployment from a reduction in the minimum wage, long-run aggregate supply shifts right.Shifts arising from capital: If there is an increase in physical or human capital, productivity rises and long-run aggregate supply shifts right.Shifts arising from natural resources: If there is a discovery of new resources, or a favourable change in weather patterns, long-run aggregate supply shifts right.Shifts arising from technical knowledge: If new inventions are employed, or international trade opens up, long-run aggregate supply shifts right.

The short-run aggregate-supply curve slopes upward (positively) because a change in the price level causes output to deviate from its long-run level for a short period of time, say, a year or two. There are three theories that explain why the short-run aggregate-supply curve slopes upward and they all share a common theme: output rises above the natural rate when the actual price level exceeds the expected price level. The three theories are:

The new classical misperceptions theory: When the price level unexpectedly falls, suppliers only notice that the price of their particular product has fallen. Hence, they mistakenly believe that there has been a fall in the relative price of their product, causing them to reduce the quantity of goods and services supplied.The Keynesian sticky-wage theory: Suppose firms and workers agree on a nominal wage contract based on what they expect the price level to be. If the price level falls below what was expected, the real wage W/P rises, raising the cost of production and lowering profits, causing the firm to hire less labour and reduce the quantity of goods and services supplied.The new Keynesian sticky-price theory: Because there is a cost to firms for changing prices, termed menu costs, some firms will resist reducing their prices when the price level unexpectedly falls. Thus, their prices are "too high" and their sales decline, causing the quantity of goods and services supplied to fall.

Note two features of the explanations above: (1) in each case, the quantity of output supplied changed because actual prices deviated from expected prices; and (2) the effect will be temporary because people will adjust their expectations over time. As each explanation is due to a change in the price level, and price is a variable on the vertical axis, there can only be a movement along the short run aggregate supply curve curve, not a shift.

Events that shift the long-run aggregate-supply curve also tend to shift the short-run aggregate-supply curve in the same direction. However, the short-run aggregate supply curve can shift while the long-run aggregate-supply curve remains stationary. In the short run, the quantity of goods and services supplied depends on perceptions, wages and prices, all of which were set based on the expected price level.

For example, if people and firms expect higher prices they set wages higher, reducing the profitability of production and reducing the quantity supplied of goods and service at each price level. Thus, the short-run aggregate-supply curve shifts left. A lower than expected price level leads to lower wages and shifts the short-run aggregate-supply curve to the right.In general, things that cause an increase in the cost of production (an increase in wages or oil prices) cause the short-run aggregate-supply curve to shift left, while a decrease in the cost of production causes the short-run aggregate-supply curve to shift right.

Two causes of recession

Exhibit 1 shows the model of aggregate demand and aggregate supply in long-run equilibrium. That is, the level of output is at the long-run natural rate where aggregate demand and long-run aggregate supply intersect, and perceptions, wages and prices have fully adjusted to the actual price level as demonstrated by short-run aggregate supply intersecting at the same point.

There are two basic causes of a recession: a leftward shift in aggregate demand; and a leftward shift in aggregate supply.

A leftward shift in aggregate demand: Suppose households cut back on their spending because they are pessimistic or nervous about the future. Consumers spend less at each price level, so aggregate demand shifts left in Exhibit 2. In the short run, the economy moves to point B where the economy is in a recession at P2, Y2 because output is below the natural rate.Policymakers could try to eliminate the recession by increasing aggregate demand with an increase in government spending or an increase in the money supply. If properly done, the government moves the economy back to point A. If the government does nothing, the recession will remedy itself or self-correct over time. Since actual prices are below prior expectations, price expectations will be reduced over time, and wages and other input prices will. As wages and other costs of production fall, the short-run aggregate supply curve shifts to the right and the economy arrives at point C.

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To summarise, in the short run, shifts in aggregate demand cause fluctuations in output. In the long run, shifts in aggregate demand only cause changes in prices.

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A leftward shift in aggregate supply: Suppose OPEC raises the price of oil, which raises the cost of production for many firms. This reduces profitability, firms produce less at each price level and short-run aggregate supply shifts to the left in Exhibit 3. Prices rise, reducing the quantity demanded along the aggregate-demand curve, and the economy arrives at point B. Since output has fallen (stagnation) and the price level has risen (inflation), the economy has experienced stagflation. If policymakers do nothing, the unemployment at Y2 will, in time, put downward pressure on workers" wages, increase profitability and shift aggregate supply back to its original position, and the economy returns to point A. Alternatively, policymakers could increase aggregate demand and move the economy to point C, avoiding point B altogether. Here, policymakers accommodate the shift in aggregate supply by allowing the increase in costs to raise prices permanently. Output is returned to long-run equilibrium but prices are higher. To summarise, a reduction in short-run aggregate supply causes stagflation. Policymakers cannot shift aggregate demand in a manner to offset both the increase in price and the decrease in output simultaneously.