Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik1 Universität Leipzig Introduction to Economics Lecture 9: Business Cycles Alexander Fink, PhD

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik2 Overview Characteristics of short-run fluctuations Differences between short-run and long-run economic developments Model of short-run fluctuations building on aggregate demand and aggregate supply

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik3 Short-Run Economic Fluctuations A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik4 Short-Run Economic Fluctuations Output Y Time t Output with full employment Currrent output Boom Recession The Business Cycle

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik5 Three Key Facts About Economic Fluctuations Economic fluctuations are irregular and unpredictable. –Fluctuations in the economy are often called the business cycle. Most macroeconomic variables fluctuate together. As output falls, unemployment rises.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik © Schäffer-Poeschel Verlag für Wirtschaft Steuern Recht GmbH Institut für Wirtschaftswissenschaft. Universität Erlangen-Nürnberg. 6 Indicators of Short-Run Fluctuations: German GDP Real GDP Growth rate of GDP Growth rate of GDP in % Growth rate of GDP Year Real GDP (bill. Euro)

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik © Schäffer-Poeschel Verlag für Wirtschaft Steuern Recht GmbH Institut für Wirtschaftswissenschaft. Universität Erlangen-Nürnberg. 7 Indicators of Short-Run Fluctuations: Investments Investments Growth rate of investments Growth rate of Investments in % Year Real investments (bill. Euro)

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik8 Indicators of Short-Run Fluctuations: Unemployment Rate Year Unemployment rate in %

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik9 Explaining Short-Run Economic Fluctuations How the Short Run Differs from the Long Run –Most economists believe that classical theory describes the world in the long run but not in the short run. Changes in the money supply affect nominal variables but not real variables in the long run. The assumption of monetary neutrality is not appropriate when studying year-to-year changes in the economy.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik10 The Basic Model of Economic Fluctuations Two variables are used to develop a model to analyze the short-run fluctuations. –The economys output of goods and services measured by real GDP. –The overall price level measured by the CPI or the GDP deflator.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik11 The Basic Model of Economic Fluctuations The basic model of fluctuations is based on changes in supply and demand: – the aggregated supply –The aggregated demand Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik12 The Basic Model of Economic Fluctuations The aggregate-demand curve shows the quantity of goods and services that households, firms, and the 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.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik13 Quantity of Output Price Level 0 Aggregate supply Aggregate demand Equilibrium output Equilibrium price level Aggregate Demand and Aggregate Supply...

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik14 The Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX with: C = Household Consumption I = Private Investments G= Government consumption NX = Net exports

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik15 Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the price level increases the quantity of goods and services demanded. The Aggregate-Demand Curve...

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik16 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

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik17 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 (the real value of, for instance, cash holdings increases), which in turn encourages them to spend more. –This increase in consumer spending means larger quantities of goods and services demanded.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik18 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. –Why does the interest rate decrease? With a lower price level, less money is being held for transactions, i.e. the demand for money decreases.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik19 Why the Aggregate-Demand Curve Is Downward Sloping The Price Level and Net Exports: The Exchange- Rate Effect –A fall in the Euro price level causes Euro interest rates to fall. –Lower interests rates relative to other currencies lead to lower capital inflows and larger capital outflows –The Euro depreciates, which stimulates Euro net exports. –The increase in net export spending means a larger quantity of goods and services demanded.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik20 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. Shifts arising from –Consumption- Investment –Government Purchases - Net Exports

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik21 Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik22 The Aggregate-Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik23 The Aggregate-Supply Curve The Long-Run Aggregate-Supply Curve –In the long run, an economys production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. –The price level does not affect these variables in the long run.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik24 Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P2P2 1. A change in the price level does not affect the quantity of goods and services supplied in the long run. P The Long-Run Aggregate-Supply Curve

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik25 The Aggregate-Supply Curve The Long-Run Aggregate-Supply Curve –The long-run aggregate-supply curve is vertical at the natural rate of output. –This level of production is also referred to as potential output or full-employment output.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik26 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 –Labor- Capital –Natural Resources- Technological Knowledge

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik27 Quantity of Output Y 1980 AD 1980 AD 1990 Aggregate Demand,AD 2000 Price Level 0 LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P In the long run, technological progress shifts long-run aggregate supply and ongoing inflation leading to growth in output... P 1990 P and growth in the money supply shifts aggregate demand... Long-Run Growth and Inflation

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik28 A New Way to Depict Long-Run Growth and Inflation Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends. In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik29 Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level reduces the quantity of goods and services supplied in the short run. Y P Y2Y2 P2P2 The Short-Run Aggregate-Supply Curve

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik30 Why the Aggregate-Supply Curve Slopes Upward in the Short Run When relatives prices (including wages) do not change, we move along the long-run aggregate supply curve and the price level has no effect on output and employment. This implies that along the short-run aggregate supply curve relatives do change: –The Misperceptions Theory –The Sticky-Wage Theory –The Sticky-Price Theory

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik31 Why the Aggregate-Supply Curve Slopes Upward in the Short Run 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. –If the prices of output goods fall and wages remain constant, profits fall. –A lower price level makes employment and production less profitable. –This induces firms to reduce the quantity of goods and services supplied.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik32 Why the Aggregate-Supply Curve Slopes Upward in the Short Run Alternative approaches that are not further discussed here give the same result: –The misperceptions theory –The sticky-price theory

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik33 Why the Short-Run Aggregate- Supply Curve Might Shift The short-run aggregate supply curve reflects the costs of production When the costs of production increase (e.g. because wages rise) firms accordingly increase their prices at any level of output The short-run aggregate supply curve shifts up When the costs of production decrease, the short-aggregate supply curve shifts down

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik34 Output Y Price level P 0 SRAS 1 Increasing costs of production shift the SRAS up. Y1Y1 P1P1 SRAS 2 P2P2 34 The Short-Run Aggregate Supply Curve (SRAS)

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik35 Why the Short-Run Aggregate Supply Curve Might Shift The expected price level affects the SRAS. Why? When firms expect the price level (including wages) to increase, they adjust prices. At a given price level they will produce less goods and services (in other words: at any given level of output the price rises)

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik36 Why the Short-Run Aggregate- Supply Curve Might Shift The SRAS shifts to the right when –more of the production factors are available (labor, capital) –technological progress occurs These shifts of the SRAS curve are real and therefore equivalent to shifts in the long-run aggregate supply curve

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik37 Y1Y1 Output Y Price level P 0 SRAS 1 LRAS 1 A Equilibrium price level SRAS 2 LRAS 2 Y2Y2 More factors of production allow to produce more at any price level. The economy moves from A to B. B Verschiebung der kurzfristigen Angebotskurve

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik38 Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium Price level The Long-Run Equilibrium

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik39 Quantity of Output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD A P Y AD 2 AS 2 1. A decrease in aggregate demand causes output to fall in the short run but over time, the short-run aggregate-supply curve shifts and output returns to its natural rate. CP3P3 B P2P2 Y2Y2 Copyright © 2004 South-Western A Contraction in Aggregate Demand

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik40 Two Causes of Economic Fluctuations 1. Shifts in Aggregate Demand –In the short run, shifts in aggregate demand cause fluctuations in the economys output of goods and services. –In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik41 Two Causes of Economic Fluctuations 2. A Shift in Aggregate Supply –A decrease in one of the determinants of aggregate supply shifts the curve to the left: Prices of imports rise Prices of inputs rise –Consequences: Output falls below the natural rate of employment. Unemployment rises. The price level rises.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik42 Quantity of Output Price Level 0 Aggregate demand and the price level to rise causes output to fall An adverse shift in the short- run aggregate-supply curve... Short-run aggregate supply,AS Long-run aggregate supply Y A P AS 2 B Y2Y2 P2P2 A Negative Supply Shock

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik43 The Effects of a Negative Supply Shock Stagflation –A negative shock in aggregate supply causes stagflationa period of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik44 The Effects of a Negative Supply Shock Policy Responses to Recession –Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Winter Semester 2011Alexander Fink, Institut für Wirtschaftspolitik45 Quantity of Output Natural rate of output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD P2P2 A P AS which causes the price level to rise further but keeps output at its natural rate policymakers can accommodate the shift by expanding aggregate demand When short-run aggregate supply falls... AD 2 C P3P3 Accommodating of a Negative Supply Shock