Economic Fluctuation and the Business Cycle

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Economic Fluctuation and the Business Cycle

• The business cycle is up-and-down movement in
  production and jobs.
• A business cycle has two phases, expansion and
  recession, and two turning point, a peak and a
  trough.
• A Recession is a decrease in real GDP that lasts
  for at least two quarters (six months) or a
  period of significant decline in total output,
  income, employment.
• Ques When is unemployment above/below its
  natural rate? At what point is unemployment at
  its lowest?

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Aggregate Supply and Aggregate Demand

• Recall- We covered models determining real
  output, the market for loanable funds, and the
  money market.
• (can someone comment on some major aspects of
  these models?)
• We need a model to analyze economic fluctuation.
• The AS-AD model is one that helps explain
  economic fluctuation, the business cycle, and the
  aim of government policy.
• AS-AD prices and money supply does affect real
  GDP.

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AGGREGATE SUPPLY

• Aggregate supply is the relationship between the
  quantity of real GDP supplied and the price level
  when all other influences on production plans
  remain the same.
• -a change in the price level changes the quantity
  of real GDP supplied.
• n.B There is a 1) short run AS curve that slopes
  upward.
• Shifters- Changes in firms cost of production
• (i.e wages , rent , interest rates, corporate
  tax rates).
• 2) Long run AS curve, that identifies the level
  of potential GDP. ( the idea is the output will
  always return to its long run potential.
• Shifters- Factors that change potential GDP.
  (recall)
• n.b- A shift of the long run AS curve also shifts
  the short run curve.

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AGGREGATE DEMAND

• Aggregate demand is the relationship between the
  quantity of real GDP demanded and the price level
  when all other influences on expenditure plans
  remain the same.
• A change in price impacts the quantity of AD via
  three effects.
• Wealth Effect, Interest Rate Effect, Exchange
  Rate effect.
• Can you think how they work.
• Recall- Y CIG(N-X)
• Shifters
• Expectations on future income, profits.
• Government and Fed policy
• Overseas economies.

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AGGREGATE DEMAND

• Government can use fiscal policy to influence
  aggregate demand.
• Fiscal policy is changing taxes, transfer
  payments, and government expenditure on goods and
  services.
• The Federal Reserve can use monetary policy to
  influence aggregate demand.
• Monetary policy is changing the quantity of money
  and the interest rate.

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13.4 UNDERSTANDING BUSINESS CYCLES
Three possible macroeconomic equilibriums are
1. Below full-employment equilibrium, when
potential GDP exceeds equilibrium real GDP.
2. Full-employment equilibrium, when equilibrium
real GDP equal potential GDP.
3. Above full-employment equilibrium, when
equilibrium real GDP exceeds potential GDP.
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Analysis of the Business Cycle Fluctuation

• 4 step analysis.
• Decide if there is a shift in AS, AD or both.
• Decide which direction
• Describe how output, prices, and wages are
  affected.
• Keep track of short-run and long-run equilibrium.
• Describe how the economy transitions to long
  run.
• Example. New technology is created increasing the
  profitability of firms. Analyse the possible
  economic fluctuation that may occur.

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UNDERSTANDING BUSINESS CYCLES

• Ex. 2 Analyze the short run and long run impact
  of a global rise in oil prices.
• What we see occur is called stagflation/stagnation
  .
• Stagflation is a combination of recession
  (falling real GDP) and inflation (rising price
  level).

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• Definitions
• Inflationary gap is a gap that exists when real
  GDP exceeds potential GDP and that brings a
  rising price level.
• Recessionary gap is a gap that exists when
  potential GDP exceeds real GDP and that brings a
  falling price level.

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• Figure 13.12 shows adjustments toward full
  employment.

Real GDP exceeds potential GDP there is an
inflationary gap and the price level rises.
As the money wage rate gradually rises, aggregate
supply decreases, real GDP decreases, and the
price level rises farther.
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• Potential GDP exceeds real GDPrecessionary gap
  and the price level falls.

Eventually, the money wage rate starts to fall,
aggregate supply increases, real GDP increases,
and the price level falls farther.
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Additional Questions

• Use the AS-AD model to describe how Real GDP and
  prices are impacted in the short-run and long run
  if there is a
• An increase in the corporate tax rate
• A reduction in wages
• A increase in the average education level.
• 2) Use the AS-AD model to identify a
• Fed policy that may remove a recessionary gap.
• Fiscal policy that may combat an inflationary
  gap.
• 3)Use the AS-Ad model to analyze the business
  cycle created by the wall street crisis.
• Analyze the policy tools used to shorten the
  recessionary period.