eco fluctuation

8/13/2019 ECO Fluctuation

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Macroeconomics

Aggregate demand and

Aggregate Supply * Economics

Fluctuation


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Economic Fluctuation

Economic activity fluctuate from year to year. Inmost of years production of goods and servicesrises. In some years however, this normalgrowth does not occur. The variables we studyare largely those include GDP, unemployment,

interest rate, and price level. The policyinstruments of government spending, taxes, andthe money supply. But these variables are nothelp in focus on economic fluctuations, the differ

occurs the time horizon, the behavior of theeconomy in the long-run. Now we study theeconomys short-run fluctuations around its long-run trend.


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Key Facts About Economic Fluctuation

Fact-1: Economic Fluctuation Are Irregularand Unpredictable.

Fluctuation in the economy are often called thebusiness cycle. As this term suggests economic

fluctuations correspond to changes in businessconditions. When real GDP grows rapidly,business is good. During such period ofeconomic expansion most firms find thatcustomers are plentiful and that profits are

growing. When real GDP falls during recessionbusinesses have trouble. During such period ofeconomic condition most firms experiencedeclining sales and dwindling profits. Businesscycle are not regular and predictable.


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Key Facts About Economic Fluctuation Fact-2: Most Macroeconomic Quantities Fluctuate Together.

Real GDP is variable that is most commonly used to monitor short-runchanges in the economy because it is the most comprehensive measureof economic activity. Real GDP measures the value of all final goods andservices produces within a given period of time. It also measures the totalincome (adjusted for inflation) of everyone in the economy.

It turns out however that for monitoring short-run fluctuations it does notreally matter which measure of economic activity one looks at. Mosteconomic variables that measure some type of income, spending, orproduction fluctuate closely together. When real GDP falls in a recession,so do personal income, corporate profits, consumer spending, investmentspending, industrial production, retail sales, home sales, auto sales andso on. Because recession are economy-wide phenomena, they show upin many sources of macroeconomic data.

Although many economic variables fluctuate together they fluctuatedifferent amounts. Even though investment averages about one-seventhof GDP declines in investment account for about two-third of the declinesin GDP during recessions. In other words, when economic conditiondeteriorate much of the decline is attributable to reduction in spending onnew factories, housing and inventories.


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Key Facts About Economic Fluctuation

Fact-3: As Output Falls, Unemployment Rises.Changes in the economys output of goods and servicesare strongly correlated with changes in the economysutilization of its labor forces. In other words, when realGDP declines the rate of unemployment rises. When

firms chose to produce a smaller quantity of goods andservices they lay off workers, expanding the pool ofunemployed. In each of the recessions theunemployment rate rises substantially. When therecession ends and real GDP starts to expand, theunemployment rate gradually declines. Theunemployment rate never approaches zero; instead itfluctuates around its natural rate of about 5% or 6%.


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Short-run Economic Fluctuations The Assumption of Classic Economics:

What determines most important macroeconomicvariables in the long-run is based on related ideas theclassical dichotomy and monetary neutrality. Accordingto the classical macroeconomic theory, changes in themoney supply affect nominal variables but not realvariables. Money does not matter in classical world. Ifthe quantity of money in the economy double everythingwould cost twice as much and everyones income wouldbe twice as high. The change would be nominal, but thepeople really care about weather they have jobs, howmany goods and services they can afford and so on.

Nominal variables are the first things observed when weobserved an economy because economic variables areoften expressed in units of money. But real variables andforces that determine them are important.


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Short-run Economic Fluctuations

The Reality of Short-Run Fluctuation:

Most economist believe that classic theorydescribes the world in the long run but not in theshort run.

Change in money supply affect prices and othernominal variables but do not affect real GDP,unemployment, or other real variables asclassical theory says. When study year-to-yearchanges in the economy, the assumption of

monetary neutrality is no longer appropriate. Inshort-run real an nominal variables are highlyintertwined and changes in the money supplycan temporarily push real GDP away from itslong-run trend.


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Short-run Economic Fluctuations

Modal of Aggregate Demand and AggregateSupply:

The modal that most economists use to explainshort-run fluctuations in economic activityaround its long-run trend.

Aggregate Demand Curve:that shows thequantity of goods and services that households,firms, the government and customers abroadwant to buy at each price level.

Aggregate Supply Curve:that shows thequantity of goods and services that firms chooseto produce and sell at each price level.


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The Aggregate Demand CurveOther things equal, a decrease in the economys overall level of prices (from P1 to P2)

raises the quantity of goods and services demanded (from Y1 to y2) and vice versa.

Aggregate Demand

Y1 Y2

P2

P1

2increases the quantity of

Goods and services demanded

1.. A decrease

in the price level

Quantity of

output

Price

level

0


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Why the Aggregate Demand Curve Slopes Downward

Y=C+I+G+NX

Each of these four components contributes to the aggregate demand forgoods and services. Government spending is fixed by policy, other three

depend on economic conditions and in particular on the pric e level.

Consumption: the wealth effect, a decrease in the price level raises the

real value of money and makes consumer wealthier, which in turn

encourages them to spend more. The increase in the consumer spending

means a larger quantity of goods and services demanded, and vice versa.

Investment: the in terest rate effect, a lower price level reduces the

interest rate, encourages greater spending on investment goods and

thereby increases the quantity of good and services demanded, and vice

versa.

Net Export: the exchange-rate effect, when a fall in the Pakistans pricelevel causes Pakistans interest rate fall, the real value of the Pak-Rupees

decline in foreign exchange market, and this depreciation stimulates

Pakistan Net Exports and thereby increase the quantity of goods and

services demanded, and vice versa.


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Why the Aggregate Demand Curve Might Shift

many other factors affect the quantity of goods and services demanded at a

given price level. When one of these factors changes the aggregate demandcurve shifts.

Change in Consumption:Any event that changes how much people want toconsume at given price level shifts the aggregate demand curve. Increase inconsumer spending means a greater quantity of goods and services demandedat any given price level, so the aggregate demand curve shift to the right.

Change in Investment: any event that changes hoe much firms want to investat a given price level also shift the aggregate-demand curve. If firms becomeoptimistic about the future business conditions, they may invest more oninvestment spending shifting the aggregate-demand curve to right.

Change in the Government Purchases: the most direct way that policymakersshift aggregate-demand curve is through government purchases. If Governmentof Pakistan starts building more highways the result is a greater quantity

demanded at any given price level, so the aggregate-demand curve shift to theright.

Change in Net Exports: any event that changes net exports for a given pricelevel also shifts aggregate-demand. When foreigners star buying more goodsand services of Pakistan, this increases Pakistans net exports at every pricelevel and shift the aggregate-demand curve to right.


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The Aggregate-Supply Curve

in the long-run the aggregate-supply curve is vertical, because in the long-run an

economys production of goods and services (its real GDP) depends on its supplies of

labor, capital, and natural resources and on the available technology used to turn thesefactors of production into good and services.

Price

levelLong-run

Aggregate-

supply

Natural rate

Of output

P1

P2

2 does not affect

The quantity of goodsAnd services supplied

In the long-run.1.. A change

In the price

levelQuantity of

output


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Why the Long-Run Aggregate-Supply Curve might Shift

The long-run aggregate-supply curve is vertical because in long-run

the overall level of prices does not affect the economys ability toproduce goods and services.

Long-run level of production is sometimes calledpotential output orfull-employment. We call it the natural rate of outp ut; the

production of goods and services that an economy achieves in the

long-run when unemployment is at its normal rate, because it showswhat the economy produces when unemployment is at its natural ornormal rate.

Any change in the economy that alters the natural rate of outputshifts the long-run aggregate-supply curve, because output in theclassical modal depends on:

Change in Labor Change in Capital

Change in Natural resources

Change in Technological Knowledge


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Why the Aggregate-Supply Curve Slopes Upward in the short-Run

In the short-run the price level affects the economys output, over a period of a year or two an

increase in the overall level of prices in the economy tends to raise the quantity of goods and

services supplied.

Price

level

Quantity of

output

Y2 Y1

P1

P2

Short-run

Aggregate

supply

1.. A decreaseIn the price

level

2 reduces the quantity

Of goods and servicesSupplied in the short0run.


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Why the Aggregate-Supply Curve Slopes Upward in the short-Run

In the short-run the price level affects the economys output,over a period of a year or two an increase in the overall levelof prices in the economy tends to raise the quantity of goodsand services supplied.

Macroeconomists proposed three theories for the upwardslope of the short-run aggregate-supply curve.

The Sticky-Wage Theory : an unexpected low price levelraise the real wage, which causes firm to hire fewer workersand produce a smaller quantity of goods and services.

The Sticky-Price Theory : an unexpected low price levelleaves some firms with higher-than-desired prices, whichdepresses their sales and leads them to cut back production.

The Misperceptions Theory: an unexpectedly low pricelevel leads some suppliers to think their relative prices havefallen, which induces a fall in production.


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Long-Run Growth and Inflation in AD & AS Modal

As the economy becomes batter able to produce goods and services over

time, primarily because of technological progress, the long-run AS curveshift to the right. At the same time, as the SBP increases the money

supply, the AD curve also shift to the right. Long-run trend provide backgrou ndfor s hort - run f luctuat ion.

Price

level

Quantity of

output

AD1980

AD1990

AD2000

Y1980 Y1990 Y2000

P1980

P1990

P2000

AS1980 AS1990 AS2000 1. In the long-run

technological

progress shiftslong-run AS

2.. And growth

in the money

supply shifts AD

3 leading to

growth in output..

4. And ongoing

inflation

0


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Causes of Economic Fluctuations

Output and the price level are determined in the long-run by the intersection of the

aggregate-demand curve and long-run aggregate-supply curve. At equilibrium point output is

at its natural rate. Because the economy is always in a short-run equilibrium, the short-runAS curve passes through long-run equilibrium point as well, indicating that the expected

price level has adjusted to this point. That is when an economy is in its long-run equilibrium

the expected price level must equal the actual price level so that the intersection of AD with

short-run AS is the same as the intersection of AD with long-run AS.

Price

level

Equilibrium

price

0Natural rate

of output

Aggregate

demand

Short-run

Aggregate

supply

Long-run

Aggregatesupply

A

Quantity of

output


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The Effects of a Shift in Aggregate Demand: a wave of pessimism (outbreak of war,

crash stock market, emergency in country, and may be government scandal etc);

suddenly overtakes the economy. Because of such events many people loss theirconfidence in the future and alter their plans; households cut back in their spending and

delay their major purchases and firms put off buying new equipment.

The falling level of output indicates that the economy is in a recession, firms respond to

lower sales and production by reducing employment, that cause the shift in AD curve and

leads to falling incomes and rising unemployment.

The reduction in AD the price level falls from the level people expected before the suddenfall in AD.

People will not remain surprised; over time expectation catch up with this new reality. The

fall in the expected price level alters wages, prices and perception, which in turn influences

the position of the short-run AS curve.

In the long-run equilibrium point output is back to its natural rate. The economy has

corrected itself. The decline in output is reversed in the long-run without action by policymakers.

In the short-run shift in the AD cause fluctuation in the economies output of goods and

services.

In the long-run shift in the AD affect the overall price level but do not affect output.

Policymakers who influence AD can potentially mitigate the severity of economic

fluctuation.


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Causes of Economic Fluctuations The Effects of a Shift in Aggregate Demand: when the AD curve shifts to the left,

for instance output and prices fall in the short-run. Over time as a change in the

expected price level causes wages, prices and perceptions to adjust the short-run AScurve shifts to the right and economy returns to its natural rate of output at a new

lower price level.

Long-run

Aggregate

supply SR AS1

SR AS2

AD1

AD2

C

B

A

Price

level

Quantity of

output

3,,,but over

time the short-

run AS curve

shifts..

1. A decrease

in AD

4.and output returns to

its natural rate.

2..causes output to fall in the short-run

P1

P2

P3

0 Y2 Y1


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The Effects of a Shift in Aggregate Supply:suddenly some firms experience an

increase in their cost of production, may be because of bad weather in farm states

might destroy some crops, driving up the cost of producing food products, or a waragainst terrorism, cost of crude oil, cost of raw materials or rise in minimum wage, etc

Change in the production costs alter the position of AS curve. An increase in

production cost affects the firms supply of goods and services; shifts short-run AS

curve to the left.

The economy goes from moving along the existing AD curve

The output of the economy falls and the price level rises. Economy is experiencingboth stagnation and inflation, simply called stagflat ion.

Firms and workers may at first respond to the higher level of prices by raising their

expectations of the price level and setting higher nominal wages. In this case firms

cost will rise again and stagflation even worse.

The phenomenon of higher prices leading to higher wages in turn leading to even

higher prices is called a wage-price-spiral. The low level output and employment put downward pressure on the workers wages,

because workers have less bargaining power when unemployment is high.

As nominal wages fall producing goods and services become more profitable and

short-run AS curve shifts to the right; the price level falls and the quantity of output

approaches to its natural rate. Where the AD curve crosses the long-run AS curve.


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Causes of Economic Fluctuations The Effects of a Shift in Aggregate Supply: when the AS curve shifts to the left,

the short-run effect is falling output and rising prices. Over time as wages, prices and

perceptions to adjust the price level falls back to its original level, and outputrecovers.

Long-run

Aggregate

supply SR AS2

SR AS1

AD1

A

B

Price

level

Quantity of

output

1. An adverse

shift in the

short-run AS

curve

2,,cause output to fall

3and

the price

level to

rise

P2

P1

0 Y2 Y1

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